The author is President of the University of Cambridge's Queens & # 39; College and an advisor to Allianz and Gramercy
Global economic thinking in terms of austerity measures has changed dramatically. This was made clear at the annual meetings of the IMF and World Bank earlier this month.
In sharp contrast to what the IMF and others had called for after the 2008 global financial crisis, high-profile figures at the meetings encouraged governments to "find their way out of the pandemic."
The world will now see a further rise in debt and deficits from what most economists and financial market participants would have thought unthinkable nine months ago.
Many markets may be tempted to see this as unequivocally good news, ushering in a time when fiscal policy has reliably and repeatedly worked with monetary policy to flood the system with liquidity and raise asset prices around the world.
The impact is likely to be much more nuanced, however – dominated by a pronounced dispersion in the risk-return outlook for companies and countries as opposed to another significant “collapse” in equities, emerging markets and corporate bonds.
A tax bridge over a damaged economic landscape due to Covid-19 is seen as critical to preventing viable businesses from going bankrupt
The change in austerity reflects a review of what is both desirable and feasible. It is almost universally recognized that governments should do all they can to avoid “scars” that structurally embed short-term problems into the economy.
A fiscal bridge over a damaged economic landscape due to Covid-19 is seen as critical to preventing viable businesses hit by a money crisis from going bankrupt and vacations from turning into long-term unemployment.
This approach is now more workable as interest rates are extremely low and central banks willingly buy an unimaginable amount of government and corporate bonds, unimaginable not so long ago.
It is tempting to view this as clearly good for the prices of financial assets that have long been supported by loose monetary policy. In fact, it may seem even better as large deficits not only inundate the system with central bank-funded funds, but also include direct grants and other forms of income support for high-concession households.
However, the notion of general market support must be highly qualified. As we continue to live with Covid-19, we should expect government support to gradually shift from a universal to a more selective approach: people over businesses, viable sectors over permanently damaged and more partial household income replacements.
The result will be a growing distinction between preferred stocks and bonds versus orphaned. The former includes several names from the healthcare, technology, and green economy sectors. The latter is heavily influenced by hospitality and other elements of the service sector. These are exposed to a significantly higher risk in the event of bankruptcies and a weakening of contract debts.
Countries will also differ in their ability to maintain high deficit spending. What is not a problem for the US will be a headache for many developing countries, as the rapidly increasing debt and debt service obligations make it more difficult to finance themselves through the capital markets.
With their growth models and currencies also in question, they will turn more to the IMF and other official funding sources. The only real question is whether these will be preventative and orderly for some subsequent debt rescheduling or will instead involve a default on previous payments.
This greater diversification of market winners and losers will come at a time when investors struggle to find reliable risk mitigators.
With central bank market intervention pushing yields to very low – if not negative – levels, government bonds risk falling prices as markets react to ever higher debt and hopefully better growth prospects. This applies in particular to longer-term maturities, unless the central banks exceed a rubicon in the event of financial market distortions by opting for an explicit return target for maturities that are far outside the range of their reference interest rate.
The old days of all-powerful vigilante groups might actually be over for the time being. That does not mean, however, that another well-intentioned – indeed necessary – surge in debt and deficit is clearly good for the markets.
From a ROI perspective, it will likely only support certain sectors and companies, as well as a subset of countries around the world. Elsewhere, it may not be enough to avoid the bankruptcies and debt rescheduling that go hand in hand with a global recovery that is too weak, too uneven and too uncertain.