From debt do us part

WHAT YOU NEED TO KNOW

 

• One of the key long-term legacies of the COVID-19 pandemic is very high debt levels across the world. Coping with such an unprecedented economic and fiscal burden requires governments being able to fund at affordable costs.


• Historical and geographical precedents, along with our own calculations, suggest that the typical response of central banks is engineering negative real interest rates across the yield curve for a long time.


• Whether this approach creates consumer price inflation over the medium term is an open question. But lowering the discount rate applied to risk assets is likely to boost their present value. Therefore, a likely outcome is asset price inflation.


 

We recently published our Counterpoint 2020 Mid-year Outlook against the backdrop of a global health crisis and an unprecedented economic contraction. Just as extreme was the monetary and fiscal policy response. These events, despite their unusual trigger (a pandemic), seem to follow the pattern of past cycles to a much greater extent than one may think at first sight. So historical analysis of what happened during prior recessions can help us shed some extra light on what’s likely to happen going forward – not just in the near future, but also over longer horizons.

HOW NORMAL IS THIS CYCLE? WE THINK QUITE A BIT, FOR THREE REASONS:

First, the conditions that existed at the start of this year shared many characteristics that preceded other recessions: low unemployment, rising inflation, high market valuations, low volatility, confident consumers and an inverted yield curve, just to name a few. Of course, most of these late-cycle characteristics applied to the US. Europe, with less inflation and more spare capacity, was closer to a mid-cycle economy.

Second, the way the market bottomed in March relative to still deteriorating economic data was also similar to prior recessions – reflecting the forward-looking nature of financial markets, which tend to anticipate economic developments captured in lagging statistical releases.

Third, the way economic data is behaving looks relatively normal too. It takes six months for manufacturing activity, as measured by the US ISM index, to return to expansionary territory from the lows. Several past cycles have seen this happening within three or four months. The latest crisis turned out to be the sharpest and most likely shortest of all, taking just two months from the trough in the Institute for Supply Management (ISM) to get back to signal expansion, but the pattern appears rather common.

A SHARP AND SHORT RECESSION

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