Macro update

Risk markets continue to grind higher, even as economic data and forecasts further discount hopes for a swift economic recovery. For now, it is all about growth in money supply facilitating public sector spending to offset a private sector collapse. Eventually, this system will have to rebalance in a way that is unlikely to be pleasant for financial markets.

• Promised spending is already past $17 trillion globally and is likely to reach $20 trillion.
• Unless governments maintain existing levels of stimulus through to 2021, the private sector will need to expand global GDP by around 4 per cent in order to keep growth flat.
• The majority of the borrowing is being done by the US, a country best positioned to bear the burden.

Equity markets hit the lows in March when the US Federal Reserve announced that its monetary support would be effectively unlimited, and practically overnight the systemic stress in the financial system disappeared. Thus, correlated (if not coordinated) central banks actions prevented an economic collapse.

However, the financial backstop provided by the Federal Reserve has thus far been largely unutilised by the private sector. So far, less than 5 percent of the available liquidity has been tapped by the private sector, which is all for the best. The mere existence of the central bank’s support has been enough to keep liquidity flowing in the markets and thus preventing cash-crunch driven bankruptcies, but it is unlikely to prop up earnings.

Much of the promised central bank liquidity promised will be taken up by the public sector, if not the private sector. Another week passes and another few trillion of fiscal stimulus has been put on the table. China has announced an increase in the fiscal deficit by over $800 billion, Japan has pledged another $1.1 trillion, and the debate in the United States is heating up for as much as $1.5 trillion of additional spending in the coming months. The most significant spending announcement this week, however, was the relatively “modest” proposal for the EU to provide €500 billion of grants to the hardest hit members (with another €250 billion of loans). In this case, the significance is less about the size of the stimulus and more about the political rubicon being crossed with implicit mutualisation of EU liabilities.

“In sum, the promised spending is already past $17 trillion globally, and likely to reach $20 trillion – something on the order of $2,500 per person on the planet.”

Of course, the devil is in the details. An increase in spending by central governments, for example, will be partially offset with reduced spending by cash-strapped regional governments. Moreover, there is some accounting trickery to financial stimulus promises, so the amount ultimately delivered will likely not equal the amounts initially announced. Finally, not all spending will have the same impact – a bridge to nowhere, a wage support subsidy to a struggling firm, or a cash payment to every citizen will all vary in their effect on growth.

Setting aside these devilish details, it looks like the change in the global cyclically adjusted primary fiscal balance as a percent of GDP will be above 4 percent in 2020. That compares to a cumulative 2.8 percent over 2008 and 2009, which was itself easily the highest level of fiscal stimulus since World War 2, and makes no allowance for another round of support in 2021. Putting back in the cyclical factor – reduced tax receipts and increased counter-cyclical spending – and the global budget deficit for 2020 will probably be around 13% of GDP.

This begs three questions – who spends and who receives, what happens tomorrow and how does the bill get settled in the end?

About two-thirds of the stimulus spending is coming from the developed markets, with the US in the lead. This is basically because they can. The US, Japan, maybe Britain, China (reluctantly) and Europe (belatedly) all have some ability to finance public spending by transferring the burden to central bank balance sheets. Unsurprisingly, these countries will all focus on spending their money domestically as much as possible. Thus, developed markets will spend and developed markets will receive, leaving emerging markets in the cold.

In 2021, or 2022 if programs are extended, the fiscal tailwind will at best disappear and thus become a headwind. If the temporary surge in government spending is to contribute 4 percentage points to GDP growth this year, then the absence of this contribution in the following year will result in a 4 percentage point deceleration in the rate of growth, all else equal. Of course, all else is never equal and a rebound in private sector activity should help growth next year. Nonetheless, unless governments maintain the stimulus in 2021, the first 4 percentage points of private sector contribution to global GDP growth will just offset the absence of stimulus. Thus, todays boost will be tomorrows drag.

“Eventually the carousel will stop, and the public sector debts incurred on behalf of their private sector citizens and shareholders will have to be resolved.”

The global public debt to GDP ratio is likely to reach 100% by the end of 2021, which is at or slightly above the level at which debt burdens are associated with structurally lower growth rates. Of course, that is a global average – around a third of all countries will face an even larger debt to GDP ratio. Ultimately, there are only four ways to retire a debt – grow out of it, inflate out of it, pay it down, or default:

• If interest payments are lower than income growth and the debt is not increased, then over time (perhaps a very long time) the debt to GDP ratio will decline.
• If the rate of interest paid is less than the rate of inflation, then the value of the debt relative to GDP will decline.
• If spending is constrained and/or taxes increased, then a primary surplus will pay down the debt over time.
• The borrower can refuse to pay the debt, either by extending duration, reducing payments, or replacing a hard currency with a soft currency.

Ultimately, it will likely be some combination of all of the above.

There is good news, and there is bad news. The good news is that most of the borrowing is being done by the country best positioned bear the burden – the United States. The US is the largest economy in the world, has relatively attractive demographic and productivity trends, entered the crisis with a still-manageable debt level and most importantly, can borrow from itself in its own currency. The bad news is that even the US will eventually have to settle the debt.

For those who enjoy financial market history, in 2008 a surprise bestseller was Adam Fergusson’s When Money Dies, a gripping page turner about the Weimar experience with debt and hyperinflation. Alarm during the Global Financial Crisis over the heretofore unprecedented experiment with quantitative easing proved unfounded, as disinflation and not 1920’s German-style hyperinflation took hold. Fast forward to 2020 and the next crisis, and policy makers have even more eagerly embraced quantitative easing. Perhaps this time money will live on, but in any case, it seems inevitable that one day there will be another economic crisis. When that day comes, public sector finances are unlikely to have been restored, and thus policy makers will again turn to quantitative easing and de facto debt monetisation. Policy makers will resort ever more frequently to ever greater bouts of money printing because it hasn’t hurt – yet.

Eventually the carousel will stop, and the public sector debts incurred on behalf of their private sector citizens and shareholders will have to be resolved. When this happens, it will likely be with a combination of higher taxes, higher inflation, less growth and less appetite for risk. Right now, none of this is priced into the markets. Perhaps one day it will.

Next steps

• If you have any questions please contact your Dolfin relationship manager
• If you would like further information, please read our Q2 2020 investment outlook on our website
• To watch our Dolfin Discussions and Beyond Coronavirus series of videos, visit the research section of our website