The Ex-President of the European Central Bank Reveals the Playbook
It’s rough out there — not just for the United States, but the entire world.
The global economy is expected to face its worst recession in 80 years, according to a new Global Economics Prospects report published by the World Bank.
This means that, to find a comparably bad recession year for the global economy — all countries across the board — you would have to go back to 1940, the first full year of World War II (which began in September 1939).
And yet, because the 2020 economic collapse is so broad, the World Bank reports, the sheer scale of the global downturn is the worst not in 80 years but 150, dating all the way back to 1870.
“This is a deeply sobering outlook, with the crisis likely to leave long-lasting scars and pose major global challenges,” says Ceyla Pazarbasioglu, a vice president of the World Bank Group. “Given this uncertainty, further downgrades to the outlook are very likely,” she adds.
The pandemic is adding to those uncertainty levels.
As we noted on June 8, the novel coronavirus is not in retreat — and in many developing-world countries, it is spreading like wildfire. In some countries, the surge is triggering an authoritarian cover-up response. Shortly after Brazil’s death toll surpassed Italy’s, for example, the Brazilian government decided to stop publishing COVID-19 data and wiped key statistics from its website.
Anne Richards, CEO of Fidelity International, has also warned of a “global corporate solvency crisis” due to severe funding shortages for emerging market companies.
Simply put, publicly traded emerging market companies have too much debt on the books, and not enough cash to weather revenue shortfalls while shouldering new COVID-related expenses. They will need cash injections in the form of new investment, and there isn’t enough cash available.
Though Fidelity International manages more than $380 billion in assets, and other big asset managers run even more, it is small beer in comparison to what is needed. “The industry is not going to be enough to solve this solvency problem,” Richards said.
The market appears unfazed by any of this.
Emerging market assets have surged almost to the point of going vertical in the past 10 trading days, even as the outlook for emerging-market countries and companies, debt-laden and wrestling with the pandemic, remains somewhere between terrible and catastrophic.
Nor is this a case of anticipating a fast recovery, because even a return to 85 to 90% of prior capacity — a wildly generous forecast in a pandemic — would mean less profit and reduced operating leverage in a world of rising burdens and costs.
It might be Mario Draghi, ex-president of the European Central Bank (ECB), who gave away the game.
In summer 2012, Draghi famously halted an ongoing eurozone debt crisis by promising to do “whatever it takes” to save the euro currency, and thus by extension the European Union itself.
In March 2020, Draghi — no longer running the ECB but influential as a private citizen — penned an op-ed in the Financial Times that took the “whatever it takes” mantra even further, spelling out just how far Draghi assumed things would go. On March 23 he wrote:
“It is already clear that the answer [to avoiding a depression] must involve a significant increase in public debt. The loss of income incurred by the private sector — and any debt raised to fill the gap — must eventually be absorbed, wholly or in part, on to government balance sheets. Much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation.”
As ECB president, Draghi introduced a negative interest rates policy in June 2014, taking the target deposit rate to negative 0.1%. After the pandemic crashed into markets, Draghi laid out where things could go. As we can summarize from his blunt statement:
- There will be a “significant increase” in public debt.
- Private companies that lose income can borrow en masse.
- Private debt must eventually convert to government debt.
- “Much higher public debt levels” will become permanent.
- Private debts will also be cancelled.
If Draghi is accurately describing the playbook, then global central banks, perhaps in coordination with their respective treasury departments, will be able to support indebted companies without limit.
This might be bullish from a liquidity perspective. But for any time horizon other than a short-term one, it sounds like an utter economic nightmare.
Private debts are generally owed to private creditors, who would scream bloody murder if asked to absorb a default. This means that, in order to cancel those debts, the government would simply have to pay up. That means either new debt issuance from the treasury or, perhaps, currency printed by the central bank.
Then, too, if governments start absorbing private debt via public balance sheets, that would make the government an increasingly large stakeholder in the private sector. That, in turn, would mean ramped-up political meddling and the dead hand of bureaucracy holding industry in its grip.
This is a recipe for returning to 1970s pre-Thatcher Britain, or a pre-Reagan 1970s United States.
Think of the sprawling, all-encompassing, non-free-market-oriented nationalization efforts that had made the U.S. and U.K. into stagflationary basket cases in the disco decade. That is what the Draghi playbook would potentially lead us back to, except with even higher debt levels.
Then, too, a horde of corporate “zombies” — low-to-no-profit organizations kept alive by artificial debt support — would roam the economic landscape, killing the prospects for entrepreneurial growth.
And yet, a bullish equity case can still be made for this dystopian vision.
Not for all public companies, but rather the ones with sufficient crony capitalism connections to enjoy a protected quasi-monopoly status, courtesy of effective government lobbying.
A debt-laden, zombie-filled future could also be weirdly favorable for the juggernaut tech companies, like Amazon, Microsoft, and Google, which could see their embedded growth story expectations become even more valuable, with assignment of stratospheric multiples, in a world otherwise devoid of growth.