October 19, 2020
The Macquarie Fixed Income (MFI) team recently gathered for our third Strategic Forum of 2020. This year has passed so quickly and we can only wish the COVID-19 virus had done the same. What was hoped to be only a first-half problem for the global economy has morphed into a much longer-term challenge with a vaccine still a distance away, rather than a nearer-term reality.
We came together in September with the knowledge that much has changed since our May Strategic Forum, relishing the opportunity to take time away from the noise and the numerous narratives, and seeking to get to the core of market dynamics and drivers. Over the course of the Strategic Forum, we discussed in-depth the economic outlook, policy effectiveness and the likely need for ongoing stimulus, the upcoming US election, and finally the highly topical outlook for inflation.
Summarising our economic outlook, we observed a noticeable bounce in economic activity, although it is uneven across countries and sectors. Comparing where we are today with January, before the virus impacted the economy, we first recognised that this starting point was one where the pace of economic growth was already lacklustre. Next, it was apparent that it will likely be multiple quarters, if not more, before we might attain these prior levels of (uninspiring) economic activity due to the ongoing prevalence of the virus and need for social distancing.
On policy, there is no doubt that the contraction would have been far worse without the incredible support from both central banks and governments, yet we felt it is important to reference these interventions as support and not stimulus. Looking forward, there are now some genuine question marks over whether these programs can be extended at current levels, in particular on the fiscal side with this avenue more aligned toward politics, and as with anything in politics, progress generally takes much longer. This is particularly the case in the United States, with the upcoming election creating uncertainty with some scenario outcomes likely to result in significant policy change.
This era of ultra-loose monetary policy has yet again raised the topic of inflation with concern that a surge is inevitable. Analysing this, we started with the structural influences such as debt, demographics, and dependencies, and concluded all are still present and, if anything, many are now worse. Coupled with current output gaps, it is difficult for us to conclude anything other than that inflation has a considerable hill to climb if it is to appear. Nonetheless, with the likelihood that monetary financing could be introduced to support fiscal spending in a significant way, it is rational to surmise that, ultimately, the end game could result in a notable uptick of inflation. For the moment though, we think the former series of events, the structural issues that have been weighing on inflation plus the output gap, are more likely to interreact to keep inflation contained and perhaps pressure it lower.
Turning to investment implications, we recognised that the V-shaped recovery, while not evident in economic activity, was certainly prevalent in financial markets, in particular credit. Looking ahead, our longer-term anchoring focusses on an “absence of yield” theme that will characterise fixed income for what we expect will be a considerable period. And with it, we see a continued strong influence that the need or chase for yield should have on credit and emerging markets in particular.
The economic outlook: There are mountains and hillsides to climb
In May, we highlighted the conjecture about the potential shape of the COVID-19 recovery with an alphabet soup of ideas like V-shaped, Ws, Ls, swooshes, and more recently, Ks. In September, we received a clearer picture of what has taken place and gained a greater sense of the likely recovery.
The global economy suffered an unprecedented hard and fast contraction in March, which continued through the second quarter, as lockdowns and the concept of social distancing impacted so many parts of the global economy, particularly the services sectors. Since then, most economies have reopened to some degree, and we have witnessed the type of recovery that is occurring. We can conclude that the worst looks to be behind us, albeit with economies remaining in a state of adaption as the virus ebbs and flows.
Noting the strong initial bounce in economic activity from very low levels, it is understandable that this offered a sense of confidence that the pace of recovery toward prior levels could be relatively quick. However, to what level specifically is a far more important component of the analysis. As we stepped away from the noise and examined all the evidence in September, it was quite apparent to us that the recovery, while quick at first, had not retraced anywhere close to prior levels. Furthermore, the speed at which the global economy is recovering now appears to be stalling. We also observed that as the recovery unfolds, it is uneven across countries and across sectors. As we assessed the recovery, comparing where we are today with January, before the virus impacted the economy, we first recognised that this starting point was one where the pace of economic growth was already lacklustre. Next, it was apparent that it will likely be multiple quarters, if not more, before we might regain these prior levels of (uninspiring) economic activity.
The virus: It will (not) go away
The primary driver of this more uncertain, likely lacklustre, trajectory is that we can easily observe that the virus is still with us and continues to spread with significant new infections every day around the world. The one constant is the concept of social distancing, and we also now see the impact that this new social norm is having on so many different companies and the way they operate, particularly those in the services sectors.
The other key point to acknowledge is, whether it be central banks in the “just do a lot, lot more” monetary stimulus, or the enormous and rapid fiscal support structures that governments put in place, the contraction could have been a lot worse. Indeed, the preventative measures put in place by governments have been very effective, although, on closer examination, they are more in the nature of being support-based, rather than stimulus-based.
As the year continues, there are now some genuine question marks around whether these programs can be extended at current levels, or indeed whether they are reduced and start to weigh on the recovery by way of a (potentially considerable) fiscal drag. Further, when we consider this in light of the upcoming US election and politicisation of these programs, there is a genuine risk that further support from the fiscal side may disappoint and pose a very real risk to the outlook.
Knowing that the virus is likely to be with us for some time and that social distancing will remain a key feature in all of our lives, having a clearer picture of the impact on unemployment levels, appreciating the support-based nature of the fiscal programs, and the potential for them to be reduced, we concluded that the recovery from here is likely to be a tougher grind. Indeed, the most likely scenario is one that will require further policy maker support and stimulus.
Economic “V” requires a “V”accine
On the positive side, there is always the possibility that a vaccine will be found. Numerous companies are getting closer to the successful completion of clinical trials, and if one ultimately progresses, then optimism about how quickly the vaccine could be rolled out to the global population would boost confidence and we would likely see the pace of the recovery quicken. This scenario is definitely one that we cannot discount.
At the Strategic Forum, we considered the reporting that suggests that conclusions of late-stage clinical trials may still be a number of months away and the ability to roll out a vaccine could only be realistically achieved by mid-2021 at the earliest. So, for at least until year end, and quite possibly well into 2021, the economic recovery may still be under way but is likely to be more gradual and laboured than the initial bounce.
V-shaped markets: Great things have been priced
The economic outlook contrasts somewhat with what we have seen in financial markets, which have experienced a more or less V-shaped recovery with no small thanks to the incredible support provided by policy makers – both monetary and fiscal.
The provision of liquidity through quantitative easing (QE) programs by central banks has been significant in supporting the recovery in financial markets. In particular, the intervention in the credit markets to ensure that credit continued to flow to companies was very effective.
When we examine monetary policy, we concluded that QE is very effective in ensuring that financial markets continue to function, and the well-known side effect is higher and higher asset prices. Although when we look at the track record and the historical relationships between QE and economic growth, and QE and inflation, these are a lot less encouraging. Indeed, they are quite underwhelming.
While this should present questions for central banks related to their real goal of aiding the real economy, for the time being few, if any, are being asked. Central banks have made it clear that they can do more (a lot more), and they will do more if it is required.
What the world needs now
While even more monetary support could further aid financial markets, it is not the panacea, in our view. What is required is stimulus that is focussed on the broader economy. As such, what is required are substantial and prolonged fiscal policy programs.
As we highlighted above, fiscal policy to date has focussed more on the nature of being support-based, rather than stimulus-based. By support, we mean that their design was aimed at attempting to keep as many people connected to the workforce as possible. In other words, the enaction of government transfer payments to people in need has prevented the economic downturn from becoming much worse. These programs offer a bridge as a means to continue, but they are not designed to create ongoing or sustainable economic growth (as perhaps building a real bridge would).
While the world has been adjusting to the COVID-19 environment, these programs have been very effective, but they have also been incredibly costly. While it is easy to conclude that fiscal policy is required and given we have now seen that it is possible to run much greater government budget deficits, it is understandable that many commentators believe a move to proper fiscal stimulus is inevitable. Yet the debate around the current programs is actually shifting the other way. Fiscal policy steps us further toward politics, and as with anything in politics, progress generally takes a lot longer.
This situation is particularly acute with the US election coming up. An automatic assumption that fiscal stimulus is a given and will be effective is probably somewhat naïve and premature at this time, in our mind. The structure of Congress and how this body interacts with the president in the next four years will be crucial in determining the shape of fiscal policy and hence the economic recovery.
When we add this to the already challenged recovery, we are left concerned that any improvement from here could be further tested by way of the inability to offer proper fiscal stimulus – or worse, via the potential for considerable fiscal drag. We will be watching fiscal policy developments closely, particularly as we head toward the US election in early November. This timing places the election right in the sights of financial markets as a key event for the coming quarter.
Policy, polarisation, politics – and the US election
We examined in depth the upcoming US election, with all the different scenarios and how financial markets might react to each of them. In recent memory, elections have been difficult to predict, and the polls have been unreliable. Currently, they are suggesting that the Democrats will win, potentially both houses of Congress, and so quite possibly we could see a significant change in US policy. For the moment at least, it seems financial markets are reluctant to price too much into this possible outcome given how unpredictable the polls have been. Neither do they appear to reflect the other possibility of some form of a “too close to call” or contested election outcome, a possibility that our team believes is something to be prepared for.
The election will be an important determinant whether the ability to stimulate the economy with more focussed fiscal policy will be possible or become more difficult. When we consider the V-shaped performance of financial markets over the past four months, with the prospect of the economic recovery becoming more laboured in the coming months, and a number of election scenarios that may not be supportive for financial markets, the balance of risk seems to be tilting to an amber signal for financial markets.
Inflation: Lower for even longer
The concept of ultra-loose monetary policy and the potential for inflation is again capturing attention and is a topic that almost all clients are interested in discussing. Clearly, with more and more (once unthinkable) stimulus coming through, the inescapable concern is that a surge in inflation is inevitable.
We have seen the pattern numerous times over the past 12 years or so, with the extraordinary amount of monetary support through QE and other programs, and now the very real prospect that this ultimately extends further to central banks financing government deficits. Naturally this has many calling for higher inflation, this time including a number of long-held proponents of the ice-age deflationary / secular stagnation / lower-for-longer views – joining those gravitating toward the conclusion that inflation will, sooner or later, be the ultimate outcome.
To analyse this, we revisited the structural issues that we have talked about many times in our presentations and commentaries – the 5 Ds of structural disinflation (debt, dependency on central bank support, demographics, digitalisation, and deglobalisation). Unsurprisingly, we found these structural influences are all still present and if anything, many are now even worse, some markedly so. Adding to this is the very significant unemployment output gap that COVID-19 has created in the global economy. When output gaps like the one we have now occur, wages fall, and when wages are falling it is extremely difficult to create inflation. With both the output gap and the 5 Ds combined and considered, it is difficult to conclude anything other than inflation has a considerable hill to climb if it is to appear. Indeed, perhaps the greater risk is the risk of deflation.
Nonetheless, with the likelihood that monetary financing could be introduced to support fiscal spending in a significant way, it is rational to surmise that ultimately, the end game could result in a notable uptick of inflation. For the moment though, we think the former series of events – the structural issues that have been weighing on inflation plus the output gap -- is more likely to interreact and keep inflation contained and perhaps pressure it lower.
Further, as we highlighted above, fiscal policy is currently only supporting economies; it is not stimulating. There is the genuine risk that the level of support that has been very effective to date will not be able to continue, and could actually be lower as we head toward the end of the year. As such, the team concluded that for the foreseeable future, the concept of higher inflation is most likely just a theme, but a theme that many may be keen to embrace. It is therefore well worth watching.
For the time being, observing the Federal Reserve and other central banks and their very grounded outlooks for the global economy, in conjunction with our own economic growth and inflation outlooks, we again concluded, as we have for many years now, that the lower-for-longer environment is with us, and will remain with us, for even longer.
Fixed income asset class implications
When it comes to portfolio positioning, our longer-term anchoring focusses on an “absence of yield” theme that will characterise fixed income for what we expect will be considerable period. And with it, we see a continued strong influence that the need or chase for yield will have on credit and emerging markets in particular. Nearer term, the uncertainty surrounding the US election and the possibility of a fiscal drag encourages a more cautious stance ahead of anticipated volatility in the leadup to the November election.
- Rates | With developed central banks at their effective lower bounds for monetary policy for now, the view is lower for even longer but with increased volatility. Against this backdrop, the strategy is to take a more tactical approach to duration, lowering it leading into the election, and adding it back if yields go back up on the promise of more stimulus – as ultimately elevated yields are unlikely to be sustainable and present a buying opportunity.
- Credit | Despite continued limited company guidance, the second quarter appears to be the trough for fundamental credit deterioration as many sectors under pressure have recovered more quickly than expected, while the sectors most impacted by COVID-19 continue to lag. Within investment grade, valuations at the overall level reflect the expansion phase of the cycle, yet opportunities exist below the surface. The approach is to maintain current credit exposure and focus on exploiting opportunities within the asset class including sector rotation, credit quality, curve, and single names. Within high yield and bank loans, the team recommends a disciplined and cautious approach with a higher-quality bias reflecting the disconnect between valuations and fundamentals.
- Structured products | The asset class continues to offer opportunities. Within commercial mortgage-backed securities (CMBS), improving fundamentals are supportive of current valuations, and the credit curve flattening affords opportunities to migrate up in credit quality, although transaction numbers are limited. In collateralised loan obligations (CLOs), loan fundamentals have weakened although they have stabilised, with AAA-rated securities seemingly offering both value and quality.
- Emerging markets | Fundamentally, growth in emerging markets is recovering, yet debt is elevated as borrowing needs are high. Valuations appear tight on an absolute basis, although remain favourable versus developed markets, with the technical backdrop still supportive. On a risk-adjusted basis, US dollar-denominated emerging markets debt offers a source of carry, especially corporates, while selective emerging markets foreign exchange (FX) exposure offers opportunities at this time. Our view is to shift on local duration from overweight to neutral.
- Currency | Following months of steady decline we see more two-way risk for the US dollar into year-end. The combination of stretched short positioning and increased volatility around the US election are likely to be US dollar-supportive in the short term. A resumption of the US dollar downtrend is more likely once election uncertainty has been removed. In this environment, our approach is to overweight exposure to safe havens such as the Japanese yen and Swiss franc, and underweight positions in high beta currencies particularly where their central banks are moving toward negative interest rate policies (New Zealand dollar and British pound).