Navigating Uncharted Waters
Liam Pattison
On the surface an optimistic outlook on the future of advanced economies and their financial markets is a reasonable position. Indicators of economic growth continue to show positive signs and are driving financial markets upwards. Economies are recovering faster than expected, workers are in high demand and there is a global construction boom. So, why are some central bankers worried about the future of the global economy? The answer: the ending of government support packages.
During the pandemic, Australia and other advanced economies implemented fiscal policy which assisted their citizens and their economies as they battled through lockdowns. The policies implemented were unprecedented and, in most parts, successful in keeping economies functioning. However just like the initiation of these supports, winding down their accessibility will also be unprecedented.
Concerns about the consequences of removing these supports has recently been reported by the Bank for International Settlements (BIS) an institution of Central Banks, which includes the Reserve Bank of Australia. In their Annual Report (2021), the BIS outlines a scenario where the current economic recovery stalls. The BIS state that in this scenario a surge in firm insolvencies could occur and would have significant adverse impacts on economic recovery. To see how such a scenario could arise and is driven by government policy, it is useful to look at the USA as it is currently winding back fiscal support.
The USA has recently been reducing unemployment benefits across the country and has recently extended the nationwide moratorium on evictions until October. A survey conducted by the US Census Bureau (2021) shows that over 18% of renters have missed one or more rental payments. The problem is that by reducing cash transfers to unemployed citizens and lifting the eviction moratorium, consumers will have reduced incomes to spend and a significant proportion of them will have to pay their deferred rent or be evicted. As a result of consumers experiencing a reduction in their discretionary spending, firms may experience a drop in consumer demand which can affect their earnings to the extent that the firms go insolvent.
If insolvencies do occur, banks and other financial institutions would be hit hard, which could cause further trouble for the economy. An analysis by the rating agency Moody’s (2021), shows that during the pandemic US high yield bonds (also known as Junk Bonds) have become riskier as investors are only reclaiming 55% of capital in the instance of default which is significantly lower than the pre-pandemic average of 77%. This may be worrying for the holders of $435 billion worth of US high yield bonds issued last year. Interestingly, the high yield bond default rate is expected to fall to 4.1% this year. Although this is considerably lower than the Global Financial Crisis (GFC) rate of 14%, an economic downturn could cause, this relatively low default rate to increase to GFC levels.
From an economic outlook, these high levels of debt could raise serious problems. With firms already highly leveraged, if a decrease in consumer demand leads to the economic recovery slowing or even reversing, credit may not be as forthcoming as it was at the start of the pandemic. Furthermore, this problem is compounded if financial institutions reclaim less than average amounts of capital from high yield bonds. This potential lack of credit could result in firms not having access to the credit required to operate and thereby becoming insolvent. Even without insolvencies occurring, the current high level of debt held by firms will cause higher debt expenses compared to their debt expenses before the pandemic. To pay the interest and the underlying debt, some firms may have to lower their labour costs by reducing the number of staff or cut back on capital investment. Both choices can negatively affect future economic growth.
So, why would governments risk their economic recovery by removing these supports?
It is important to note that policy makers are balancing between short- and long-term economic growth. Whilst the supports may be helping the economy in the short term, it could be causing inefficient labour markets which can be detrimental to future economic growth. Inefficient labour markets can be seen by the existence of Zombie Companies, which are firms which would not have been able to operate under normal conditions and are kept alive by government payments. These Zombie Companies pose a problem for economic growth as they prevent an efficient allocation of resources within labour markets. This occurs as Zombie Companies can retain their workers but are unable to grow. Without government intervention, these companies would collapse, and productive companies would hire these workers to expand their business and the economy. The existence of Zombie Companies highlights the importance that policy makers must ensure that their payments are contributing to economic growth, rather than delaying eventual job losses.
Governments are in a fortunate position of having record low interest rates. These low interest rates have allowed governments to fund sustainably their fiscal policy by debt. This approach is considered sustainable as the expected economic growth is greater than the interest rates, allowing the government to stabilize or reduce their debt to GDP ratio, without increasing taxation.
Where to from here?
Policy makers must provide some level of comfort for the immediate economy whilst it recovers. However, policy makers need to ensure that the recovery is not at the expense of future economic growth. Countries which are still providing substantial support (e.g. Australia) should construct their future fiscal policy with consideration of the consequences experienced in countries which have removed some or all of their supports (e.g. USA).
Investors who understand potential motivations and consequences of policy can engage in deeper analysis. An understanding of how current monetary policy influences the current fiscal policy and thereby is influencing firms reliant on government payments, can help investors navigate towards greater returns in these uncertain financial markets.
References
Australian Broadcasting Corporation: Global construction boom sending timber and iron ore prices through the roof. https://www.abc.net.au/news/2021-05-15/construction-boom-sends-timber-iron-ore-prices-through-the-roof/100131678
Bank for International Settlements: 2021 Annual Economic Report June 2021 https://www.bis.org/publ/arpdf/ar2021e.pdf
CNBC: States cutting unemployment benefits didn’t get people back to work, study finds. https://www.cnbc.com/2021/07/22/cuts-to-unemployment-benefits-didnt-get-people-back-to-work-study-finds.html
CNBC” The Junk bond market is on fire this year as yields hit a record low. https://www.cnbc.com/2021/07/14/the-junk-bond-market-is-on-fire-this-year-as-yields-hit-a-record low.html
CNET: Biden extends eviction ban: What renters need to know about new 60-day order from the CDC. https://www.cnet.com/personal-finance/biden-extends-eviction-ban-what-renters-need-to-know-about-new-60-day-order-from-the-cdc/
Company Rescue: What is a Zombie Company? https://www.companyrescue.co.uk/guides-knowledge/guides/what-is-a-zombie-company-3931/
The Guardian: Western economies recovering faster than expected from Covid, says IMF.https://www.theguardian.com/business/2021/apr/06/western-economies-covid-imf-growth-forecast-us-uk
Financial Times: Labour shortages continue to disrupt economic recovery. https://www.ft.com/content/c3468f97-f30a-4d42-a277-bb6e31ab72f2
Marketwatch: Rising defaults in high yield bonds puts this year on track for post 2008.https://www.marketwatch.com/story/rising-defaults-in-high-yield-bonds-puts-this-year-on-track-for-post-2008-crisis-record-warns-goldman-sachs-2019-08-17
Reserve Bank of Australia (2021): The global Fiscal Response to Covid-19 https://www.rba.gov.au/publications/bulletin/2021/jun/the-global-fiscal-response-to-covid-19.html
Table 1b. Last Month’s Payment Status for Renter Occupied Housing Units, by Select Characteristics (Housing Tables) From Week 33 Household Pulse Survey: June 23- July 5 by United States Census Bureau. https://www.census.gov/data/tables/2021/demo/hhp/hhp33.html
The Economist: America’s high-yield debt is on ever-shakier foundations. https://www.economist.com/finance-and-economics/2021/06/17/americas-high-yield-debt-is-on-ever-shakier-foundations#
