The government moved swiftly to help diminish the impact of the coronavirus on the economy. In all, the federal government has spent close to $4 trillion in program assistance, direct giveaways and loans. This is roughly the amount in today’s dollars that the United States spent on World War II. However, the spending programs may not be enough to avoid a prolonged recession. In addition, the aggressive spending will have consequences and we expect the actions taken will have repercussions. Here are the themes we are working through at this time.
1) Continued credit deterioration in investment grade and high-yield issuers. The investment-grade bond market has become a means for established companies to refinance and term out existing debt. With U.S. Treasury rates below one percent, gradations of spreads between credit quality become less meaningful for companies that are able to lower their cost of capital regardless of the rating.
2) General obligation and essential service revenue municipal bonds historically are some of the most secure for investors. However, other types of municipal bonds, including municipalities that support arena and convention center bonds, economic development bonds and universities will be challenged during the recovery. Higher education may be forced to re-evaluate their model of charging high rates of tuition to support expensive infrastructure supported by student loans.
3) The domestic labor market will likely be impaired for several years as a portion of the positions for furloughed workers are permanently eliminated. We have moved from the best labor market in 50 years and ten years of job gains to a record 14.7% unemployment rate and the loss of over 20 million jobs in the month of April. We expect the travel and leisure sectors to take several years to fully recover.
4) It is estimated that 30% of the domestic labor force lives paycheck-to-paycheck. This includes service-sector workers who are the hardest hit in this downturn. Income inequality and our ability to provide support to lower-income workers will be a growing challenge over the next decade.
5) In order to fund the massive economic stimulus programs, we are running a budget deficit of nearly $4 trillion. That deficit is funded through the issuance of federal debt. The level of federal debt is expected to increase by over $4 trillion over the next two years. While the growth in federal debt is not a sin, the large debt burden ultimately will hamstring the country when it comes to the next crisis that requires stimulus. We are emptying the tank.
6) Our biggest concern for investors is Europe. The European Union is a cooperative of 27 member countries with each having their own political system, taxing authority, fiscal budget and debt issuance. However, they share a common currency, the euro. The problem the EU has is that the European buying of sovereign bonds is not proportional. In effect, the EU is subsidizing countries like Italy that have consistently run huge deficits to fund their government.
Recently, Germany’s high court in Karlsruhe, Baden-Württemberg, quietly ruled that by purchasing more than €2.2 trillion (nearly $2.4 trillion) of government bonds since 2015, the European Central Bank has “manifestly” flouted European Union treaty. Germany wants the bond buying to be proportional and does not want to be in a position to fund the ECB’s purchase of the debt of weaker EU countries. French president Emmanuel Macron recently fired a warning shot saying that without making all EU countries mutually responsible for the debts of individual countries, the EU could collapse.
The EU does not have euro-denominated debt. However, the ECB has asked eurozone finance ministers to consider a one-off joint debt issuance of “corona bonds” to assist with the coronavirus pandemic. This has been met with opposition by Germany and other northern European countries since they do not want to be responsible for the debts of other more spendthrift nations of the EU.
The large spending programs and rapid accumulation of debt in response to the crisis will likely impact the role of government in our society in future generations. We expect the economic recovery to be slow and pressure to continue on the labor market. This is going to feel like the slow recovery coming out of the financial crisis. The government response, on the heels of the financial crisis, will ultimately force a dialogue on the role of government in helping society and at what cost.
Gregory Hahn, CFA, is president and chief investment officer at Winthrop Capital Management in Indianapolis.