Aurelia Butler

Good morning. Dick’s Sporting Goods lost a quarter of its value yesterday when it cut its outlook, saying theft is up and unpopular inventory had to be pushed out the door (in a better world, these two trends would cancel each other out, but not in our world). The economy is not strong everywhere. Email us: [email protected] and [email protected]. Inflation and unionisationThe strongest way to make the case that inflation will keep falling is by working from the bottom up — that is, by looking at each component of the price index, and then drawing conclusions about the index overall. Start with shelter. Private market data suggests rental inflation should fall a lot. Next, used vehicle prices have gone nuts but are now turning over. And outside of these two categories, inflation looks tame. Here’s that argument in one picture:(If you want all the gory details, Skanda Amarnath at Employ America had a nice post earlier this month.)Making the argument from the top down — that is, starting with the macroeconomy — is tougher. Historically, wages tend to set a lower bound on how much inflation can fall. In the past century, the two variables have rarely travelled more than a percentage point or two apart, as Matt Klein of The Overshoot has pointed out. His chart:

Wage growth is now elevated by any measure, with the Federal Reserve’s favourite gauge, the employment cost index, running at 4.6 per cent, compared with about 3 per cent in 2019. So it’s hard to see how inflation returns to 2 per cent.Matching the wage growth data is another indicator we looked at back in December: union activity. Then, we noted an uptick in strikes and labour protests. It hasn’t quieted down. July marked the largest number of US workers on strike in one month since January 2021, according to Cornell’s labour action tracker. This could matter to inflation. One study last year by two Fed economists argued that inflation’s structural decline since the 1980s is largely attributable to the decline in worker bargaining power. Even today, US regions with higher union density experience a sharper inflation-unemployment trade-off, they find. The authors quote the late economist James Tobin:Inflation is the symptom of deep-rooted social and economic contradiction and conflict. There is no real equilibrium path. The major economic groups are claiming pieces of pie that together exceed the whole pie. Inflation is the way that their claims, so far as they are expressed in nominal terms, are temporarily reconciled. But it will continue and indeed accelerate so long as the basic conflicts of real claims and real power continue.Behind today’s surge in labour action is a combination of a tight labour market raising employee leverage and the pandemic’s stark reminder that working conditions matter, said Candace Archer, policy director at the AFL-CIO union federation. She adds that inflation is better attributed to high corporate profits and supply-side disruptions than wage growth.Wall Street is noticing. As Dan Clifton of Strategas wrote in a July note called “Worker strikes are becoming a macro issue”:Strikes receiving more attention makes sense, with four new strikes authorised in the last month . . . We got the sense from investors that the issue was less about economic disruption from the strikes, but that the strikes will result in large pay increases. I celebrate American workers getting paid more, but two dominant discussion points of these pay increases are: 1) Margin compression for companies and 2) Future inflation.Ian de Verteuil, head of portfolio strategy at CIBC, is concerned by the wage agreements embedded in existing union contracts. He says these provide a unique glimpse into companies’ willingness to pay for labour, because they require multiyear commitments signed upfront. Using a Bloomberg Law contract database, wage increases pencilled in for the average contract’s third year are above 4 per cent, and rising:

Of course, only 10 per cent of US workers are unionised and Bloomberg Law’s data isn’t all-encompassing (covering about 350,000 workers). But de Verteuil argues union contracts’ “quasi-public nature” lends them “disproportionate impact on employee wage expectations”.Other data shows those expectations rising. The New York Fed’s thrice-yearly survey of consumer expectations includes a question about the “reservation wage”, the lowest annual wage the average respondent would be willing to accept for a new job. The latest survey, published on Monday, showed record wage expectations of $78,600. The increase since March 2020 has outstripped inflation:Should Wall Street worry about unions? Says the AFL-CIO’s Archer: “Maybe they should. If you keep doing things unfairly, people will organise to change that.” (Ethan Wu)Is Goldman cheap?Yesterday I wrote about how everyone at Goldman is angry with the CEO, David Solomon, nominally because he is not very nice. Writing the piece got me thinking about whether Goldman might be undervalued. I am struck by how good Goldman’s historical performance has been relative to peers. According to RBC, Goldman’s total shareholder return is second among large banks over 20 years (8.4 per cent compound annual rate), fifth over 10 years (9.3 per cent) and second over five (10 per cent). In growth in book value per share and dividends, it is number one over five and 20 years, and number two over 10.Why has it done so well? Because its franchises in investment banking and trading are market-leading, and in finance, big incumbents are very hard to dislodge (as Goldman discovered when it tried consumer banking and got nothing but a big, expensive bloody nose). And you can get these franchises for 1.1 times book value and 12 times earnings.The main reason for the limp valuation is volatility of results. Here is the annual change in Goldman’s net income compared with that of JPMorgan Chase:People will pay more for steady, predictable earnings. But if you are a long-term investor, this is stupid, as Warren Buffett has taught us. At a company with a sustained economic advantage, all that that earnings and share price volatility does is offer good prices at which to buy and sell.That said, investors are not going to suddenly become more rational and start paying a richer valuation for Goldman’s deep competitive moat. The market does not get wiser (another favourite point of Buffett’s). Goldman will always trade at a weakish multiple. But grabbing a good business like Goldman when everyone is talking about what a jerk the CEO is, and while it is recovering from a strategic own-goal (consumer banking) and still rebuilding its reputation after a scandal (1MDB), might not be such a bad idea?The argument against Goldman is the argument against owning any bank: banks are leveraged, opaque and vulnerable to systemic risks. But there is an argument that Goldman’s business, which is driven by fees and market volatility rather than the rate environment, is less vulnerable to these forces than most; hence its strong performance over time. Perhaps I’m missing something. If I am, send an email.One good readJames Kynge on China’s plans for the world order. More

When more iPhones roll off production lines in China or a South Korean plant manufactures fewer drugs for Pfizer, it is hard to believe such shifts could seriously distort Europe’s economic data. But they do. In fact, they do so frequently.The reason is that many of the biggest US technology and pharmaceutical companies have headquartered their international operations in Ireland to take advantage of the country’s relatively low 12.5 per cent corporate tax rate.Groups such as Apple and Pfizer increasingly use contract manufacturing or merchanting arrangements to have their products made in low-cost countries, often in Asia, but they keep the intellectual property rights and income in their Irish subsidiaries.So much of the revenue these companies record in their Irish units comes from activities that provide few jobs or incomes for residents of Ireland or of anywhere else in Europe. Yet they still have a massive impact on perceptions about how the region’s economy is performing. The latest example came when eurozone industrial production figures, published this month by the EU’s statistics arm Eurostat, showed month-on-month growth of 0.5 per cent in June, confounding analysts’ expectations for a slight decline. The growth was entirely down to Ireland’s 13.1 per cent surge. Excluding “statistical quirks and distortions” in the Irish data, Mark Cus Babic, an economist at Barclays, calculated eurozone industrial production would have fallen 0.9 per cent in June.While a double-digit percentage move in industrial production is rare for most countries, Ireland has recorded 14 of them in the past 24 months.“Attracting these large industries to Ireland through the tax regime regularly causes havoc with Irish economic data,” says Stefan Gerlach, a former deputy governor of the Central Bank of Ireland who is now chief economist at Swiss bank EFG, adding that the issue “does little to enhance Ireland’s reputation”.Melanie Debono, an economist at consultants Pantheon Macroeconomics, spotted another problem with Ireland’s contribution to the latest eurozone industrial production figures: they don’t add up. Debono pointed out that when the subsectors were added up and weighted by their share of total output, the result was an overall decline of 0.6 per cent — rather than the rise of 0.5 per cent. “Something is wrong here,” she said.Eurostat told the Financial Times that “some inconsistency” between the headline 0.5 per cent figure and the total of the subsector figures had been “caused by the data of one country”, which it refused to name.The culprit? Almost certainly Ireland’s method for seasonally adjusting its data. The country’s Central Statistics Office told the FT that because it calculates each subsector separately to the overall industrial production figure, the total can differ from the sum of its parts.Other eurozone members use the same direct seasonal adjustment method. But because their data is not as volatile as Ireland’s, it matters less. Big swings in Irish industrial production even affect gross domestic product figures, including for the eurozone. In the three months to June, more than half the region’s 0.3 per cent growth from the previous quarter was due to Ireland’s 3.3 per cent expansion in the period.The Central Statistics Office said much of the country’s second-quarter growth was “driven by increases in the multinational dominated sectors”. In other words, the activities of Apple, Pfizer and other big US groups such as Meta, Intel and Google — often in Asia — are distorting Europe’s GDP.Analysts and officials are grappling for solutions. Oliver Rakau, an economist at consultants Oxford Economics, has gone as far as to suggest Eurostat should publish some economic data excluding Ireland “where the impact of the Irish data quirks is the largest”.The country’s statisticians are considering switches to a different technique. In the meantime, they have attached a health warning to the industrial production data and suggested analysts take a “longer term view”. Ronan Dunphy, a research analyst at Irish brokerage Goodbody, said it tended to ignore the data that was “of very questionable value on a month-to-month basis”.Ireland does benefit from multinational companies’ operations. They manufacture some products in factories there and their profits helped to boost Irish corporation tax receipts by 48 per cent last year to a record high of €22.6bn.But as long as it keeps warping Europe’s economic data, the artificial boost coming from Ireland’s tax-minimising guests will only intensify calls for action to tame the wild numbers coming out of the Emerald Isle. More

“Here’s the good news — the pricing is done.” With those words Miguel Patricio, chief executive of Kraft Heinz, offered some assurance to cash-strapped consumers as he delivered interim results earlier this month, giving hope that the cost of branded goods such as Philadelphia cream cheese and Heinz tomato ketchup would stop rising.The US food maker is not alone. After raising prices to pass on raw material, energy and labour cost inflation to shoppers, some of the world’s largest consumer goods companies have signalled they might be ready to ease off. At Nestlé, chief executive Mark Schneider said the company, which makes Nespresso and KitKats, would slow price rises in the second half of the year. French giant Danone’s chief executive Antoine de Saint-Affrique echoed the sentiment, saying, “it will be decreasing as we go through the next quarter but there will be still inflation”. Unilever chief financial officer Graeme Pitkethly said “we have passed peak inflation” and that while prices would continue to rise, the rate of growth would “moderate​” through the year.According to analysis by Jefferies, consumer goods companies increased prices an average of 11 per cent year-on-year for three consecutive quarters, until the three months to July, in which the average rises pulled back to 9.7 per cent. The prospect of a halt in price rises will be welcome news to consumers — but they are unlikely to see price reversals or even moderation. Shoppers will continue to pay for the considerable prices increases companies initiated in the first half of the year well into next year, according to analysts. “They say pricing will moderate, naturally, because they were jacking up prices last year. So year-on-year the price increase becomes smaller — because they are not doing more additional pricing,” said Bruno Monteyne, analyst at Bernstein.James Edwardes Jones, analyst at RBC, said consumer staple groups “almost never cut prices” and were more likely to boost promotional activity than actually drop the price of goods. Saint-Affrique told analysts that Danone was moving away from “broad-based pricing discussions” to individual products, and “using promotion rather than our pricing”. Huw Pill, the Bank of England’s chief economist, has warned that supermarket prices would still be rising much faster at the end of the year than overall inflation, in part because some had entered contracts to secure supplies when global commodity prices were at a peak.Consumers have been more resilient to price rises than expected and have continued to buy popular brands, helping companies offset significant sales declines. But as the cost of living crisis drags on, it has become harder to maintain volumes, making them cautious about further price increases. “They’re all slightly nervous about volumes,” said Edwardes Jones.Consumers have been more resilient to price rises than expected and have continued to buy popular brands © Hesther Ng/SOPA Images/LightRocket/Getty ImagesReckitt’s interim chief executive Nicandro Durante said he was “cautious” about passing on price rises to “stressed” consumers in Europe. Heineken said its sales volumes had plummeted 5.4 per cent in the first half of the year, dropping further in the second quarter following “the cumulative effect of pricing actions”, while Nestlé also reported lower than expected sales volumes earlier this month. Mike Watkins, head of retailer and business insight at NIQ, said consumer goods sales volumes in Europe were “the lowest in recent memory”, particularly in branded goods and fresh foods.To manage higher costs, consumers had been shopping around at different retailers, buying less and shopping more often. “In Europe the manifestation of this is the growth of discount channels while in the US it was growth in dollar stores and warehouse clubs [such as Costco],” he said.Retail giant Target lowered its annual profit forecast last week following disappointing sales as US consumers cut back on discretionary purchases such as food and home goods.“[US] consumers are still willing to spend, but they have become increasingly cautious and selective amidst still-high prices and tighter credit conditions,” said EY chief economist Gregory Daco. “This has translated into much slower consumer spending momentum after a strong start to the year.”

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The down-trading has become more apparent as some companies reported significant loss of market share in first-half results. Unilever said the proportion of the business gaining share had fallen from 48 per cent in the first quarter to 41 per cent in the second quarter, the lowest level since 2018. Monteyne said the loss of market share was an early sign that consumer confidence was dropping. Kraft Heinz said it had lost some of its position in the second quarter of the year as a result of pricing its products higher than the market. “We are losing incremental share to brands who are promoting more than we are,” said Patricio. Some categories were more resilient to down-trading than others. Consumer health manufacturers have seen volumes hold up better during the cost of living crisis, as consumers were more likely to trade down on food items than on over-the-counter medicines and personal care products such as toothpaste. Consumers have proved less likely to trade down when it comes to healthcare products © Islandstock/Alamy GSK spin-off Haleon and Johnson & Johnson spin-off Kenvue reported better than expected sales in the first half of the year. “While consumers may be trading down in more discretionary and traditional staple categories, we have not seen this dynamic in our portfolio,” said Kenvue chief executive Thibaut Mongon. Haleon’s chief executive Brian McNamara reiterated the sentiment, telling analysts that to date the company has not seen evidence of down-trading, even in Europe where private label was rapidly gaining share in other consumer categories. Consumer goods companies have pushed back against accusations of profiteering by politicians and consumers, saying they put up prices to reflect higher commodity costs in order to protect their margins. The costs of energy, shipping and most commodities have fallen from their highs last year following Russia’s full-scale invasion of Ukraine — but an analysis by Barclays found that the gross margins of 10 of the largest consumer goods companies were lower in 2022 than in 2019.Bruno Monteyne said that after 18 months of raising prices, “most companies are now close to the level of price increases they needed to restore profitability”, as lower costs will begin to feed through.

However, some companies — such as those making affordable luxuries like fizzy drinks and confectionery — have managed to maintain volumes while pushing up prices. Some have indicated prices will have to rise higher. Coca-Cola raised prices 10 per cent in the three months to June 30, which did not dent sales volumes in the same period. The drinks maker’s chief financial officer John Murphy told the Financial Times the company would continue to increase prices in the second half of the year. Chocolate maker Lindt also warned of further price rises after raising prices without sacrificing sales volumes. Even Nestlé’s Schneider said further price rises would be necessary, particularly on products that rely on cocoa and sugar, which have soared in price as a result of climate-related shortages. “We still need to take the liberty to price where needed,” he said. More

Investors are set to assess whether enormous demand for artificial intelligence products can help offset a slump in global sales for computer hardware when Nvidia reports quarterly results on Wednesday.The US group said in its previous earnings report that demand for its processors for training large language models, such as OpenAI’s ChatGPT, would drive up revenues by nearly two-thirds and help quadruple its earnings per share in the three months to the end of July. The world’s most valuable chipmaker now plans to at least triple the production of its top H100 AI processor, according to three people close to Nvidia, with shipments of between 1.5mn and 2mn H100s in 2024 representing a massive jump from the 500,000 expected this year. With AI processors already sold out into 2024, the massive thirst for Nvidia’s chips is hitting the broader market for computing equipment, as big buyers pour investment into AI at the expense of general-purpose servers.Foxconn, the world’s largest contract electronics manufacturer by revenues, last week forecast very strong demand for AI servers for years to come, but also warned overall server revenues would fall this year. Lenovo, the biggest computer maker by units shipped, last week reported an 8 per cent revenue drop for the second quarter, which it attributed to soft server demand from cloud service providers (CSPs) and shortages of AI processors (GPUs).“[CSPs] are shifting their demand from the traditional computers to the AI servers. But unfortunately, the AI server supply is constrained by the GPU supply,” said Yang Yuanqing, Lenovo chief executive. Taiwan Semiconductor Manufacturing Company, the world’s largest contract chipmaker by revenues and exclusive producer of Nvidia’s cutting-edge AI processors, predicted last month that demand for AI server chips would grow by almost 50 per cent annually for the next five years. However, it said this was not enough to offset downward pressures from the global tech slump caused by an economic downturn. In the US, cloud service providers such as Microsoft, Amazon and Google, which account for the lion’s share of the global server market, are switching their focus to building up their AI infrastructure.“The weak overall economic environment is challenging for the US CSPs,” said Angela Hsiang, vice-president at KGI, a Taipei-based brokerage. “Since in AI servers every component needs to be upgraded, the price is a lot higher. The CSPs are aggressively expanding in AI servers, but that was not on the cards when capital expenditure budgets were drafted, so that expansion is cannibalising other spending.”Globally, CSP capital expenditure is expected to grow by just 8 per cent this year, down from almost 25 per cent growth in 2022, according to Counterpoint Research, as interest rates rise and businesses cut back.Industry research firm TrendForce expects global server shipments to decrease by 6 per cent this year and forecasts a return to only modest growth of 2 per cent to 3 per cent in 2024. It points to a decision by Meta Platforms to slash server purchases by more than 10 per cent to channel investment towards AI hardware, and delays in Microsoft upgrades to its general purpose servers to free up funds for AI server expansion.Besides the Nvidia chip shortages, analysts point to other bottlenecks in the supply chain that are delaying the AI harvest for the hardware sector. “There is a capacity shortage both in advanced packaging and in high-bandwidth memory (HBM), both of which are limiting production output,” said Brady Wang, a Counterpoint analyst. TSMC plans to double its capacity for CoWoS, an advanced packaging technology needed to make Nvidia’s H100 processor, but warned the bottleneck would not be resolved until at least the end of 2024. The two main suppliers of HBM are South Korea’s SK Hynix and Samsung.The Chinese market faces an additional hurdle. Although Chinese CSPs such as Baidu and Tencent are allocating as high a proportion of their investment to AI servers as Google and Meta, their spending is held back by Washington’s export controls on Nvidia’s H100. The alternative for Chinese companies is the H800, a less powerful version of the chip that carries a significantly lower price tag.A sales manager from Inspur Electronic Information Industry, a leading Chinese server provider, said customers were demanding quick delivery, but manufacturers were experiencing delays. “In the second quarter, we delivered Rmb10bn ($1.4bn) of AI servers and took another Rmb30bn of orders . . . the most troublesome thing is Nvidia’s GPU chips — we never know how much we can get,” he said.But once the global economy improves and the shortages abate, companies in the server supply chain could reap massive benefits, corporate executives and analysts said.The KGI brokerage predicts that shipments of servers for training AI algorithms will triple next year, while Dell’Oro, a California-based tech research firm, expects the share of AI servers in the overall server market to rise from 7 per cent last year to about 20 per cent in 2027.Because of the markedly higher cost of AI servers, “these deployments could constitute over 50 per cent of the total expenditure by 2027”, its analyst Baron Fung said in a recent report.“For the supply chain, it’s just multiples of everything,” KGI’s Hsiang said. With eight GPUs in one AI server, the demand for baseboards, on which the GPU modules sit, is bound to soar compared with general servers, she said. AI servers also need larger racks on which to position the processor modules.

The much higher power consumption of generative AI servers compared with general purpose ones also creates the need for different cooling systems and new specifications for power supplies.Foxconn could be among the main beneficiaries of the shift because the group offers everything from the various components to final assembly. Its affiliate, Foxconn Industrial Internet, is already the exclusive provider of Nvidia’s GPU module.For WiWynn, an affiliate of Foxconn competitor Wistron that specialises in servers, AI orders are already accounting for 50 per cent of revenues, more than double the proportion seen last year, according to Goldman Sachs.Analysts also see a strong upside for providers of components. Taiwanese printed circuit board (PCB) maker Gold Circuit Electronics could see AI servers jump from less than 3 per cent of its revenues this year to as much as 38 per cent, Goldman Sachs said in a report in June — an expectation driven by the sevenfold increase in PCB content in AI servers over general purpose servers. More

The worst of the global inflation shock may be behind central bankers as they descend on the Rocky Mountains for the Federal Reserve’s annual gathering this week, but policymakers are wary of declaring victory.Last year, officials who attended the high-profile event hosted by the Kansas City Fed in Jackson Hole, Wyoming, sought to burnish their inflation-fighting credentials after failing to identify or respond quickly enough to the most acute surge in consumer prices since the 1970s.But after pushing interest rates up to multi-decade highs, the central bankers in attendance must grapple with another arduous task: fine-tuning policy just right to get inflation under control, without causing undue hardship and job losses.That they have to do so when the dust is yet to settle on a global pandemic and a war in Ukraine that may have fundamentally rewired the economy makes the challenge more difficult still.The Fed, European Central Bank and Bank of England are among central banks still sussing out how much more to raise their respective benchmark interest rates, with the impact of past increases yet to take full effect. The spectre of a growth slowdown also looms, while views internally about the outlook have become more fractured. Soon, they too must confront how long to keep those rates elevated to ensure price pressures do not flare up again.At least in the US, the Fed may be near the end of the rate-rising phase of its inflation battle, having already slowed the pace of tightening as the federal funds rate has crested above 5 per cent. ECB officials are now also toying with a pause, while further increases are expected in the UK this year. But while resilience across the world’s largest economy has damped fears of an imminent recession it has challenged expectations about when the Fed will feel comfortable cutting rates.“Most of the tightening that they have done was just recovering from an inappropriately loose stance, so only in the last few hikes have they actually brought [rates] into restrictive territory,” said Joseph Gagnon, a former senior staffer at the US central bank. “They’re really in a place where they have to feel their way forward carefully.”

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Officials have begun to describe the risks confronting the US economy as “two-sided”, meaning that while their fear of inflation still percolates they are also aware of the costs for consumers and businesses if the monetary screws are tightened excessively. Those concerns have been amplified by China’s economic woes, as well as the continued pullback by US regional lenders in the aftermath of this year’s banking stress.But even with inflation receding, the manufacturing sector slumping and financial conditions tightening, the labour market — so far — remains strong. Despite monthly jobs growth slowing, the unemployment rate still remains near 50-year lows. That has helped to fuel spending, even as more Americans fall behind on loans and savings stockpiles dwindle.Raghuram Rajan, a former governor of the Reserve Bank of India, described the recent data as “a little bit problematic”.“The fact that the labour market is still so strong makes you a little worried that that last mile down to 2 per cent [inflation] may be really prolonged,” he said.

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Ellen Meade, who served as a senior adviser to the Fed’s board of governors until 2021, cautioned the central bank against overconfidence about its grip on inflation.“You don’t want to flip-flop and say we are done and are going to hold for a long time and then find out by the end of the year you have to hike a couple more times,” she said.Meade also urged the Fed to make clear that once it is done raising rates, its policy will remain “pretty restrictive”.

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Former policymakers and economists expect the central bank’s chair Jay Powell to emphasis this “higher-for-longer” stance on interest rates during his much-anticipated speech on Friday.That approach hinges in part on an assumption that the so-called neutral rate of interest — a level that neither stimulates nor suppresses growth — is higher than in the past.While the debate is far from resolved, Donald Kohn, who served as the Fed’s vice-chair during the 2008 global financial crisis, thinks loftier borrowing costs are likely to linger.Ballooning government deficits, increased spending on green energy investments, and heightened focus on domestic manufacturing coupled with stronger-than-expected growth have coalesced to tip the odds against a retreat to the ultra-low interest rates of the post-crisis period, he said.Fed officials’ own estimates of the neutral rate — also called R-star — have begun to creep up even though the median forecast still hovers at a pre-pandemic level of 2.5 per cent, or 0.5 per cent in real terms, once adjusted for inflation at 2 per cent.Researchers at the New York Fed surmise that R-star has risen in the short-run, but expect it to fall back to a lower level in the longer term. That is a view also held by the IMF, which warns of secular forces such as ageing demographics again taking over to push down borrowing costs.

Whether or not rates will be permanently higher, Kohn believes a soft landing, in which inflation comes down without a recession, is possible.Other ex-policymakers are more sceptical. Randall Kroszner, who served as a Fed governor between 2006 and 2009, said he was bracing for a “hardish” landing that could propel the unemployment rate to at least 5 per cent.“There are very few episodes where you’ve just had a little bit of movement up [in unemployment] as the Fed has tightened,” he said. “It’s not impossible, but that’s a scenario where everything has to go exactly right.”Kroszner added: “We’re in a world where it’s hard to see everything going right for the next year.” More

The writer is chief economist at AllianzAre eurozone governments getting too close for comfort to a new danger zone? The signs are there, with sovereign exposure to the corporate sector crossing 20 per cent of gross domestic product. This comes from both the European Central Bank’s asset purchases and the generous policy support to shield companies from the effects of back-to-back crises.Government credit guarantees and liquidity support certainly hit the mark, helping to keep vulnerable firms afloat. But they mask considerable economic scarring. Some sectors and firms have yet to fully recover, and some may never recover, especially those hit the hardest by pandemic-related containment measures and consequent changes in consumer behaviour.At the same time, delayed insolvency proceedings and the (so far) shallow recession have helped keep corporate defaults low. But these suppressed bankruptcies are hiding sizeable losses, which could emerge quickly as the effects of strong policy support fade, given the build-up of corporate leverage and still weak fundamentals.In fact, many small businesses are still barely afloat and will need to be wound up or restructured. Unless addressed early, worsening corporate profitability could quickly turn into losses — and these liabilities would become real losses for the sovereign.In a worst-case scenario, the complex system of interlinkages between real activity, banks and sovereigns means that an incipient corporate necrosis would spread rapidly, triggering a fundamental repricing of risk in a new doom loop. A trickle of defaults in some critical and well-connected sectors could grow rapidly into a torrent, and the sudden realisation of losses would jolt capital markets, precipitating a systemic crisis that reverberates through corporate, financial and sovereign feedback loops — where price falls trigger further weakness in related areas.If it is anything like previous crises, this extreme scenario could result in a cumulative default rate of 10 per cent over the next two years. This would imply a steep increase in insolvencies, based on a current annual default probability of less than 1 per cent. The resulting losses in the corporate sector would wipe out about three years of profits for banks, which would respond by cutting back on their riskiest lending to preserve capital — typically to the small and medium enterprises that need it most.For eurozone governments, direct losses and foregone corporate tax revenues could add up to 5 per cent of GDP on average, which would cut deeply into what little policy space is left. In this situation, the eurozone would find itself in a prolonged recession, but this time with more debt and minimal policy space for yet another fight.In this context, financial sector policies in the eurozone need to be more forward-looking when it comes to corporate sector risks, especially in countries where lower-for-longer insolvencies and lower asset-recovery rates amplify economic scarring, undermine the financial system and erode valuable policy space. To reduce the debt overhang, the eurozone also needs more efficient and robust debt-resolution frameworks, including simplified insolvency procedures for SMEs, hybrid restructuring mechanisms and out-of-court debt workouts.Ultimately, the best defence would be to complete the EU’s Banking Union with a truly bloc-wide market for bank services, common regulation and a European safety net for depositors. Without this, times of stress will always raise fragmentation risks — with even speculation of one or more countries falling out of the eurozone. Progress has stalled when it comes to closing important gaps, such as the design and implementation of the European Deposit Insurance Scheme safety net. This requires a new push to reach a consensus and encourage greater cross-border banking. And while the European Commission has adopted a proposal to adjust and further strengthen the EU’s existing bank crisis-management and deposit-insurance framework, it ignores the role of effective national institutional protection systems and the importance of EDIS for completing the Banking Union.At the same time, policymakers should consider new ways to work more with the private sector to restructure public sector exposures to distressed yet viable firms. This will require a new policy mindset, shifting away from thinking like a creditor looking to collect principal or roll over loans to that of an equity investor looking to maximise recovery value, such as by incentivising debt restructuring through tax credits and injecting new equity.But taking no action at all could leave the eurozone dangerously close to a déjà-vu crisis that will be hard to recover from. More