Daily Comment (February 19, 2021)

by Bill O’Grady, Thomas Wash, and Patrick Fearon-Hernandez, CFA

[Posted: 9:30 AM EST] | PDF

We have several recent multimedia offerings.  First, we have a new chart book recapping the recent changes we made to our Asset Allocation portfolios.  As we noted last week, we’ve also posted a new Confluence of Ideas podcast.  Being Friday, we have a new Asset Allocation Weekly, chart book, and podcast.  The new Weekly Energy Update is now available; it was delayed a day due to the holiday earlier this week.  You can find all this research and more on our website.

U.S. equity futures are higher this morning as markets grapple with the steady rise in interest rates.  We begin the discussion with our view of rising debt levels.  From there, we cover policy and economics, with special focus on the minimum wage developments.  A roundup of international news follows, and we close with a pandemic update.

Following last year’s debt binge that saw households, companies, and governments raise over $24 trillion to offset the pandemic’s impact, worldwide debt levels have soared to unprecedented levels. This surge in global debt has sparked concerns of a possible financial crisis in the offing. Here are our thoughts about it:

This time may be different: The four deadliest words in economics are “this time is different,” as almost every time an economist has uttered the phrase, he was proven wrong.  Therefore, we hedge the statement with the word may. That being said, we are optimistic that the debt binge will not lead to an imminent financial crisis for the following reasons:

  • Creditors are being proactive. Unlike the months leading up to the Asian Financial Crisis and Global Financial Crisis, global creditors this time around appear to be more flexible regarding working with debtors to restructure loans.  The IMF, World Bank, and some private institutions have provided struggling countries and companies with much-needed debt relief and debt forgiveness in order to prevent future defaults.
  • Households are deleveraging and throughout the developed world have used stimulus money to improve their balance sheets. As a result, the Euro area, U.K., Japan, and the U.S. have all seen declines in household debt as a percentage of GDP.  The reduction of debt suggests that households are better positioned to withstand a recession.  In general, households have less power in the creditor/debtor relationship, so the decision by households to reduce debt reduces the risk that we will see a repeat of the Great Financial Crisis.  At the same time, using stimulus to reduce debt does weaken the overall impact of fiscal spending.
  • Financial institutions are more capitalized. In December, the Fed released the results of its 2020 stress test. It concluded that the banking sector was sufficiently capitalized to lend to households and businesses in the event of a crisis.  Given the role of the U.S. in providing global liquidity, strong banks here likely bode well for the global financial system.
  • There is low rollover risk. Increases in the federal funds rate have frequently led to weakness in the financial system as companies and governments often finance debt with short-term loans.  Thus, a rise in those rates generally results in increased servicing costs.  Although there is growing concerns that the Federal Reserve could raise rates in order to contain inflation, Fed Chair Powell has signaled that he is more focused on full employment rather than inflation.

 If we are wrong: The biggest risks to our prediction are:

  • There is a possibility that creditors may become less patient over time. As the recovery solidifies, debt moratoria will be lifted, and we could still see debt deflation develop.
  • Higher interest rates pose a risk. As we have seen the yield curve steepen, there is a risk that rising rates will increase financial system stress.  Thus, we are paying close attention to the FOMC and the idea of yield curve control.
  • Although the banking system is well-capitalized, the non-bank financial system is probably less so. Because this part of the financial system is “in the shadows,” it is more difficult to determine its health.  Usually, rising interest rates trigger problems in this sector.
  • Rising asset prices, over time, present a risk. This is what Hyman Minsky noted when he said, “stability breeds instability.”  Rising asset prices can encourage excessive risk taking, leading to problems.  The important factor to note from this “Minsky risk” is that excessive behavior is endemic to financial markets; the key is whether or not the excessive action occurs within a critical sector.  The activities we have seen discussed this week on Capitol Hill are probably not.

Policy and economics:

International news:

China news:

 COVID-19:  The number of reported cases is 110,146,931 with 2,435,733 fatalities.  In the U.S., there are 27,854,389 confirmed cases with 491,411 deaths.  For illustration purposes, the FT has created an interactive chart that allows one to compare cases across nations using similar scaling metrics.  The FT has also issued an economic tracker that looks across countries with high-frequency data on various factors.  The CDC reports that 73,377,450 doses of the vaccine have been distributed with 57,737,767 doses injected.  The number receiving a first dose is 41,021,049, while the number of second doses, which would grant the highest level of immunity, is 16,162,358.  The Axios map shows marked declines in infection rates.


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