2021: The year debt chickens might come home to roost

On Wall Street, it is said that the market’s consensus view of the economic outlook generally turns out to be wrong. Judging by the overwhelming market consensus that we will see a continued V-shaped recovery from the pandemic-induced economic crisis, it looks like 2021 will back Wall Street’s adage again.

Indeed, markets will have underestimated the serious risks to the U.S. and global economic outlook from a bleak winter of COVID-19 and massive debt accumulation during the pandemic.

To say that the markets are bullish on the US and global economic outlook would be a gross understatement. Indeed, as measured by the Shiller Cyclically Adjusted Price Earnings ratio, current US stock market valuations are at great heights last seen in the run-up to the stock market crash of 1929. Meanwhile, those in Europe were not far behind.

Certainly, some of these valuations may be justified by the plausible expectation that central banks are likely to keep interest rates at their current historically low levels for a long time. However, to be justified, these valuations also require a continued strong V-shaped economic recovery.

One of the reasons to doubt that we will have a smooth and robust economic recovery in 2021 is because of the very bleak COVID-19 winter that health experts are now warning us about. If this were to happen in the months leading up to the widespread distribution of a vaccine by mid-year, we could see a significant rollback from the earlier lifting of the COVID-19 lockdown.

In Europe, where COVID-19 related restrictions have already been significantly tightened, a further downward stage of the European economy is now officially foreseen. With over 1 million new cases of COVID-19 in the United States per week currently announced, there is good reason to fear that, contrary to market expectations, early next year we could have another leg down in the US economy. We might have it in response to the new economic restrictions induced by the pandemic.

The most serious challenge to the U.S. and global economic recovery next year is likely to come from increased difficulties in coping with the global explosion in government, household and corporate debt that has been occasioned by the pandemic. This would seem all the more so given the likely magnitude of these debt problems in many sectors of the global economy.

Even before the COVID-19 crisis, Janet Yellen sounded the alarm about the unhealthy buildup of debt in the $1.5 trillion highly leveraged loan market. After household and business debt continues to pile up to stay afloat during the pandemic, Ed Altman, the New York University bankruptcy expert, is now warn of a looming wave of US corporate debt defaults in the coming months.

The record accumulation of debt in emerging market economies, which now make up about half of the global economy, is of even greater concern for the global economic outlook. Hit by a perfect economic storm of low commodity prices, falling export demand and the pandemic, these countries have been forced to borrow at record rates to cover their soaring budget deficits. Carmen Reinhart, the World Bank’s chief economist and internationally renowned debt expert, now warns that it’s only a matter of time before we have a real emerging market debt crisis. She also thinks it could have serious repercussions on global financial markets.

Highly indebted and systemically important southern European countries such as Italy and Spain should also be cause for concern. These economies now have higher debt levels and much higher budget deficits than at the time of the European sovereign debt crisis of 2010. As was the case during the previous sovereign debt crisis, stuck in again in the straightjacket of the euro, these countries will have the greatest difficulty in reducing their budget deficits and restoring any semblance of public debt sustainability. This could set us up for another European sovereign debt crisis.

After the 2008 U.S. housing and credit crisis, former Citibank CEO Chuck Prince explained his bank’s speculative activity during the bubble by noting that when the music is playing you have to dance. Today, as the world’s major central banks continue to supply markets with record amounts of liquidity, there is little doubt that the music is ringing. The question no one in the markets seems to ask is what happens when the music stops? Maybe 2021 will be the year we find out again.

Desmond Lachman is a resident scholar at the American Enterprise Institute. He was previously Deputy Director of the Policy Development and Review Department at the International Monetary Fund and Chief Emerging Markets Economic Strategist at Salomon Smith Barney.

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