Deficits are rising across the developed world as governments aggressively loosen their purse strings in response to the COVID-19 pandemic. But what are the ramifications of all this debt? Our K2 Advisors team weighs in on the longer-term unintended consequences for governments that maintain massively leveraged balance sheets for an extended period.

It is estimated global government debt will reach US$66 trillion by year end, and debt to gross domestic product (GDP) will rise from 105% to 122%, a bigger increase than any seen during the global financial crisis (GFC).1 In the United States, for example, the government borrowed a record US$3 trillion just in the second quarter of 2020, more than five times as much as it did in 2008 during the GFC.2 The US deficit could balloon even higher in the months ahead, as legislators seek to pass additional spending bills aimed at supporting state and local municipality budgets.

Debt levels create long-term uncertainty related to if or how countries will unwind their borrowing.

However, we believe the current environment presents opportunities for hedged strategies, such as long/short equity.3 Coming out of this crisis, we believe there will be clear winners and losers across almost every sector. In our view, this will create opportunities for idiosyncratic stock selection, long and short trading, and alpha capture.

A Necessary Evil?

Few would argue, including the most conservative economists, whether the massive government stimulus in the wake of the COVID-19 pandemic was the prudent choice. For all intents and purposes, these deficits are (at least according to modern economic theory) a necessary evil.

Without significant bank easing and fiscal support, a global depression of historic proportions is all but assured. Lawmakers, the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of England (BOE) and the Bank of Japan (BOJ) have little choice but to act aggressively.

Necessity notwithstanding, the fact remains the world is now left with a massive fiscal burden. This is on top of the already significant pile of debt left behind from the GFC, as seen in the chart below. Managing such colossal debts will burden advanced economies for years, if not decades, to come. To navigate the legacy of COVID-19, the world will have to strike a delicate balance between necessary stimulus and conservative fiscal policy. A daunting challenge on many levels—as we will discuss.