Covid-19 will be terrible for the economy, but it might just be terrific for the stock market, here's why.
The Covid-19 pandemic will inevitably lead to significant increases in public debt as governments across the rich world seemingly compete to offer the most expansive economic relief packages. Public debt is interesting for a number of reasons, not least because it has ramifications on private investment; investors want safe investments and who is safer to lend to than the government? In this week’s post I want to discuss how public debt is likely to impact financial markets in the aftermath of the Covid-19 crisis, and why I expect stock markets to far outperform the real economy.
Public debt is often measured against Gross Domestic Product (GDP) which is the price of all goods and services produced in a country in a year. A high debt-to-GDP ratio is obviously bad, but it’s worth considering the mathematical mechanics of increasing debt-to-GDP ratios in economic crises. A ratio is essentially a fraction, and all fractions are made up of a numerator and a denominator. There are two ways ratios can increase, either by an increasing numerator or a decreasing denominator and in the case of public debts during the Covid-19 pandemic in most economies the debt is increasing while the GDP is decreasing which makes the debt-to-GDP ratio increase more than the absolute increase in public debt. Worth considering when statistics about increasing public debts are released.
I want to introduce the concept of “crowding out”, the idea that higher government budget deficits, which leads to increased public borrowing, leads to less investment in the private sector as it will be important to the rest of this discussion. The basic explanation for crowding out is as I mentioned that the government is a very safe investment in most of the developed world and therefore investors flock to government bonds at the expense of the private sector. I don’t want to make some sort of neo-classical argument that fiscal intervention is wrong, in fact I think it’s necessary to minimise the long and short term damage from economic crises but I want to stress that debt is a problem as well as a possible solution. The current fiscal stimulus and economic relief packages also has an interesting interaction with the current standard monetary policy of buying government bonds with newly minted money, and could be one explanation for why the developed world’s bourses have fared quite well considering the circumstances even as millions of people have lost their jobs and entire countries have been shut down for two months. Crowding out results from a desire for safety and predictability from investors, which is amplified in a time with violent tumbles in stock markets and abysmal growth projections. The only downside with government bonds is that they don’t offer any returns, but you can’t lose in government bonds as long as the government doesn’t default. If you expect the central bank will keep buying government bonds then those bonds become even safer to hold and might even appreciate in price which further adds to the appeal. There are those who want or need a higher return than government bonds can offer though, and they struggle to find a worthwhile investment which can match the risk/reward profile of government bonds in the corporate bonds markets which offer a quite limited increase in return for the considerable increase in risk which for many leaves stock as more or less the only option.
As countries which had high levels of public debt, like Italy and Japan, before the crisis get a double hit through falling GDP and rising debt which makes their debt-to-GDP ratios increase even more it could make their bonds less attractive to investors; further cementing the current system where you have the choice between boring government bonds which pay nothing or taking a bit more risk in the stock market. Expect stock markets to far outperform the real economy, and don’t be surprised if the coming years turn out to be good for equity investors.
If you liked this post you can read last week's post about the spat between Karlsruhe and the ECB here. I'd love it if you shared this post with a friend or coworker who might find it interesting, and please come back next week for a new post!
Written by Karl Johansson
