No one likes to be in debt, it causes stress and anxiety. You might be sure you can repay it today, but what if tomorrow you lose your job or your business goes bankrupt? Yet many people continue to take loans and eventually fall into different sorts of debt traps. Some even take payday loans to pay off the previous loan.
Monetary policy and household debt
The Covid-19 crisis is one of the reasons households could experience difficulty managing their debts. The problem is that instruments used to mitigate the negative consequences of the recession and stimulate economic growth also have an opposite effect.
For example, by lowering interest rates, the US Federal Reserve made borrowing cheaper, causing more indebtedness problems for American consumers.
Last quarter, Americans’ mortgage debt climbed to a record high of nearly $10 trillion. Aggregate household debt balances increased by $87 billion in the third quarter of 2020, a 0.6% rise from Q2, and now stand at $14.35 trillion, according to the Federal Reserve Bank of New York.
So basically, it’s a tale of two tails: On the one side it is good that consumer spending is recovering, but at the same time the overall level of indebtedness grows. On the other side, when the debt bubble begins bursting, lenders and borrowers will face problems.
Covid-19 crisis effect
The Covid-19 crisis has hit workers hard, causing millions to lose their jobs or been furloughed, and as a result, many of them have defaulted on loan payments. In the UK, businesses were encouraged to take out state-backed loans. Households got payment “holidays” on mortgages and credit cards.
In the US, many card issuers let debtors pause their credit-card funds for a month or longer. Some are reducing or waiving late charges, and even forgiving parts of shoppers’ balances.
Loan-forbearance agreements allow borrowers to reduce or suspend payments for a short period, providing extended time for consumers to become current on their payments. However, this does not lighten the financial burdens people are shouldering.
Another problem is that for many, wages and revenues after the pandemic will be lower than before. As a result, many could end up in insolvency, homelessness, or destitution.
As US Treasury Secretary Steven Mnuchin said, “For companies that are impacted by Covid – such as travel, entertainment, and restaurants – they don’t need more debt, they need more [Paycheck Protection Program] money, they need more grants.” Exactly the same is true for individuals.
Stock markets’ reaction
Meanwhile, the stock market continues to erupt, reaching on many occasions pre-pandemic levels. It is important to remember that equity returns come from three sources: changes in earnings expectations, changes in the price investors are willing to pay for those earnings, and the dividend that companies pay to shareholders.
Hype and fear of missing out caused the price-to-earnings (P/E) ratio of many companies to skyrocket. Now, we have dozens of companies that have gotten much more expensive relative to their expected earnings.
It is also true that in times of low interest rates, stocks become more valuable as there are fewer attractive alternatives. For example, the risk-free yield from a government bond is near historic lows.
It isn’t the best idea to compare what happened in the past with what we are observing these days, as times and conditions are very different. Before investing in a company, it is crucial to analyze its solvency, cash-flow generation/evolution, and future earnings.