February 26, 2021
The Macquarie Fixed Income team gathered in January for our first Strategic Forum of 2021, contemplating the extraordinary circumstances in markets and the global economy, and our outlook for 2021.
To summarise our economic outlook: Our deep research and evidenced-based approach recognised that different economies are at different stages of recovery. While an out-of-sync global economy continues to recover, it would likely be a difficult year, requiring even more and, most likely, ongoing monetary and fiscal support.
A running theme throughout the Strategic Forum centered on the power of popular narratives and their disconnect from fundamentals. We observed that expectations of a quick recovery were too optimistic and failed to draw on the experience of past pandemics, instead embracing the euphoria as the first wave subsided. The severe impacts of the subsequent wave, in particular in Europe, flattened activity and with it hopes of a V-shaped economic recovery. Yet, this mattered little for markets that disconnected and continued their V-shaped recovery.
We explored this disconnect in detail, reflecting that financial markets have become increasingly enamoured with a number of popular optimistic narratives, emboldened by policymaker sponsorship and past behavioural patterns, and discount the reality of a much more challenging backdrop. We explored vaccines, monetary policy, and fiscal policy, and in each case, observed the often-simple popular narrative, contrasting each with what the deeper research and evidence indicates.
For example, we subscribe to the view that vaccines are fantastic news, yet our evidence-based analysis suggests their ability to aid the recovery could be slower than the popular narrative suggests given the significant task to vaccinate an entire population and that the path to societal immunity will likely be more uneven and protracted. Turning to fiscal policy, the ease in which these programs were enacted at the height of the pandemic has emboldened financial markets with the belief that this is the new norm. Yet, little attention is given to the high probability that further support may face waning political will, disappoint on size and scope, and take longer to enact than anticipated. Finally, reflecting on monetary policy, it is increasingly clear that since the global financial crisis, central bank policymakers have continuously produced what was once unthinkable amounts of stimulus. This has emboldened markets with a backstop or safety net, and in just about all scenarios, rather than de-risk, many investors have been wondering how quickly central banks might come back and again take action to attempt to prevent volatility in financial markets. Yet evidence shows that monetary policy is benefitting very few and tends to result in the by-product of indebtedness and unintended consequences bubbling up.
As we begin 2021 with valuations across most asset classes disconnected further from the reality of fundamentals, the big question for us is, "Do we run with the crowd – comfortably numb – or continue to rely on our research and keep our heads?"
When it comes to portfolio positioning, we acknowledge that the "absence of yield" theme is likely to continue to be a key driver in the way that clients and market participants think about their portfolios. This encourages some continued participation in this trend albeit in reduced and more nuanced ways. Nonetheless, given the fuller valuations, crowded positions, and strong consensus around the environment prevailing, we believe increasing defensive and liquid allocations and reducing some of the credit segments is prudent.
2021 economic outlook
We have always prided ourselves on deep research and using evidence to truly understand the prevailing environment and inform our investment decisions. In analysing the ongoing impacts of the pandemic on the global economy, the clear objective view from the Strategic Forum can be summarised as one that is very grounded about how quick the economic recovery, and the journey back to normal, whatever that normal now is, will be. In fact, we posit that if it wasn't for the development of vaccines in November, the outlook for 2021 would have been far more concerning.
Despite the amazing advances of science and the short time in which effective vaccines were achieved, the reality is that most of the global economy continues to experience considerable societal impacts of the pandemic. While economies continue to adapt with impressive resilience and are in various stages of continuing albeit fragile recovery, the impacts remain. New habits and ways of operating are becoming increasingly permanent. The now clearly inaccurate narrative that COVID-19 would be a brief disruption, and things would quickly resume, no longer seems likely, leaving us approaching the year ahead wondering: How long it will take for the global economy to find its new rhythm, what type of economic recovery will be experienced, and most importantly, how quickly can unemployment levels be reduced?
Appreciating that different economies are at different stages of recovery, the conclusions from our analysis in January was that the out-of-sync global economy, while continuing to recover, would likely have a difficult year – emphasised by our view that the global economy would require yet even more and most likely ongoing monetary and fiscal support.
Disconnect – Embrace popular narratives or do the work?
Nonetheless, as we begin 2021, there is little doubt that financial markets have continued with their V-shaped recovery that commenced in the middle of last year, reflecting a far more upbeat view of the outlook, than our analysis of the global economy would perhaps suggest. It is also worth highlighting that this disconnect exists between the rhetoric of central banks and financial markets. Barely a time comes to mind when central banks have been anything other than the primary source of optimism regarding economic outlooks, ever posturing that better times lie ahead – yet not this time. Indeed, they have switched almost unnoticed to a more grounded voice, espousing "ultra-loose" when it comes to a monetary outlook – an interesting, if not troubling, observation. For the first time in memory, it appears central banks are far more concerned about the outlook than financial markets. A disconnect indeed. And so the simple question is: Why might these disconnects be occurring?
When we consider the policies of the past decade, combined with the events and incredible response of policymakers in 2020, it isn’t difficult to conclude that financial markets appear increasingly enamoured with a number of popular narratives and emboldened by policymaker sponsorship and past behavioural patterns.
Vaccines and vaccinations
The first theme or popular narrative is the boost to sentiment from the discovery of vaccines. Economic forecasters and financial markets participants have embraced the concept of vaccines wholeheartedly – and we agree that they are fantastic news. A closer examination, however, presents a potential disconnect. Vaccinating a worldwide population is quite a task and not something that has ever been done before. Supply could be a major constraint to the rollout and there will be differences and inconsistencies depending on the nation, with winners and losers. There is also the possibility that large sections of the population do not wish to be vaccinated. And of course, as we are becoming increasingly aware, the virus can mutate and create different types of variants that spread exponentially, whereas vaccination schedules are more linear. In summary, our evidence-based analysis agrees that vaccines are good news, yet their ability to aid the recovery could be slower than the popular narrative suggests. Deeper research reveals that the path to societal immunity is likely more uneven and protracted than the one financial markets have embraced.
The ease of further fiscal policy
The second theme is the narrative related to the increasing role of fiscal policy going forward. We know that governments in 2020 enacted significant fiscal programs. We have highlighted in previous newsletters that these programs tended to be temporary, much needed support, and preventative in nature, whereas the narrative embraced by markets simplistically characterised it as significant stimulus. The ease with which these programs were enacted has emboldened financial markets with the belief that this is the new norm.
When we reflect on the last quarter of 2020, the US election, to some degree, was clouding the outlook for fiscal policy. Now, with the election going to a new US administration with control of both houses of Congress, financial markets have embraced the possibility that further fiscal policy, whether it is the nature of a more robust, infrastructure-led stimulus or just further support payments, should also ultimately be forthcoming.
In our opinion, there is little doubt that further fiscal policy will be required. Indeed, we would argue that in order to reduce the considerable output gaps, and the increasingly extreme inequality throughout the global economy, governments will need to play a much bigger role, particularly as an employer, in the coming decade. For now, we will leave that discussion for a later time.
Coming back to the prevailing situation, while we appreciate that fiscal policy was much easier to enact in the middle of the health crisis, perhaps the narrative that this will be easily repeated may be too simplistic. Further support may face waning political will, disappoint on size and scope, and take longer to enact than anticipated. Recall we have highlighted that fiscal policy involves and means government; government involves and means politics; and politics in the day of social media is no easy feat. Indeed, it is far harder to lead and make the tough and much needed decisions. Again, a deeper analysis of the research and evidence reveals a more prolonged recovery ahead. Nonetheless, increasingly disconnected markets are embracing "more fiscal" as solid support to the narrative of a much more robust outlook for 2021.
Monetary policy – everyone knows, and everyone knows that everyone knows
Finally, the ongoing presence of monetary policy is something that we have all been experiencing for some time – "just do more" and the central bank "contained environment" as we have previously referred to. It is increasingly clear that since the global financial crisis, central bank policymakers have continuously produced what was once unthinkable amounts of stimulus, and even more in 2020.
It is increasingly clear that monetary policy is benefitting very few, with the by-product of indebtedness, and now unintended consequences are bubbling up and affecting behaviour in financial markets. The simple narrative that when there are crises or issues, central banks can "just do more (a lot more)!" has in many ways reassured markets with a backstop or safety net. In just about all scenarios, rather than de-risk, many investors are wondering how soon central banks will come back and again prevent volatility from occurring in financial markets.
The bottom line is this influence in financial markets is now very strong. As we like to say, everyone understands or knows what central banks are doing now and everyone knows the outcomes. Everyone knows, and everyone knows that everyone knows! And the beliefs around central banks and the flow to financial markets has now become a self-fulfilling, embedded belief – and in doing so, has created an insatiable chase for yield and returns.
Fear of missing out
In a world where there are no or even negative yields in cash and government bonds (and in some corporate bonds too), there is almost no alternative other than to chase yield, and riskier assets, and do it with the comfort of knowing that central banks are de facto sponsoring the behaviour. Most market participants now acknowledge that valuations no longer reflect the COVID-19-affected fundamental outlook – a considerable disconnect. Yet, the reality is that there is no alternative, and when everyone else seems to be doing it, and it has worked so well in the past, there is a built-in human fear of missing out. That pull has been significantly strong, particularly toward the latter part of 2020 and into 2021. Bottom line – everyone knows the trick now, and everyone knows that everyone else also knows, and everyone is doing it.
We can’t help but get the sense that the combination of these three real themes and associated popular narratives are all that anyone in financial markets wants to hear and, despite apparent considerable disconnections, that doing the detailed research no longer matters. The price action has been so fulfilling and whether it be creeping determinism or plain complacency, the notion that we should just keep following the increasingly frenetic crowd, rather than keeping a close eye on the evidence, leaves us feeling increasingly uncomfortable. This is particularly because the bond market (which we believe rarely gets it wrong) is not buying into it, and neither it seems are central banks. We recall the quote from the TV comedy, "The Office," to remind us that the broader the consensus and the more crowded the positioning, the less likely the trend may continue.
If you can keep your head when all around you have lost theirs, then you probably haven't understood the seriousness of the situation.
- David Brent, "The Office" (UK)
As we begin 2021 with valuations across most asset classes disconnecting further from the reality of fundamentals, the big question for us is, "Do we run with the crowd – comfortably numb – or rely on our research and keep our heads?"
Fixed income asset class implications
When it comes to portfolio positioning, we acknowledge that the "absence of yield" theme will likely continue to be a key driver in the way that clients and market participants think about their portfolios. This encourages "some" continued participation in this trend albeit in reduced and more nuanced ways. Importantly, given the fuller valuations, crowded positions, and strong consensus around the environment prevailing, we advocate increasing defensive and liquid allocations and reducing some of the credit segments as prudent.
- Rates | Developed central banks are exerting large control over bond markets, with strong forward guidance, no tapering, and no rate hikes expected this year. With markets likely to embrace the reflation theme amid the economic reopening, the team believes there is the potential for yields to drift higher and curves to steepen, and remain neutral on duration with a view to accumulate on weakness.
- Credit | Credit fundamentals remain lacklustre for most industries and COVID-19-affected sectors continue to lag, with fundamental improvements likely to be closely correlated with the effectiveness and distribution of vaccines. Within investment grade, overall valuations remain tight though we believe there are opportunities below the surface, especially in BBB- and BB-rated corporates and bonds on the 20-year part of the credit curve. Central bank support and the global chase for yield remain the dominant themes, and credit appears attractive against the alternatives. With post-election stimulus expected to provide further support to the high yield and bank loan market, the team suggests a disciplined approach amid tight valuations.
- Structured products | Select structured products continue to offer opportunities. There remain pockets of value in certain commercial mortgage-backed securities (CMBS), most notably in COVID-19-affected hospitality and lodging, with fundamentals likely to improve on the economic reopening. Within collateralised loan obligations (CLOs), loan fundamentals have stabilised as the economic outlook has improved, with AAA-rated securities offering value as high-quality and short-duration assets.
- Emerging markets | While economic and policy uncertainty remains high, there are reasons to be constructive in emerging markets. With a supportive global backdrop, rising commodity prices, and relatively benign inflation, the team favours maintaining a broadly neutral exposure to hard currency debt, skewing to corporates over sovereigns that offer additional carry over developed markets. Emerging markets foreign exchange (FX) appears undervalued to us compared to the long term and offers some room for appreciation.
- Currency | Our base case remains for further US dollar weakness, with central bank support mattering more than economic reality. The team favours short US dollar exposure versus currencies that are both fundamentally undervalued and can provide further fiscal support. Our preferred exposures are the commodity block of the Australian dollar, Canadian dollar, and Norwegian krone, while we have a more neutral outlook on European currencies (euro and British pound).