The impact of healthcare crisis, coronavirus aka Covid-19 has been devastating with more than 119,000 deaths worldwide as of April 11. This healthcare crisis has disrupted lives and the supply and demand lines of the economy; brought entire sectors of economy to shutdown and as a result the economic fallout of this healthcare crisis labelled as global coronavirus recession (GCR) is predicted to be much more severe and widespread than the Global Financial Crisis (GFC) of 2006-2008. Unlike GFC, this time around banks are now well capitalized and consumers are less leveraged (consumers have increased their debt by only 19% since 2009) however companies have increased their debt by 50% since 2008 to over $72 trillion as per Bank for International settlements (BIS). In US, the share of corporate debt held by non-financial companies is at an all time high relative to US GDP as shown in Figure I. Even before Covid-19 there were concerns about rise in corporate debt, covenant-lite loans and the easy availability of credit by venture capitalist (remember WeWork) and private equity firms and now with the blow of Covid-19 the credit bubble may well have been burst.
- Increase in Unemployment – The most visible sign of the pace and severity of the impact of GCR is reflected in the new unemployment claims filed in the US as shown in Figure 2; more than 16 million people have filed for unemployment claims in US in last 3 weeks which is 10% of the total US workforce and the rate of increase in unemployment is unprecedented and not even remotely matched by the 2008 financial crisis.
- Fall in output – The surge in unemployment has happened as large parts of the US has collapsed or shutdown as a result of social distancing; a study conducted by Moody’s Analytics and reported in WSJ estimates that U.S. daily output has fallen roughly 29%, compared with the first week of March. In comparison, the annual output fell 26% between 1929 and 1933, during the Great Depression and quarterly output fell almost 4% between late 2007 and mid-2009 during the GFC. If the 29% drop of 29% in daily output is sustained for more than two months then US GDP would fall at a roughly 75% annual rate in the second quarter which will be a very severe drop. This fall in output is also happening globally as measured by the drop in PMI (Purchasing Managers Index) for all major economies in Figure 3 where a level below 50 indicates contraction.
- Downgrades in IG Corporate Bond Market – As people lose jobs and large parts of the population stop non-essential spending, companies are experiencing negative cashflows and rating agencies have started downgrading them to reflect the bleak outlook ahead. The investment grade (IG) corporate bond index, ICE had the fastest amount of downgrades since 2002 as per Bank of America and in total $569 billion of corporate bonds were downgraded since March 16 . This is still small fraction of the $3 trillion in IG corporate bond market but there is more pain to come and S&P sees default rates in the investment grade corporate bonds in United States to triple from 3.5% in Feb 2020 to go past 10%.
- Rise in Defaults in High Yield sector – A consequence of the downgrades in the investment grade (IG) corporate bond market is that as the previously investment grade rated companies become ‘fallen angels’ they will tap into and flood the $1.2 trillion junk (high yield, HY) bond market and raise the spreads of the high yield/junk bond markets. This anticipation is seen in the gap between IG and HY premiums which reached a peak last month and has come down only slightly with the Fed’s announcement to buy HY securities on March 16th. As a result, junk bonds are predicted to be harder hit with Goldman Sachs predicting a trailing 12-month average of 13% later this year with a wave of defaults for the most leveraged companies even if the global economy is able to turn the corner in the coming months.
- Leveraged Loans – Another looming concern is the increase in defaults in the leverage loans and the CLO Market. Fitch now expects defaults in leveraged loan sector to rise to 8-9% by end of 2021 due to decreased economic activity from 1.8% in 2019. A decade of low interest rates and easy supply of credit has resulted in vast majority of leveraged loans having very little covenants or protections for lenders. This means that the borrowers have unprecedented flexibility in how they behave in paying back their loans.
Policy Responses – The silver lining in all of this is the swiftness and the immensity of the actions undertaken by the central banks and governments across the globe in response to the crisis dwarfs what had been done previously for GCR. The amount of stimulus measures announced globally is a mind-boggling $6 trillion led by the $2 trillion package announced in the US. What is the fallout of this global stimulus on future inflation and interest rates and monetary and fiscal policy in coming years? It is a challenge to contemplate these questions now while putting out the fire of economic recession at hand but the time for this question will come sooner than we think.