A Targeted Fiscal Response Cannot Erase All Risks

Co-Head of Global Bonds Nick Maroutsos explains that while the recently enacted COVID-19 fiscal package correctly targets workers and small businesses, insolvency risk remains and additional action may be warranted.

Key Takeaways

  • Last week’s fiscal response to COVID-19 should directly help the liquidity-constrained small businesses and workers most acutely affected by the outbreak.
  • While we welcome this legislation along with the Fed’s early actions to calm financial markets, we believe that insolvency risk remains and that authorities will eventually have to act again.
  • Although liquidity has been largely restored and corporations remain flush with cash, we see a number of paths where stresses in the real economy could further weigh on financial markets.

In a bipartisan and relatively rapid response, the U.S. government enacted a $2 trillion package aimed at addressing the economic dislocations caused by the COVID-19 pandemic. While earlier actions by the Federal Reserve (Fed) focused on easing illiquidity in financial markets, this package targeted the nation’s workers and small businesses that are likely most acutely affected by the dramatic slowdown in economic activity. While we welcome these moves, we believe that neither the economy nor financial markets are out of the woods. Liquidity risk has been diminished owing to recent Fed actions, but insolvency risk remains as businesses – large and small – seek to meet obligations in what is still an uncertain economic environment.

Something for Everyone – Almost

The package passed into law includes direct payments to individuals and households, expanded unemployment insurance, loans to small businesses and aid to cities and states. Also included are loans and direct relief to airlines and support for hospitals. In aggregate, we believe the package sufficiently targets segments of the economy most directly impacted by COVID-19. The proportion directed toward small businesses and workers is notable given that – in contrast to the corporate sector – these groups tend to have limited liquidity. With small businesses accounting for almost half of U.S. economic activity and – framed differently – personal consumption comprising 70% of GDP, addressing liquidity shortfalls in these areas, we believe, are well placed.

Building on Fed Actions

In recent years, central bankers globally have harped that monetary policy alone cannot remedy all economic woes and that governments must also play a role by crafting pro-growth fiscal policies. As the COVID-19 crisis unfolded over recent weeks, we were again concerned that any fiscal response may be a day late and a dollar short. Thus far, both the monetary and fiscal side have struck the right notes, with the former unclogging markets and the latter injecting cash and other support – totaling roughly 10% of GDP – into the real economy. But given this is nearly an unprecedented event in terms of both speed and global reach, we believe risks remain, with much riding on how quickly a sustained containment of the virus materializes. Consequently, we don’t believe the Fed or fiscal authorities are done, and that the scale of future actions will be determined by the duration of the crisis.

Unavoidable Insolvencies

Despite the breadth of this legislation, we believe that defaults will occur. The disruption to earnings and wages means that entities – both households and businesses – without ample savings will be unable to meet all their financial obligations. This may potentially place policy makers in the awkward position of choosing winners and losers should the crisis linger on and aid runs thin.  Many companies have survived the past decade not because of their ability to consistently generate cash flow but due to access to cheap credit. These organizations may be most at risk as policy makers could make business viability a criterion for continued support.

Market Contagion

Many corporations are sitting on ample cash and markets have calmed in recent days. Still, insolvency risk should be top of mind for investors. Even if the source is households and small businesses, we believe transmission mechanisms exist to transform these “real” economy problems into financial market problems. Several forms of consumer debt have been packaged into securitized products. Their prospects rest on the duration of this crisis, how consumer behavior shifts in its aftermath and if some of these recently lost jobs never return. Similarly, highly leveraged companies focused on the consumer may face strains in a post-COVID-19 economy.

While we welcome steps by authorities, the risk and return profiles of several asset classes depend upon how these unprecedented events continue to evolve and which businesses exhibit the resilience and adaptability necessary to come out the other side.

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