So much uncertainty surrounds the future path of coronavirus that it seems perverse that US equities in April staged their biggest monthly gain since 1987. In part the bounce back after the rout in March is an acknowledgment that central banks and policymakers will continue to throw everything at this crisis that can be thrown. There are no political constraints in addressing a pandemic that affects everyone in society equally.
Yet this endorsement is strictly qualified. The equity market recovery has been substantially driven by Microsoft, Apple, Amazon, Alphabet and Facebook, which together account for more than one-fifth of the S&P 500 market capitalisation. In other words, share prices are not pointing to a broad-based recovery. Nor are wider markets, with 10-year Treasury yields at record lows, oil prices severely depressed — even after a big rise this week — and emerging market currencies plunging against the US dollar since early this year. Also striking is how halfhearted the relief rally in global bank shares has been.
Nervousness in equities at the start of this week also served as a reminder that we are still in a world of intense trade friction. It is clear, too, that China, whose fiscal and monetary response to the 2007-08 financial crisis helped drive the global recovery, will not be offering similar help this time.
While speculation continues as to which letter of the alphabet will describe the shape of the post-coronavirus recovery, the letter V can safely be ruled out. The huge accumulation of corporate sector debt since the financial crisis means that those companies that manage to pull through will be restoring their balance sheets by paying down debt rather than investing. The retreat from globalisation and a switch from just-in-time supply chain management to just-in-case inventories will not be good for corporate profits. And with unemployment at levels not seen since the 1930s households will be averse to risk and anxious to increase savings. In the short term the environment will be hugely deflationary. Fiscal and monetary policy will have to bear all the burden of driving aggregate demand.
Even as the virus appears to retreat and economic recovery picks up, there is a big risk of policy error, argues Harvard University’s Jeffrey Frankel. He points out that President Roosevelt’s premature removal of fiscal stimulus after the 1930s depression inflicted severe recession in 1937-38. Much the same was true after the great financial crisis in the UK and elsewhere.
A more fundamental question about the recovery relates to the central banks’ asset-purchasing programmes. William White, former head of the monetary and economic department at the Bank for International Settlements, points out that repeated monetary easing to stimulate demand brings forward private spending in time, with purchases being financed by debt accumulation. As the weight of the debt burden increases, the effectiveness of monetary easing declines. In short, the continuation of ultra-low interest rates procures less and less growth.
On a longer run perspective, the problem is one of asymmetric monetary policy. Since 1987 the Fed has put a safety net under markets when confronting systemic threats, while choosing not to restrain prices when they are in bubble territory. This morally hazardous approach to monetary policymaking means central banks repeatedly set the stage for the next boom and bust cycle, fuelled by ever declining credit standards and ever expanding debt accumulation.
The Institute of International Finance, a trade body, estimates that global debt, both public and private, topped $255tn at the end of 2019. That is $87tn higher than at the onset of the 2008 crisis and it is undoubtedly going to be very much higher as a result of the pandemic.
The question, then, is how to break out of the asymmetric policy bind. In due course, potential measures could range from equalising the tax treatment of debt and equity; changing boardroom incentive structures that encourage debt-financed stock buybacks that weaken corporate balance sheets; and tougher competition policy to curb debt-financed takeovers that create near-monopolistic corporate giants.
The current debt overhang will never be repaid in full. With central banks directly monetising government deficits, much of the debt will ultimately be inflated away — which is something that fixed-income markets resolutely refuse to believe. Since the turn of the millennium, markets have been plagued by widespread mispricings of risk. Here, almost certainly, is another case in point.
Get alerts on Central banks when a new story is published