The low interest rates contributed to steadily increasing levels of debt as companies were increasingly incentivised to restructure balance sheets away from equity and towards debt. “Share buybacks” were a key support for equity markets, particularly in the US. However, the financing of the share buybacks through the issuance of debt increased balance sheet fragility.
As the world emerges from this crisis, the aggregate debt burden will be higher still. Companies will have to borrow even more to weather the collapse in revenue during the economic slowdown. The large and rapid response by policymakers globally has also sharply increased public debt levels and shifted risk onto government balance sheets. Such elevated levels of debt in turn limits the extent interest rates could rise without causing a significant slowdown in the economy.
To date, the rapid policy response and fall in interest rates have helped boost asset prices and reduce the likelihood of a deep financial crisis. With policy interest rates at or already below zero, central banks have had to resort to increasingly unconventional measures to support the economy. In many countries, central banks have increased the range of assets purchased and reduced the quality of collateral needed.
Paradigm shifts in policymaking
Two fundamental changes are happening to policymaking.
The first relates to monetary policy. The major central banks are now unlikely to respond pre-emptively to signs of higher inflation and are instead willing to accommodate periods of above-target inflation. This is a marked change from the past when interest rates were usually raised in response to leading indicators of inflation, which subsequently dampened economic activity.
The second is the bigger role played by fiscal policy in stimulating the economy, given limited policy room for central banks to cut rates. The size of fiscal stimulus packages is expected to be US$11 trillion, almost 20% of GDP for advanced economies and about 5% of GDP for emerging economies. Alongside the impact of lower tax revenues and higher government transfers due to the deep recession, these stimulus packages are expected to contribute to an increase in public debt of around 19% of global GDP in 2020 alone.
Not all countries can afford such large-scale stimulus, and concerns over how these programmes are financed will likely weigh on debt markets, particularly in lower-income economies and those that are reliant on foreign capital flows. Relatedly, there is also greater implicit or explicit cooperation with monetary policy in either leveraging up fiscal programmes, increasing purchases of government debt, or keeping financing costs for the government low. While these coordinated monetary and fiscal policies have been critical in supporting the economy, they may prove difficult to calibrate and reverse in some cases once the economy normalises.
These shifts in policymaking have the potential to change the investment environment in two ways.