As Jim McCormick, of NatWest Markets, recently pointed out in a Financial Times article, in spite of the negative economic impacts of the pandemic to date, credit markets have been remarkably buoyant, with many indices actually positive year-to-date, and borrowing costs for companies perceived as creditworthy falling to very low levels.
The perception is that central bank actions (whether by the Fed, Bank of England, ECB or Bank of Japan) have been the key factor underpinning this outcome. In some senses, this is accurate, as markets perceive that the central banks have significantly widened the scale and scope of their operations and so will continue to “underpin the bid”.
However, while central banks can create liquidity, they cannot fix solvency. After all, eventually debt has to be repaid or re-financed, and that requires a business that has the ability to survive the pandemic and “come out the other side” in a viable (even if changed) form. Only governments can address solvency on an economy-wide basis.
To date, while varying in form, governments have provided support on a hitherto unprecedented scale through subsidies, rebates, deferrals, forgivable loans and outright grants. They can do all this because they can borrow (currently at very low, or even negative interest rates) and have the coercive power of taxation. Of course, that ability to borrow at such low rates is only feasible because of central bank policies and the continuing belief of investors that those same governments will be able (and willing) to honour their obligations when due. If that belief and confidence changes (likely to be tested if inflation eventually returns) governments will face a challenge. Modern Monetary Theory (MMT) posits that government spending can be paid for by the creation of money, with the purpose of taxes being to limit inflation, by controlling the money supply, so spending should not be determined by deficit levels. It may have suddenly become “fashionable”, but its robustness has yet to be tested.
And, as Mr. McCormick quite reasonably points out, what if “fiscal policy fatigue” sets in? Most politicians have short attention spans, little real understanding of economics and markets, and are driven by a desire to be re-elected. If electors’ own attention moves on to a different focus, will fiscal policies be maintained, or adapted to meet new needs, setting to one side the issue of funding all the commitments made? Once what one may call “solvency support” it taken away, or re-directed, then what?
Given the level of uncertainty which still attends the timing and likelihood of the pandemic being brought under control in many large economies, there is an increasing risk that at some point what amounts to a precarious equilibrium (created by central bank expansion of the money supply, ultra-low interest rates and trust in the current system) will come to an end, whether as the result of a change in capacity, or because of policy fatigue, even if economies are not “back to normal” in terms of activity and demand.
While we would not be so foolish as to make specific predictions on a macro-economic scale, it seems to us that at some point there will be a “winnowing” across a range of industries (including (re)insurance), which will separate the “prospering survivors” or beneficiaries of the pandemic from those who are not viable without continuing solvency support and/or a significant and swift rebound in demand for their products. Of course, as specialists in credit, economic and financial risks, our aim is to continue to make appropriate assessments and decisions at the micro level, and ensure the integrity of our existing portfolio and business model, while sourcing new business that will prove robust in the face of all the uncertainty.
Not straightforward in the current circumstances, but one we are confident it is achievable with appropriate caution.
The Awbury Team