June 30, 2021
Recently, many of our clients have been asking questions related to two interconnected themes. The first centres around our well-known belief about the lower-for-longer environment and whether the fiscal response to COVID-19 means we are considering changing our long-held view. Second is the related question about whether we believe the increase in inflation we are now witnessing is transient or more sustained.
The May 2021 Macquarie Fixed Income Strategic Forum focused on these themes. In addressing these, we were really investigating a very important thesis: whether or not we believe financial markets are at a significant turning point. Are we at the beginning of a paradigm shift toward a new investing regime, a regime where ultra-loose monetary policy coupled with a sustained fiscal impulse means that output gaps finally close, and that has sustained higher levels of economic growth with potentially higher inflation?
Over the last 10-plus years, our once nonconsensus, lower-for-longer thesis was predicated on the significant structural issues that have hampered the global economy. The pandemic has heightened almost all these structural challenges, and at an even more rapid rate. Indeed, comparing them to 2019 when a consensus had finally formed around their role in creating the lower-for-longer environment, these challenges are now far worse, not better. When considering what would encourage us to think that the structural environment was improving, our view has always been that a shift toward a greater use of fiscal policy would be necessary.
As is well known, the policymakers’ response to the pandemic was a surge toward utilisation of fiscal policy. In 2020, fiscal policy was engaged in significant ways to help many countries deal with the sudden stop and dislocation that occurred with social distancing. As a result, fiscal policy has become more relevant and accepted, and it makes sense that we are being asked whether our views regarding the lower-for-longer environment are evolving.
At our latest Strategic Forum, we conducted a deep dive into the prevailing narrative to understand whether this fiscal shift is enough to make a significant improvement to the structural challenges that have created and maintained the lower-for-longer environment. Our analysis looked at whether current policies will be big enough, sustained enough, targeted enough, and potentially even global enough to witness a turning point that is being priced into markets. The team also examined the likelihood of the policies sparking a sustained increase in inflation, resulting in a paradigm shift away from the lower-for-longer environment. We concluded that while the Biden Administration’s fiscal plan had the potential to create much needed jobs and aid in the economic recovery, it was not clear to us that it will be large enough and sustained enough. Further, the team was sceptical that the plan would be enacted in full with the challenging political environment likely to see the proposed package scaled back.
With the strong rebound in asset prices across asset classes over the past 18 months, we have seen a continuation of the market themes from the last Forum, with even fuller valuations and more crowded positioning as the chase for yield in a low yield world persists. While there is the potential for a fiscally driven growth acceleration from here, a number of questions remain about how effective this may be and how markets may react. In this environment, we believe selectively participating in markets while positioning portfolios with increased defensive and liquid allocations is sensible.
The popular narrative
The popular narrative in markets is that fiscal has arrived. In 2020, the fiscal emergency glass was broken, and massive transfers were expected to easily evolve into sustained direct fiscal spending. Even if it is not fully apparent yet, it will increasingly
become the policy of choice going forward with monetary policy unable to effectively stimulate an economic recovery. Given that fiscal is here and markets have embraced the endless possibilities, the environment in which we are currently investing
may be seen at least as the start of a turning point, and quite possibly the beginning of a new regime.
Some think this is so much the case that not only will the pandemic recovery occur strongly and quickly, but all the troubles of the structural challenges1 will also be magically resolved! Pushing this narrative to the extreme, some even think
that “silly governments” will not know how or when to stop their use of fiscal policy, and combined with ultra-loose monetary support, the economy will run hot, waiting for an inflation spark to ignite it. Indeed, this would be a true paradigm shift,
one for which few are prepared.
Case of déjà vu?
Or is this just like every other time since the financial crisis, where more and more unthinkable policy actions occurred, such as zero or even negative interest rates, the implementation of quantitative easing (QE) 1-2-3, the concept of Modern Monetary
Theory, and the election of more populist leaders. Every new policy or easing was lauded as “this will do the trick!” and heralding that a new era was upon us now that “all is fixed!” and that the global economy was about to burst out of the lower-for-longer
But as we know, each of those popular narratives gradually faded as they encountered those structural forces once more. The pattern of the last decade was an obsessive belief in the any-minute-now (yet ever elusive) return to normal: “Just do more… and
more… and more” once unthinkable stimulus. Is the prevailing popular narrative just playing out like those before it? Despite all the hype and the (self-reinforcing) euphoria exhibited in the more speculative sections of financial markets (you know
who you are), we very much remain entrenched in the reality of the lower-for-longer environment.
Fiscal policy – a thorough assessment of the task at hand
What is different this time is that the policy response is actually fiscal, and it is targeted more toward the broader population. During the Strategic Forum, the team undertook a significant amount of research attempting to understand the fiscal programs
that have been announced so far, focusing on the US initiative to invest in infrastructure. We simply asked, “Will the fiscal response be large enough, sustained for long enough, and targeted at the structural issues causing secular stagnation?” We compared the current programs to effective fiscal programs of the past, such as Franklin D. Roosevelt’s New Deal in the 1930s.
Our assessment is that the Biden Administration’s fiscal plan is a solid start but will likely need to be followed by more and more programs. The initial plan of $US2.88 trillion is large in dollar terms, but relatively small when compared to the size
of the economy at around 15% of gross domestic product (GDP). Comparatively, the New Deal was around 85% of GDP. The plan is also targeted at infrastructure spending and other initiatives that would likely create much needed jobs and stable incomes.
The implementation phase is planned to be sustained over 10 years. However, there are definite question marks around whether it can be sustained for the duration of the program and thus have an impact on the structural challenges, given the challenging
Update: Budget bottom line
The latest information suggests that the Biden Administration’s fiscal plan will be smaller than originally announced and possibly far less than desired in impact. It will likely pose even less “threat” to the structural lower-for-longer trend and
in the short-to-medium term, the impact on demand could be much less than expected. The Biden Administration’s original “Build Back Better” plan totalled approximately $US3 trillion, but since then we have seen the White House come back with a
lower amount on the infrastructure part of the plan – $US1.7 trillion instead of the proposed $US2.3 trillion – probably due to political pressures, and the likelihood remains that an even lower amount might be the final figure given that the
Republican counter plan is $US928 billion. The 2022 budget projection of average economic growth of about 2.16% from 2022 to 2031 is even lower than the post-global financial crisis pre-pandemic period’s (2010-2019) average rate of 2.31%, and
as a result the budget deficit is projected to narrow considerably from about 17% of GDP to about 7.8% of GDP in 2022 and 5.6% of GDP in 2023. Whatever the final amount that emerges, this appears to be a clear indication that fiscal policy is
facing significant headwinds as a remedy to ending or reversing the structural lower-for-longer trend.
Question marks were also raised about global consistency of fiscal packages. Our emerging markets team highlighted that the US shift toward fiscal policy is more the exception than the rule. Indeed China, for example, as another significant contributor
to global economic growth, is actually going the other way, withdrawing stimulus from its economy via reforms and regulation. From a global point of view, these actions appear likely to negate the fiscal progress in other larger economies prompting
us to add a further caveat to our list of questions – will the fiscal response be global enough?
Lastly and importantly, there was a clear sense of scepticism from the team regarding Biden’s plan and the likelihood of its being passed in the proposed form. Fiscal policy is all about government – and government is about politics – and politics is
about doing difficult things. Doing difficult tasks for long-term benefit is never easy and even more so in the current age of social “me, me, me” media, rampant lobbyism, and powerful, embedded, vested interests. In a time of widespread polarisation,
the ability for the populace to express its views with instant and very direct feedback about some of these policies appears to have gone hand in hand with a more polarised population. This polarisation means the clear mandate that a government requires
to affect the type of fiscal policy required – policies that create sustainable jobs and reliable incomes – appears very difficult to achieve, particularly in the size required and for the period of time required for it to be effective.
Structural challenges – running away from their clutching hands
We define the structural challenges as widespread ongoing indebtedness, demographics, acceleration of digitalization, acute dependency on very low rates, and ongoing monetary support, and perhaps even the 5th D of deglobalization. One might consider these
similar to a growing sand pile, with the arrival of fiscal policy as a counteracting shovel. There are significant question marks about how big the always growing pile of sand is. Is it large yet manageable? If we start digging with our fiscal shovel
now, will policymakers eventually make progress? Or is the size of the pile and its rate of growth much more significant? Indeed, are policymakers standing on a vast beach, and is the progress before they can make a material impact on those structural
challenges far, far further into the future than just the current concepts or discussions – rather than actions – that are moving policymakers in the direction of fiscal solutions?
In other words, the current fiscal policy proposal is likely a step in the right direction (if it can be implemented). For the near- to medium-term, this shift is likely to slow down some of the structural trends we have witnessed in the global economy,
but it is unlikely to stop them, or create a turning point.
So, in relation to our first question, and thinking about that lower-for-longer environment, we see significant challenges to the narrative that this is the beginning of the end. We are not yet compelled to think that we are witnessing a paradigm shift.
But we do feel that we are laying out a sensible framework for considering whether we may be at a turning point or remaining stuck in lower for even longer.
While we have already laid out a very good framework for thinking about the longer term and the biggest structural themes, we must also consider the visceral and passionate views that financial markets will likely wrestle with nearer term.
Inflation – transitory or turbulent?
The second and related question was really about trying to understand whether we believe that the current uptick in, and narrative around, the possibility of inflation was something that we should factor into our portfolio positioning.
There are considerable differences being experienced in the global economy due to the pandemic. Essentially, each and every country (and even city) is at a different phase in the recovery. Some are moving quickly, successfully rolling out the vaccine,
while others are suffering setbacks in dealing with the latest outbreak. The current experience is a very unusual, unsynchronised economic recovery that none of us has ever experienced. It is plausible that demand surges, or supply shortages in certain
sectors could lead to the appearance that pockets of high prices are real. These visible signs feed into the narrative that the pandemic is accelerating the environment toward one in which price spikes could result in a higher inflation pulse coming
However, most market commentators believe the current uptick in US inflation (inflation does not appear to be a global phenomenon, at least so far) should be a transitory event, with supply lines eventually connecting and base effects rolling off. In
our discussions, while the longer-term view was around potentially disinflationary forces coming through on the supply side, we believe that over the short-to-medium term, there is a possibility that inflation may be somewhat higher and potentially
more persistent than markets are currently considering. With few attractive yield alternatives resulting in crowding behaviour, and very full valuations, the outcome could be a period of heightened volatility.
The comfort of the crowd and the risk of turbulence
The dominant theme of this prevailing environment has been and remains the absence of yield. With little in the way of alternatives, the need for yield is seemingly insatiable. While it is not often highlighted by many market commentators, the reality
is central banks are still easing – providing significant amounts of liquidity each and every month, and in doing so indirectly sponsoring the ongoing and insatiable chase for yield. The absence-of-yield theme has been a powerful force in fixed income
markets, and participating in the trend has been a rewarding experience.
Everyone is doing it. And it has been working. Central banks are still providing liquidity – so the impetus to depart the comfort of the crowd is low. Who wants to be different, particularly when the alternatives are few and very unrewarding? Despite
the narratives relating to inflation risks (transient or otherwise), the need for yield continues to dominate. Credit spreads have tightened considerably and many risk market valuations are now very full.
If the popular narrative of a strong economic recovery (supported by vaccination rollout, more fiscal policy, and ultra-loose monetary policy) is correct and the nature of inflation that may be appearing in pockets is more than transitory, then the risk
from here is that perhaps markets begin to rethink the risk reward available. Or central banks themselves may be forced to start to withdraw some of that ongoing stimulus that has been a feature in markets ever since the onset of the pandemic.
Given the dependencies that have come along with this “absence of yield” world, any change from the crowd could be quite disruptive, perhaps significantly so. We believe it is prudent to factor in the possibility of increased volatility as a near-term
Fixed income asset class implications
With the strong rebound in asset prices across asset classes over the past 18 months, we have seen a continuation of the themes from the last forum with even fuller valuations and more crowded positioning as the chase for yield in a low yield world persists.
Whilst there is the potential for a fiscally driven growth acceleration from here, questions remain on how effective this may be and how markets may react. In this environment we believe selectively participating in markets while positioning portfolios
with increased defensive and liquid allocations is sensible.
- Rates | We are at peak monetary support, and if things continue as they are, we expect less support going forward. Structural headwinds remain and while more fiscal support is expected, it is unlikely that the size and sustainability
is sufficient to overcome these headwinds. While near-term inflationary impact is probable, it is also likely to be temporary, in our view. As such, we remain relatively neutral on duration and any backup in yields represents an opportunity to
accumulate at better levels.
- Credit | Credit fundamentals are improving with corporate earnings having sharply rebounded. Supply costs and bottlenecks are having uneven effects, though most companies expect to be able to pass these on. Investment grade credit
valuations leave little margin for error with credit spreads continuing to compress tighter. We prefer to adopt a “barbell-like” strategy, increasing liquid and short-dated exposure alongside higher beta/recovery trades. Our holdings of “generic”
credit continues to be minimised with overall credit risk in multi-sector portfolios running slightly lower. We are focussing on pockets of remaining value and adopting a disciplined and cautious approach to high yield/bank loans with security
selection remaining key.
- Structured products | Spreads across the sector are at very tight levels. However, we see some select areas of value within structured securities at the moment, including AAA-rated commercial mortgage-backed securities (CMBS), Australian
residential mortgage-backed securities (RMBS), and collateralized loan obligations (CLOs), which have improved fundamentals given underlying improvements in the economy. We also see agency MBS as an area that can provide diversification and liquidity
to a portfolio.
- Emerging markets | Policy normalisation, solid external accounts, and sustained growth create an overall positive picture for emerging market debt, though geopolitics remain a risk. Policy changes and politics have widened emerging
market corporate bond spreads though there is differentiation based on particular countries and industry sectors. The team favours corporates over sovereigns in the sector, which provides attractive carry versus duration. Within sovereign we prefer
exposures with stable fiscal accounts and coherent financing.
- Currency | We expect the US dollar outlook to be more mixed in the short term though likely to continue its trajectory lower. Our preference is toward growth and reflation correlated currencies such as Canadian dollars, Australian
dollars, and New Zealand dollars as global growth momentum trends higher and shifts away from US exceptionalism. Safe haven currencies may be expected to underperform while equity markets remain supported by monetary and fiscal policy, though
they could act as a hedge to risk market volatility. Select positions in emerging market currencies provide exposure to the commodities rebound and offer carry.
1 We define the structural challenges facing global economies as the 5 D’s: widespread ongoing in-Debtedness, Demographics, acceleration of Digitalization, acute Dependency on very low rates and ongoing monetary support, and De-globalization.