Across much of the world — whether the virus has been contained or not — mobility is on the rise and businesses are re-opening as governments attempt to restore some level of normality. Data released over the last few weeks have confirmed the bounceback in economic activity that we had expected, after bottoming out in April. For example, US retail sales, boosted by generous stimulus cheques by the government, rebounded by nearly 18% in May. In the UK, they were up by almost 12%.
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A ‘V’-shaped recovery remains the most likely outcome. However, premature withdrawal of government support, a second coming of the virus, and a wave of sovereign defaults in emerging markets are all potential headwinds. Each could weaken banks’ balance sheets and lead to a global credit crunch or banking crisis. As measured by Fathom’s Sovereign Fragility Index (SFI), the fundamental drivers of sovereign risk have rocketed everywhere. In emerging markets, where central banks do not necessarily have the scope to undertake monetary financing, this is of particular concern.
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This is not unique to countries with less developed financial systems. Euro area economies also show an uptick in sovereign fragility, particularly countries such as France, Greece, and Italy. But, as seen in the chart below, financial markets seem to be relaxed about the possibility of defaults in this region — too relaxed. This may be due to overconfidence in the power of the ECB or too much optimism about the prospects of debt mutualisation, as set out by the Franco-German proposal for an EU recovery fund.
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A global credit crunch, whether the trigger is defaults by governments or by individuals, would almost certainly trigger a protracted recession, turning our V-shaped scenario into a more damaging ‘L’. With central banks already running out of options in their policy toolkit, the onus will be on fiscal policy to prevent and respond to any future crisis.
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