The easing of the coronavirus lockdowns has led to a resurgence of global economic activity in recent weeks. However, many businesses will not be able to continue after suffering major revenue losses and millions of workers have lost jobs. Will this resurgence turn into a durable economic recovery, or will the post‑lockdown green shoots wither and die?
Following a recession, it historically takes, on average, six quarters for GDP to reach its pre‑recession level. The size of the economic shock and the unique circumstances of the current recession suggest it will take a little longer this time. We believe there are six key risks presenting acute challenges to the economic recovery.
The second wave
Most, if not all, countries in the world are far from the threshold of contagion for herd immunity, and it may take a while to produce a vaccine for Covid-19. Against this backdrop, the key question becomes whether common sense social distancing will allow us to reopen our economies without driving up the reproductive rate of the virus. The experiences of South Korea and Singapore, and early indications from Europe, provide some hope this may be possible. If it is possible for countries to reopen without triggering a serious second wave of contagion, the global economic recovery will, most likely, continue. However, a second lockdown would result in a double‑dip recession.
US‑China tensions
The US presidential election is looming, and China is portrayed as a villain by both Republicans and Democrats. The US has tried to integrate China into the global economy in the hope, over time, growing prosperity will encourage its citizens to demand more democracy. However, it is now clear to the US policy apparatus that this effort has failed. At the same time, China is getting ahead in the technology race, which means the US faces a more formidable challenge from a competing governance system than it ever did from the Soviet Union. Uncertainties over the future of relations, the pressure to relocate supply chains and restrictions on the export of technology and other trade are risks to the recovery. Friction in the relationship has clearly escalated and there will be plenty of noise ahead of November’s presidential election.
US corporate defaults
US non-financial corporates have taken on a substantial amount of debt in recent years – from 66 per cent of GDP in 2012 to 75 per cent of GDP in 2019. This raises the question of whether a tsunami of corporate defaults is likely. We are less concerned about this than consensus, for three reasons. First, debt has been assumed at low interest rates, which keeps the cost of servicing at a surmountable level. Second, the US government has provided support through the $660bn Paycheck Protection Program. Third, the balance sheets of leveraged financial intermediaries are in a much better position than prior to the global financial crisis. Based on the low cost of debt servicing and the absence of a capex boom, our internal models point to a default rate for the US high yield sector in the 7-9 per cent range. Of course, should the economy be hit by another shock, such as a second lockdown, all bets are off.
Developed market fiscal consolidation
Governments have taken significant steps to support economies during the crisis. Most developed market economies have the institutional infrastructure to monetise the deficits through quantitative easing (QE), and in most cases the stock of debt will never be reduced – countries will simply ‘grow out of it’. For this reason, we are not overly concerned about ballooning developed market debt stocks. A more pressing issue is whether growth will be sufficiently resilient to withstand the headwind that follows when countries inevitably embark on fiscal consolidation. We believe fiscal consolidation will follow a similar path to that seen during the global financial crisis, when temporary measures were extended as far as possible before being phased out slowly. However, if policymakers come under pressure to reduce deficits more quickly, there is the potential for missteps.
Emerging market fiscal crisis
We are more concerned about the fiscal trajectory of the emerging economies, as most are plagued by weaker institutional infrastructures, reducing the capacity to shoulder fiscal deficits. In addition to a large fiscal deficit, the countries particularly exposed are reliant on external financing – an inherently more fragile arrangement than domestic financing. South Africa and Brazil are among the emerging market countries at risk of fiscal crises, as well as Turkey and Colombia. Non‑China emerging markets account for 21 per cent of global GDP, so while a fiscal crisis in emerging market economies would hurt the global economy, its impact would likely be manageable. The unique circumstances of each emerging market country will also create idiosyncratic opportunities.
Another eurozone crisis
Southern eurozone countries have experienced a decade of depressed growth, which has left populations frustrated and angry. The economic damage caused by the current crisis is likely further strengthen the populists’ cause. The €750bn Franco‑German Recovery Fund is an attempt to deliver enough fiscal solidarity to quell the populist surge, but whether it succeeds remains to be seen. The devil is in the details, and we worry the EU will become embroiled in a discussion over what poorer members need to deliver in return for receiving loans. We are encouraged by the steps toward pan‑EU fiscal solidarity, but we remain sceptical we have seen the end of populist policymakers. We believe voters in financially challenged eurozone countries can, after a decade of abysmal growth, look forward to another decade of scarce opportunities – hardly the bedrock of a stable political environment.
Nikolaj Schmidt is chief international economist at T. Rowe Price. The views expressed above are his own and should not be taken as investment advice.