I recently participated in a webinar for advisors and investors, Financial markets: Historical perspective and roadmap to recovery, followed by a brief Q&A session (you can watch a replay here). I’d like to take this opportunity to answer some of the questions we received but didn’t have time to address.
Q: Prior to the sell-off in February/March, the global economy already seemed to be teetering on the edge of recession. The post-COVID-19 period will likely see record unemployment, record deficits and soft consumer spending, yet the markets seem oblivious to these factors. Why is this?
A: This is an excellent question and we see this split between economic data and market performance quite often. In general, equity markets don’t trade on whether the economic data are improving or worsening, but rather on whether the rate of change is accelerating or decelerating. It’s not about whether things are good or bad, but rather the speed at which they are getting better or worse. In the present case, things may be getting worse, but at a slower rate than we have already seen.
For example, if unemployment claims rose 5% in week one, 10% in week two and 4% in week three. Clearly, another 4% rise in claims would be bad news, but it’s better than seeing the rate of change continue to climb (i.e., 12%). If the fourth week saw another increase of 4% or less, markets might view this as an improving trend, and trade higher.
The same can be seen in the rate at which COVID-19 is spreading. The number of new cases is increasing but, like the jobless claims data, is getting worse more slowly.1
Whenever I hear this question from investors, and I always remind them that the market may not wait for them to believe that things are finally “good.” It will move when it sees improvement, even if the news is still “bad.”
Q: How do you think governments will dig themselves out of the debt incurred by the virus response? Won’t taxpayers and those with money be expected to pay? What are the long-term effects of the U.S. Federal Reserve continually increasing its balance sheet?
A: There remains a great deal of confusion and conflict over whether government debt is good or bad. Historically speaking, the U.S. federal debt has risen steadily since the country’s founding. Far from being a constraint on growth, throughout the 20th century the U.S. has grown dramatically more prosperous, even as its debt has grown dramatically.2
This prosperity has underpinned the serviceability and sustainability of U.S. debt – the government can borrow more because the country as a whole is prosperous. This ability to access capital markets provides the U.S. with unrivaled fiscal flexibility needed to meet the current challenge.
The debt incurred in response to COVID-19 sounds staggering – the Coronavirus Aid, Relief, and Economic Security (CARES) Act alone cost US$2.4 trillion, which is more than the cost of social security, defense spending and discretionary spending combined for fiscal year 2019. The federal debt is projected to hit 122% of gross domestic product.3
While high by historical standards, this is only slightly higher than the peak of 119% of GDP, set in the World War 2 era. The ensuing growth over the following decades eased this burden, and I believe it will do so again.3
History has shown that rising debt has only increased demand for U.S. Treasury bonds. Government debt and spending have risen steadily over the past 30 years, yet interest rates have fallen dramatically. The attractiveness of U.S. debt has remained high as the world’s deepest and most liquid market at more than $20 trillion.4