Inequality. You, my friend, are part of the problem.

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Brett Lewthwaite

  • Executive Director, Chief Investment Officer and Global Head of Fixed Income
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Executive summary

In previous editions of our Strategic Forum note, we have continually highlighted the significant structural challenges facing global economies, including indebtedness, dependency on central banks and the increasing financialization of the global economy, ageing demographics, increasing digitalization, as well as elements of deglobalisation and how they have exerted disinflationary forces and thereby downward pressure on interest rates, creating the present lower-for-longer environment.

We are constantly vigilant about what emerging influences could shift the trajectory of these ever-growing structural forces, and indeed we were alert with the easy embrace of fiscal policy as a solution to combat the global pandemic. However, as we re-examine those structural features repeatedly, we find most, if not all, are now significantly worse than prior to the pandemic. As our guest speaker Viktor Shvets reminded us so articulately, the policymaker response of continually lowering the cost of capital to encourage more and more credit growth has resulted in a levered financial economy that is now many times bigger than the real economy. It is the real economy that is weighed down by structural disinflationary forces, and it is the real economy that is now confronting an adoption of new technology and digitalisation advancement that the pandemic further accelerated. Medium to longer term this is all very disinflationary.

The central bank policies of “just do more and more” quantitative easing (QE), which have been adopted since the global financial crisis, have not addressed these structural challenges. While QE has been wonderful for asset prices and their owners, the once embraced idea of the wealth effect trickling down to the real economy has not worked and ultimately has resulted in greater and greater levels of inequality and social tension. Indeed, this point was made recently at the Jackson Hole Symposium with a research piece, “Low Interest Rates and an Uneven Economy.”

With ageing populations and the rise in the voting power of millennials, who are unlikely to continue to favour the current policy mix, the social and political environment will likely evolve, perhaps within the next few election cycles. For now, the best we can expect from any early shift toward addressing these structural forces via greater societal support is a slowing of the ever growing disinflationary sludge. A far greater shift will be required to stop its advance.

At the September 2021 Macquarie Fixed Income Strategic Forum, we focused on the ever increasing list of uncertainties the global economy is currently facing: the fear of stagflation, central bank tapering, the shift from fiscal tailwinds to fiscal headwinds, China’s embracing “common prosperity,” and finally, the possibility of a more socially aware Federal Reserve (Fed). We analysed the supply disruptions that have emerged as a result of the pandemic and the possibility of stagflation. We discussed that we have likely reached peak fiscal support and expect that demand is unlikely to be strong enough to drive economic growth without that support. The Emerging Markets Debt team outlined the changing political landscape in China toward “common prosperity” and noted the likelihood of a mid-cycle moderation in growth. We assessed the potential for changes on the Fed Board and the impacts this might have on policy. Overall, despite a genuine sense of ongoing financial market complacency, we concluded that in an environment exhibiting a distinct rise in uncertainty, a marked increase in volatility should not be underestimated.

Dissecting the current environment

The current economic environment is still dominated by the influences of the pandemic, which is ever evolving. Vaccination continues, although country progress remains divergent as does the level of mobility and its impacts on both demand and supply. However, the greatest impact of the global shutdown with uneven recoveries has been on supply, with many supply lines and logistics congested. There is a supply problem, and it is occurring at a time of lacklustre private demand, despite demand being propped up by fiscal support.

Inflation has moved higher, driven by base effects and the supply disruptions, with growing evidence that this is also affecting demand. Stagflation is now increasingly being discussed.

A key feature of the September Strategic Forum was a deep dive into the nature of stagflation and a comparison between the supply disruptions that are being experienced today, to those experienced in the 1970s. Our research indicates this episode is not like the 1970s.

Until the pandemic passes, supply chain inflation could persist (into 2022); however, our analysis shows that it will adjust and when this occurs, prices can correct quickly. Over the next 3 to 6 months, we expect we will remain in a state of flux as these imbalances linger due to the ongoing risk that the pandemic persists. Historically, following a period of war, supply chain issues have taken 12 to 18 months to resolve once the war is over, and we expect the current supply chain disruption can only be resolved once the pandemic passes.

The economic rebound of 2020/21 has been dampened by the COVID-19 Delta variant, with slower growth evident into the third quarter. Consumer spending is slowing. Demand was being supported by government transfers, but this fiscal support is now being withdrawn. Fiscal drag is now looming as an important driver in coming quarters. As fiscal stimulus fades, we believe private demand is unlikely to be strong enough to fill that gap.

At our May Strategic Forum, we conducted a deep dive into the fiscal policy response to the pandemic and asked the key questions whether fiscal policy (”effective” fiscal stimulus) would be large enough, sustained enough (multiple years), be targeted in the right areas (permanent job and thereby income creation), and be global in its reach. We concluded that the announced programs were a good start but would likely need to be followed by more. Further, the nature of fiscal policy and its connection to government and politics, particularly in the modern day of social media, would result in significantly more challenges in enacting these programs than the common market narrative had embraced.

Fast forward to the September Forum, and the US fiscal plans appear to have met considerable political resistance and have been watered down significantly. They are now far lower than we analysed at the May Forum. What had ignited the market narrative was well short of what the economy required and is now even further short of what is needed. Our views regarding fiscal policy have panned out.

Overall, the economic outlook risks appear skewed to the downside. What will drive growth to accelerate to a new higher trend? Our best-case assumption is that we return to the uninspiring pre-pandemic trend of growth.

The chase for yield goes on… and on

Linking our long-held beliefs of the “lower-for-longer” environment with the current reality facing the global economy, we cast our focus toward the latter stages of 2021 and what it ultimately means for markets. Again, we find a world with cash rates locked at or near zero, bond yields remaining low (and in many places negative yielding), credit spreads that are tight by historical standards (and grinding tighter), and financial markets that are flush with abundant and ongoing central bank provision of liquidity.

This combination of an absolute lack of yield, in a world that is desperate for it, means it should once again be the dominant theme over our investment horizon. This insatiable chase cannot be underestimated and with no viable yield alternatives, everyone seemingly needs yields and everyone, supported by central banks, are emboldened to stretch further and even lever up to secure it. Federal Reserve Open Market Committee (FOMC)-like behavior and very full valuations are ever present. Nonetheless, the chase for yield remains a very strong anchor and belief in financial markets and was impossible to fight against throughout 2021. Yet being grounded investors does not mean we are not troubled by the ongoing trends and while we continue to participate in sensible ways, we remain constantly alert for any sign of volatility on the horizon.

To describe the situation in another fashion: Chasing yield is essentially buying credit/spread, and when you are buying credit/spread, you are in effect selling volatility. This is fine when credit spreads are wide and you are compensated for the fact that volatility is falling (realized volatility is less than implied volatility). However, that is not the case at present. Market participants are no longer earning the same premium (or outright yield even) for selling that volatility. Central bank actions since the pandemic have effectively suppressed volatility with massive amounts of once unthinkable QE creating a powerful yet uneasy false sense of security.

Zero volatility? In a world of rising uncertainty and many unknowns…

Looking to the horizon and what could potentially cause disruptions and increase volatility, we see a growing number of concerns. Indeed, the most pronounced difference between our assessment of the environment in May to now, in September, is the marked increase in genuine uncertainties. From fears of stagflation, central bank tapering, fiscal tailwinds to headwinds, to China’s embracing of “common prosperity,” and its subtle links all the way to the potential nuanced shifts in the make-up of the Fed, all suggest the world of benign suppressed volatility may soon be no longer. We are alert to the potential impact that any one of these areas could have on financial markets and discuss each of these in more detail below.

Stagflation

Many people have compared the supply disruptions that are being experienced in 2021 to the experience of the 1970s. Our research revealed that this type of supply-constrained inflation into lacklustre and even possibly weakening global demand is more likely to act as a further suppressant on demand and economic growth, rather than create a self-fulfilling wage price inflation spiral. So, the key takeaway is the recognition that the underlying drivers of the current inflation environment are from the supply side. As the pandemic fades these problems will dissipate – potentially quickly, and so too will the inflation impulse.

Nonetheless, we completely appreciate the risk of inflation and that the market narrative could easily embrace the belief that inflation may not be so “transitory.” This has the potential to create volatility in the bond market. It is the reality of what higher bond yield means to all other markets, given the amount of leverage in the system and its absolute reliance on the ongoing low cost of leverage (low interest rates), that scares us most. Even if stagflation ends up being “just a narrative,” its potential to create rippling volatility across all asset classes should not be underestimated.

The tale of the two tapers

Despite assurances at the beginning of 2021 by central banks that they would allow the global economy to run hot, there have been noticeable changes more recently about whether they should still be supporting economies and, by de facto, financial markets with their current very large and ongoing QE/liquidity programs. As such, expectations that central banks including the Fed will begin withdrawing liquidity are now fully formed. This is the first tale of tapering and, curiously, it coincides with a noticeable downshift in economic growth indicators and a stark deacceleration in global credit growth, neither of which bode well for the economic outlook.

Further, this first “monetary” taper is also occurring concurrently as the fiscal tailwind supporting economies since the pandemic is turning to a headwind and the drag will start to detract from growth across the major economies. We would argue that fiscal taper is more significant than QE taper, as this will affect actual demand. Let’s not forget how excited everyone got about fiscal stimulus lifting demand earlier this year – now it is about to go the other way and become a drag.

This brings us to the interesting question of “why now?” in relation to central bank tapering. There is little doubt that a case is building that the incredibly large and ongoing central bank liquidity support is no longer having the desired level of effect on economic growth, while more so pushing asset prices higher and higher, resulting in widespread and worsening inequality. And now this inequality is extreme and a growing part of the structural problems that are weighing on the global economy. If indeed this shift of mindset is real, its impact on financial markets would likely be vast and widespread. We also wonder if it changes the widely held belief that the “Fed has my back” and cannot tolerate volatility? Maybe the “Fed-put” just has a much lower strike than the market believes.

The story of the “two tapers” is not a welcome tale for the global recovery and if they continue, they are almost certain to cement a weak recovery. The potential for heightened volatility should again not be underestimated. The fate of western economies is like that of Japan’s – all evidence suggests that with ever increasing leverage, the cost of capital is on its way to zero. And bond yields will go there too.

China embraces common prosperity, while inequality in the west goes into space (literally)

Another topic that we discussed at length was the notable shift occurring in China. China has recently enacted several reforms (or crackdowns), targeting many sectors, and has referred to this as a pursuit, or re-adoption of Communist Party beliefs around ”common prosperity.” China is often difficult to read, although this change in direction appears to us to be meaningful, stark even. Our analysis raised two key questions. The first is in relation to the change towards more ‘common prosperity’ goals –- will China sacrifice short-term growth for long-term gain? And if so, will this result in a lower pulse of Chinese growth and thereby similarly affect the global economy that is already hampered by the pandemic? Secondly, are the reforms we are observing in China a normal part of the political cycle, or a reaction to other structural challenges China is experiencing as it continues to try to manage its economy. Either way, there is a noticeable change in direction underway, and what this will mean is highly uncertain for the global economy and the geo-political environment. It seems unlikely this change in direction will be a trigger for stronger growth near term. Our analysis highlighted the increasingly present downside risks, which can be highlighted by situations such as the property company Evergrande.

Interestingly this “clean break” by China to embrace “common prosperity” also appears to have inadvertently and in some ways accentuated the outcome of western economies with their “just do more” central bank policies and resultant extreme and widespread inequality. While China is now embracing common prosperity, inequality in the west is heading into space (literally).

Central banks – The first step to recovery is admitting you have a are the problem

The nature of the political shift in China is interesting as it highlights the flaws of the western central bank approach to addressing the lack of demand since the global financial crisis. This leads us to our final potential area of concern. As we know, central banks have been forced to roll out a series of previously unthinkable rounds of asset purchases and this has ultimately resulted in higher asset prices. Higher asset prices have spawned growing inequality, so much so that central banks now appear to be contributing to the problem rather than addressing the structural challenges facing private demand. The more central banks provide support, the higher asset prices go, the more inequality that is created. China, it seems has recognised the flaws of this approach, and appears to be rejecting it.

You my friend, are part of the problem – and there is now a risk the Fed is recognising this. A recent trading scandal by two Fed governors, Eric Rosengren and Robert Kaplan, has turned the market’s attention to a potential credibility crisis at the Fed. With Chairman Jerome Powell’s term ending in early 2022 and the need to replace the two other governors, there is the potential that the Fed (which was already becoming more socially aware) could be accelerated as the Democrats get to install their own preferred candidates.

If the Fed is pivoting and becoming more socially aware, with a focus more on maximum employment rather than containing inflation, what does this ultimately mean for rates and markets? By raising interest rates, the Fed’s main conventional monetary tool, they are effectively creating unemployment, which is something a socially aware (new) Fed will likely be loathsome to do. While the Fed may become aware of the inequality it has contributed to increasing, it is very hard for the Fed to address this directly with its current tool kit. However, they can help by making sure everyone who wants a job has one. While more QE is less likely as it hinders inequality resolution, a “new Fed” is not going to intentionally pop a bubble and create a recession (unemployment) to lower asset prices. A socially aware “new Fed” does less QE and as a result, asset prices could be more volatile or at least priced for a greater dispersion of outcomes, which means higher spreads and lower equity markets to compensate. This is probably more of a worry to our portfolio than higher bond yields.

Fixed income asset class implications

With the structural forces being exacerbated by the ongoing pandemic, and the heightened level of genuine uncertainties facing the global economy, we believe increased volatility is a near-term risk. Each of the uncertainties we have outlined in this note likely cause volatility individually, but the combined impact of stagflation, QE tapering, fiscal tapering, China’s embracing of “common prosperity,” and the potential shift to a socially aware Fed is likely to be far greater. Our portfolio positioning reflects of our expectation for increased volatility, poised to take advantage of any opportunities that may arise as a result.

  • Rates | We have reached peak fiscal support and expect central banks to begin tapering asset purchases, dependent on ongoing improvement in employment. Rate hikes are independent of the decision to taper but market pricing is likely to get ahead of the Fed. Any move higher in yield should be used as a buying opportunity.
  • Credit | Broad economic recovery is driving fundamental credit improvement in most sectors. Supply chain constraints have increased operating costs and slowed growth, but we do not expect these headwinds to derail the recovery. In intermediate grade credit, we maintain our quality bias but see some value in COVID-impacted sectors on a single name basis. Default rates are at historic lows, and we continue to prefer a barbell strategy, including an allocation to high yield while holding a material liquidity cushion.
  • Structured products | Mortgage market characteristics are stabilising ahead of the potential Fed taper, providing an opportunity to increase the allocation to agency mortgage-backed securities. The collateralized loan obligation (CLO) market has been active with high issuance volumes and strong investor demand, leading the team to participate in high-quality, short-duration CLOs. Fundamentals remain strong in Australian residential mortgaged-backed securities, and valuations remain attractive.
  • Emerging markets |Economic activity continues to improve, despite the Delta variant and supply constraints. However, disparity remains between countries and many emerging markets are still below prepandemic growth levels. Inflation has picked up in some regions, which has triggered hiking cycles. Geopolitical risks are rising. The team prefer corporates over sovereigns due to the lower leverage levels and prudent behaviour.
  • Currency | The US dollar remains stuck in a range-trading environment for now. However, longer term the risks look skewed towards a stronger US dollar. Historically, tapering has been modestly positive for the US dollar. As a simple duration alternative, we like US dollar-calls against the Australian dollar, the New Zealand dollar, and The Norwegian krone. To hedge against a true left tail event, the Japanese yen offers a compelling alternative.

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The views expressed represent the investment team’s assessment of the market environment as of October 2021, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

Diversification may not protect against market risk.

Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.

Market risk is the risk that all or a majority of the securities in a certain market – like the stock market or bond market – will decline in value because of factors such as adverse political or economic conditions, future expectations, investor confidence, or heavy institutional selling.

International investments entail risks including fluctuation in currency values, differences in accounting principles, or economic or political instability. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility, lower trading volume, and higher risk of market closures. In many emerging markets, there is substantially less publicly available information and the available information may be incomplete or misleading. Legal claims are generally more difficult to pursue.

Currency risk is the risk that fluctuations in exchange rates between the US dollar and foreign currencies and between various foreign currencies may cause the value of an investment to decline.

Credit risk is the risk of loss of principal or loss of a financial reward stemming from a borrower’s failure to repay a loan or otherwise meet a contractual obligation. Credit risk arises whenever a borrower expects to use future cash flows to pay a current debt. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation. Credit risk is closely tied to the potential return of an investment, the most notable being that the yields on bonds correlate strongly to their perceived credit risk.

Economic trend information is sourced from Bloomberg unless otherwise noted.

The disruptions caused by natural disasters, pandemics, or similar events could prevent the strategies from executing advantageous investment decisions in a timely manner and could negatively impact the strategies’ ability to achieve its investment objective and the value of the strategies’ investments.