2021: The year the debt chickens might come home to roost

On Wall Street it is said that the market consensus view on the economic outlook generally proves to be wrong. Judging by the overwhelming market consensus that we will see a continued V-shape recovery from the pandemic-induced economic crisis, it would seem that 2021 will again provide support for the Wall Street adage. 

That’s because markets will have underestimated the serious risks to both the U.S. and world economic outlook from a dark COVID-19 winter and from the massive debt buildup during the pandemic.

To say that markets are optimistic about the U.S. and world economic outlook would be a gross understatement. Indeed, as measured by the Shiller Cyclically Adjusted Price Earnings ratio, today’s U.S. stock market valuations are at lofty heights last seen in the run up to the 1929 stock market crash. Meanwhile, those in Europe are not far behind.

To be sure, part of those valuations can 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 those valuations also require a continued strong V-shaped economic recovery. 

One reason to doubt that we will have a smooth and robust economic recovery in 2021 is because of the very dark COVID-19 winter about which the health experts are now warning us. If that were to occur in the months before a vaccine is widely distributed by mid-year, we could see a significant rolling back of the earlier lifting of the COVID-19 lockdown. 

In Europe, where COVID-19 restrictions have already been significantly tightened, another leg down in the European economy is now officially being forecast. With more than 1 million new US COVID-19 cases a week currently being reported, there is good reason to fear that, contrary to the market’s expectations, in the early part of next year we could have another leg down in the U.S. economy. We might have so in response to new pandemic induced economic restrictions.

The more serious challenge to the U.S. and global economic recovery next year is likely to come from increased difficulties in dealing with the global explosion in government, household and corporate debt that was occasioned by the pandemic. This would seem to be all the more the case considering how pervasive these debt problems are likely to be across many parts of the global economy.

Even before the COVID-19 crisis, Janet Yellen sounded the alarm about the unhealthy debt build up in the $1.5 trillion highly leveraged loan market. After the further household and corporate debt buildup to stay afloat during the pandemic, Ed Altman, the New York University bankruptcy expert, is now warning about an imminent U.S. corporate debt default wave in the months ahead. 

Of even greater concern for the world economic outlook has been the record debt buildup in the emerging market economies, which now account for around half of the world economy. Hit by a perfect economic storm of low commodity prices, declining export demand and the pandemic, those countries have been forced to borrow at a record rate to cover their ballooning budget deficits. Carmen Reinhart, the World Bank’s chief economist and an internationally renowned debt expert, is now warning that it is only a matter of time before we have a full-blown emerging market debt crisis. She also believes that could have serious spillover effects to world financial markets.

The very highly indebted and systemically important Southern European countries such as Italy and Spain also have to be a source of concern. Those economies now have higher debt levels and very much higher budget deficits than they did at the time of the 2010 European sovereign debt crisis. As was the case during the earlier sovereign debt crisis, stuck within a Euro straitjacket again those countries will have the greatest of difficulties in reducing their budget deficits and restoring any semblance of public debt sustainability. This may set us up for another European sovereign debt crisis.

After the 2008 U.S. housing and credit market 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, with the world’s major central banks continuing to supply the markets with record amounts of liquidity, there can be little doubt that the music is blaring. The question nobody in the markets seems to be asking is what happens when the music stops playing? Maybe 2021 will be the year we again find out.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.