With governments around the world implementing quarantines and lockdowns to slow the spread of COVID-19, a global recession is now unavoidable. The big question is whether it will be sharp but short-lived, lasting two or three quarters, or a more sustained economic downturn. Even a short recession will be deep, but economic growth could come charging back once peak virus fears are behind us. This more benign type of recession would occur if efforts to bring the virus under control succeed within a few months; however, we could be in for something more lasting and damaging if economic contagion spreads and certain tipping points are reached.
One economic vulnerability of concern is the record-high level of U.S. corporate debt. We have often pointed out that this is unlikely to spark a recession by itself but could make matters more difficult during the next downturn. Many of these companies are reliant on steady economic growth and low interest rates. Even a short, sharp economic contraction could increase distress and cause a generalized fallout for companies with marginal finances. Total leverage in China has been another perennial downside risk factor. This has the potential to complicate matters for Chinese policymakers as they attempt to ramp up economic growth after the economy has experienced a sudden stop.
Corporate America’s Debt Binge May Come Back to Bite
Source: Datastream as of 3/20/20.
Leverage risks extend to other emerging markets, especially in Asia, where companies have borrowed in dollars to finance their operations, taking advantage of the low rates abroad. The current panic in financial markets has led to a surge in the value of the U.S. dollar, given its safe-haven characteristics. To service and pay principal on this debt, these companies need dollars. The soaring demand for the currency has made it scarce and expensive, increasing the burden of dollar-denominated debt. The dollar shortage is exacerbated by the fall in trade activity and foreign trade flows. This dynamic raises the risk of an emerging market debt crisis, as a second-order effect of current market turmoil.
Another development amplifying the coronavirus shock is the oil price plunge triggered by the Saudi/Russia oil price war, which could not have come at a worse time. The massive decline in crude oil prices is already threatening debt-servicing capacity of high yield energy companies, causing their spreads to blow out and defaults are likely to follow. Lower energy prices will have a beneficial impact on global consumers, but these benefits are diffuse and realized over a period of time, while the costs for energy-producing firms and countries are immediate and concentrated.
All eyes on policy makers
The response from global policy makers will play a critical role in determining whether collateral damage can be minimized. Global policy rates are re-converging at zero with central banks breaking out their financial crisis playbook, reintroducing quantitative easing and rolling out various liquidity measures. The U.S. Federal Reserve has gone “all in,” rolling out an extraordinary collection of measures, that even exceed in force and scope its response during the global financial crisis. It has cut its policy rate to zero, unleashed unlimited QE purchases of Treasuries and agency MBS, and—in conjunction with the Treasury—has taken steps to support a range of risky assets, including municipal bonds and corporate debt. The Fed has also enhanced and added to its existing dollar liquidity swaps, which it offers to foreign central banks to ease the current shortage of greenbacks. The idea is to alleviate some of the pressure in the currency market. The European Central Bank and the Bank of England have also taken emergency action and more than 40 other central banks have cut rates or taken easing measures. Such extraordinary measures on the monetary front are a necessary but insufficient measure in the policy-maker tool kit, and therefore the baton is passing to fiscal policy in the form of direct relief for workers and to businesses impacted by the crisis. Fortunately, governments around the world have adopted a wartime “whatever-it-takes” mentality and are throwing everything but the kitchen sink at the problem.
Even fiscal stimulus has its limits, in that it is more about treating the symptoms of the problem and cushioning the economic blow. Providing a pathway out of the crisis requires a coordinated and credible public health strategy that brings the spread of the virus under control. While there are many efforts underway by governments and perhaps some promising developments, public health experts believe the numbers will worsen over the near term and no way can say with certainty when the crisis will abate.
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