25 Mar 2021
19/03/2021 | Multiple authors
The Covid-19 pandemic has accelerated numerous pre-existing macroeconomic trends, including a dramatic rise in global debt. Our global macro and strategic asset allocation team examines the primary driver behind this: fiscal spending to mitigate the effects of the pandemic. We also assess the differing approaches to fiscal policy taken by the US, the European Union and China.
Eager to avoid errors made in the 2010s, developed market policymakers are taking advantage of highly accommodative central banks to enact as much fiscal intervention as legislative rules will allow. The coordination between the Federal Reserve and the ECB and their respective governments has never been higher in the last half century.
We expect the US to continue to deploy enormous fiscal spend of both types, due to a confluence of factors, including lack of automatic stabilisers, the need to undertake remedial infrastructure investment and the surprise Democratic sweep in the 2020 election cycle. Total discretionary fiscal spending in 2020-24 is expected to reach $8.6 trillion in the US, or 40% of GDP. This has the potential to have highly reflationary impacts on the global economy.
The EU has spent less on Covid fiscal relief than most other developed regions, partly due to existing strong automatic stabilisers. The European Commission (EC) relaxed the bloc’s fiscal rules and succeeded in coordinating a €750bn discretionary fiscal investment plan equal to roughly 8% of GDP. The programme will be funded with bonds issued by the EC, a step toward debt mutualisation. Elections to be held in September in Germany, and the EC’s treatment of fiscal prudence rules at year end, may signal whether Europe will sustain its pivot toward fiscal coordination.
China stands out as moving in contrary motion on fiscal spend compared to the US and Europe. Its quicker and more successful handling of the pandemic gives China the flexibility to pull back on spending and make further progress on controlled deleveraging. We expect China’s overall fiscal deficit to shrink from -13.6% in 2020 to -10.5% in 2021.
Just as China’s stimulus announced in 2009 reflated its own and the global economy in the GFC, total US fiscal spending since Covid began – which could approach 40% of GDP spent over several years – will also have significant impacts on the global macroeconomy and market conditions. Specifically, we expect US fiscal policy will necessarily lead to more and likely stronger tests of the Fed’s credibility, as growth and inflation expectations reach new highs with each subsequent fiscal package.
In this era of fiscal dominance (when an indebted economy requires monetary support to stay solvent), central banks including the Fed will have no choice but to use their full range of tools to try to keep real yields in check, lest the interest expense burden of public debt becomes unsustainable. Hearkening back to WWII and post-WWII periods when debt was at similarly high levels, negative real rates in themselves will be the new policy goal.
Overall, we expect the global fiscal impulse to decline in 2021 versus 2020, a natural development given easing lockdowns and widespread vaccinations boosting economic activity. However, after an initial surge in global growth, a full recovery in activity and closing of output gaps will be more difficult to achieve, a challenge that fiscal and monetary policy would have to continue to address.
Debates have emerged in recent weeks over whether the amount of US fiscal spending in 2021 is becoming too much, with the potential to lead to unwanted inflationary pressures longer-term and market dislocation in the shorter term (for example, creating a bond market tantrum).
We believe that the relationship between real yields and breakevens is the key signal to watch, and that a sustained rise in real yields is untenable, given the very heavy debt burden coming out of Covid fiscal spend. Over the medium term, tax policy will also shape market sentiment through its impact on corporate earnings as well as income and wealth redistribution.
Important information
This information is for investment professionals only and should not be relied upon by private investors. Past performance is not a reliable indicator of future returns. Investors should note that the views expressed may no longer be current and may have already been acted upon. Changes in currency exchange rates may affect the value of investments in overseas markets. Investments in small and emerging markets can be more volatile than other more developed markets. The value of bonds is influenced by movements in interest rates and bond yields. If interest rates and so bond yields rise, bond prices tend to fall, and vice versa. The price of bonds with a longer lifetime until maturity is generally more sensitive to interest rate movements than those with a shorter lifetime to maturity. The risk of default is based on the issuer's ability to make interest payments and to repay the loan at maturity. Default risk may therefore vary between different government issuers as well as between different corporate issuers. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only.