Adam Hetts: Welcome to Global Perspectives. Today, we get to check in again with John Pattullo and Jenna Barnard. John and Jenna are Co-heads of Strategic Fixed Income here at Janus Henderson. This is our fourth episode together, going back to August of last year, so let me recap our other episodes.
Starting August of last year, our first two conversations focused on navigating the economic recovery and optimism on credit markets. Then our third conversation was in February of this year and the tone shifted quite a bit. We talked about how the reflation trade had run its course, which was John and Jenna going quite a bit against consensus. And we talked about why duration was not something to fear even though the rest of the market seemed to be terrified of duration.
So here we are. It’s September of 2021. Go figure, as it turns out, John and Jenna were right – again. Duration was not as dangerous as the market had been saying, and now yields are still low and credit spreads are tight, which feels like the same backdrop as it's been most of the time for the last decade up until COVID hit last year.
So, let's start with that, Jenna. Here we are again with low yields and tight spreads, but what would you say is unprecedented about the bond markets today?
Jenna Barnard: I mean from here with the tight spreads and the low sovereign bond yields, we're back at kind of all-time low yields in corporate bonds, both high yield and investment grade. So that's a period of post-COVID adjustment, especially for U.S. investors. But broadly this year, the way bonds have behaved – so the peak in sovereign bond yields, kind of April-time, March/April – was for us, was completely logical and bonds behaved the way they usually behave, which is bond yields peaked at peak acceleration in the economy, peak rate of growth, peak impulse, really. And bonds as an asset class aren’t sensitive to levels of growth, inflation, unemployment so much as the rate of change. Is the economy accelerating at a faster pace, a slower pace? Is it decelerating? That's what bonds really care about, the second derivative.
And so, we came into the year, you know, as everyone did, knowing about the base effects, the very weak comparative data from March/April 2020 because of COVID. Then we got the reopening of the U.S. economy in March driven by vaccinations and we got that extra fiscal stimulus. So, you had these three massive impulses, which drove that acceleration in the U.S. economy, and bond yields peaked out right at that peak acceleration. So that was, as I said, that for us, didn't feel unusual. It felt logical, it felt rational. And you know, bond yields have subsequently declined as the year-on-year rate of change has decelerated. So, I apart, from the all-in yield, which as I said, is I think, somewhat uncomfortable for bond investors, particularly the corporate bond space, the moves in the bond market for us haven't been unprecedented. They've been completely logical, and bonds have behaved the way we expected them to behave based on that cyclical impulse.
Hetts: And I think important to that is you're talking about April this year, it was the rate of change and the economic growth, not just total economic growth, so it was the rate of change coming off of those…
Barnard: It was the acceleration, the year-on-year rate of change, yes, exactly.
Hetts: Off of such low base effects, right.
Barnard: Yes, base effects, that's what we knew about coming into the year, but then we got that extra fiscal stimulus for households in the U.S. in March, and we got the reopening of the economy March/April driven by vaccination. So you had this confluence of three impulses. Each one of those would have been significant in any given year, but you had all three driving the economy forward in that short time window, kind of March/April/May. So there [was] a really unusual, really enormous rate-of-change peak, which the bond market reacted to.
What was interesting actually, I think, wasn't so much that bond yields peaked at the same time, it was how little structural damage was done in the guts of the bond market. I mean given the scale of that impulse, the steepness of the yield curve – what, the 2s/10s1 got to 160 basis points? That's very low relative to where it often gets to at peak impulse coming out of a recession. You know, you'd expect 250 basis points, or so. Five-year, five-year forward interest rates,2 if you decompose the nominal yields, got to what, again, just above 2.5%, telling you where long-term interest rates might go.
I think actually, the more interesting thing wasn't that bond yields peaked right on time, it was how little structural damage was done and how the bond market signaled that this isn't a regime shift to higher interest rates in the future. And that, I think, hasn't really been commented on. You know, it was an enormous cyclical test for the bond market, but very little structural damage done in terms of the bond market pricing in a higher long-term interest rate or higher long-term inflation. The bond market pretty much shrugged its shoulders at the structural outlook.
Hetts: I think that's key right there, and that was the flavor of our February episode. You weren't seeing a structural shift in rates even though, I think, a lot of the market, as you and John explained it, was thinking a little more linear of a recovery: As we get further into the recovery, rates will linearly get higher and higher and higher, and you were seeing more of a short-term peak. So now that we're past those temporary impulses, just thinking more structurally, in this recovery phase, what's the bond market telling you two about the longer-term structural outlook from rates?
Barnard: I think, Adam, that point about avoiding these linear narratives, and you see it so often in the bond market: these forecasts of higher, higher sovereign bond yields. Whenever you get a cyclical impulse, it's the death of 60/40 [portfolios]3 and this is the beginning of the end for bonds. When actually, it's just a typical repricing driven by rate of change of growth, inflation and other economic factors. So we were quite keen not to fall into that trap of linear extrapolation, the higher bond yields. You know, really, really important.
John Pattullo: I was just going to add Jenna at the time, I mean everyone was saying, ‘Oh, the U.S. deficit is so big. This fiscal stimulus is off the scale. There's going to be a breakout inflation, there's going to be a rate regime change, the fiscal multipliers are really high, you know, it's going to be sustained.’ And like, we were all, just not convinced at all by this. But I think as we discussed last time, Jenna and I, you have to sort of fight this narrative.
And then the fiscal multipliers have been miserable, maybe like a quarter of one, a quarter to that for every dollar spent, maybe a quarter of that hit the real economy, and it was a temporary stimulus, yes. So, I would actually argue that the size of that stimulus wasn't large enough. But the bigger point was, it wasn't very well spent, and it wasn't an ongoing program of fiscal stimulus, which conceptually was offsetting the massive saving surplus that was happening on the other side because the U.S. savings ratio got up to low-30% in the middle of lockdown. So, there was a massive leakage on one side in the economy, yes. And that has to be offset by a stimulus or injection on the other side. And that money, a lot of it was saved, a lot of it was consumed. The bit which was saved, some of that actually people have paid off debt. And virtually none of it was invested in longer-term productivity, you know, infrastructure, education, health care, broadband, you know, inequality. It wasn't, it was just broadly consumed. And don't get me wrong, it did a good job because it kept people in jobs, but it didn't really change the longer-term growth prospects of the U.S. economy or the global economy. So, I would argue that money was actually pretty badly spent.
But it was a challenge to us because you obviously had monetary and fiscal [stimulus] working together. And you know, it was at the time, it was a pretty big stimulus, but you just had a huge amount of demand. And then, as you know, there wasn't much lumber stock around or copper stock around or iron ore stock around. And then Twitter sort of leapt on, ‘Oh, have you seen lumber [prices] recently?’ and all that sort of stuff. You know, or even food. Look, most of these things were just supply bottlenecks driven by temporary short-term demand. And that's why it was pretty interesting for us and, as Jen said, that's why it kind of fell over.
But moving to your longer-term structural view, we actually are of the view that the longer-term growth prospects – growth and inflation – are probably damaged post-COVID. And I know Jen will probably want to cite some academic research here, which is really interesting. But broadly speaking, we think people and companies have had to adopt technology and digitalize their businesses much faster than they would have if COVID hadn't come along. So, you've had more digital disruption than you would have had if you didn't have COVID. Broadly, as we all know, digitalization and disruption are broadly disinflationary because we can all order more efficiently at the restaurant or go through an airport more efficiently or work from home with all our computers. And we can expand on all that in a second. Let alone the normal long-term secular drivers that people worry about, such as fertility, which has been knocked because of COVID; such as migration, which has been knocked massively because of COVID, and the demographics are looking really quite tough here. And I think behaviors have changed, so I think people, understandably, are a bit more cautious. They're a bit more precautionary post-COVID and it's not the roaring ‘20s going on here. So longer-term, were actually probably a bit more concerned that there is less demand and more technological disruption than there was. And you could probably make the case for ongoing massive fiscal injections for a very long time going forward. So, net-net, we're actually probably more resolute in our sort of secular stagnation view in the longer-term structural sense because this was the ultimate test, and frankly, it kind of failed. You had a small cyclical impulse here. I mean it's a bit disappointing.
Barnard: Yes, I think, probably, if you’re reading what the bond market thinks about the long-term outlook for neutral rate of interest and where we're going, it aligns with what John's saying. When the Fed said in the June FOMC that they might hike twice in 2023, the bond market threw its toys out the pram, and you saw a massive flattening of the yield curve, the kind of flattening you typically see at the end, the kind of final rate hike. And the bond market said, ‘If you want to hike early, i.e., earlier than we thought in 2023, we’re going to lower that long-term R-star, the long-term neutral rate of interest.4 So, yes, for all the reasons John cited, we’re sympathetic to the idea that actually COVID is as likely or more likely to be disinflationary than inflationary in the long term. I think the bond market showed its hand in that June FOMC, that it agreed. And that wasn't something we were necessarily expecting, were we John, from a structural perspective?
Barnard: Even took us by surprise, actually.
Pattullo: Do you want to mention the structural differences between the fiscal expansion because of wars and pandemics, Jen, because that's pretty topical, isn’t it?
Barnard: Yes, it's not actually to do with fiscal expansion, but there was a San Francisco Fed [Federal Reserve Bank] paper last summer, kind of June 2020. It was looking at wars versus pandemics, and pandemics consistently and in a significant way lower the R-star, whereas wars raise the R-star. As I said, the bond market really showed its hand in the June FOMC, as it did a few months earlier when it had peak cyclical impulse about this actually not being a regime shift to higher interest rates and potentially locking us into this low interest-rate world. And that aligns with some of that academic research and all the kind of practical examples that John just gave.
So, it's a very different message. No one's listening to the bond market in particular. The narrative you read in the paper is that the bond market rally was driven by short covering5 and now it's driven by the [COVID] Delta variant. Well, it's really, the bond market’s telling you something. It is really, really interesting. It told you it back in June, and it told you back in April at peak cyclical impulse. You just couldn't do much damage in terms of regime shift to higher long-term interest rate expectations. So, I would listen to the bond market. It gets it right, it gets it right, and the economists don't. The investment bank economists generally don't because they're in that camp of linearly extrapolating higher yield forecasts the whole time.
So, I think it's been a brilliant test case. It's been incredibly fascinating for us to watch. Bonds behaved exactly as you'd expect from a cyclical impulse perspective. And from a structural perspective, they're telling you something about the impact of COVID being rather depressing, kind of locking us into this low interest-rate world we've been in for a while. That doesn't mean that bond yields can't rise in the next three, six months. You know, of course they can. They'll move with the cyclical impulse. But that structural message, I think, is really seminal that was sent earlier this year.
Pattullo: I was just going to highlight, post a war, capital is destroyed and needs to be rebuilt, and that's obviously reflationary and inflationary, whereas a pandemic, we haven't destroyed any capital here. I mean, if anything, we've got more supply capacity than we used to have anyway with digitalization, and even deglobalization is topical, as well. Because, you know, if we all build our own capacity in America which already exists in China, net-net, there's more capacity, which is disinflationary, yes? I mean obviously, that might be for political reasons, or we need access to pharmaceuticals and PPE [personal protective equipment] and whatever. I mean that's different. But net-net, you're still building more capacity. Whereas a wartime response, where you actually have to rebuild entire economies and nations, is a very different response to a fiscal stimulus, which I think is really topical. Especially when everyone else is saying, ‘Well, you know, this is a regime breakout and you got all this nasty inflation, and so on.’ But as we've always said, this was bottleneck inflation, supply-side inflation, the wrong sort of inflation, inflation which is like a tax. You know, the oil price goes up, it costs you more to fill your car up, you got less cash. That doesn't mean you get a pay rise, that doesn't mean central banks pull up interest rates. So, it's amazing, Adam, how it's evolved to where we are today.
Hetts: So, we have the short-term inflation pressures you just mentioned and this case for the more structural deflationary pressures; and even all the extra money being pumped into the system, it's being saved, it’s not being spent. The demand’s not there, the digitalization. I’m trying to square that disinflationary thesis with a lot of the market just focusing on the inflation thesis. But how much of this is contingent just on COVID? So, once that's in the rearview mirror, whenever that is, can we flip over to inflationary mode when all this demand is unleashed, or [is it] not as simple as that?
Pattullo: Well, I think we've already tried that, haven't we? Because we've had that impulse and demand has been unleashed, and all that happened is we just highlighted a lot of supply-side shortages we've got in commodities and various other industries. So, I don't think the rate of change of stimulus will be as big as it was last time for the reasons we kind of discussed. And you know, we think, I mean habits have changed. In entertainment, in shopping and restaurants, in the way we exercise, the way we work, the way we commute, the way we don't have a wallet. You know, the wallet, our wallet is our phone, in the way we live, let alone migration and inequality. So, I think there's been a whole load of behavioral changes. Some have changed permanently, like Internet shopping, which is an obvious one, or working from home and hybrid working. Obviously, some will go back a bit to how they were. But net-net, I think we've already had that test, and the fascinating bit now is how behaviors change permanently or not. And then the final point, obviously, you had a great demand for goods in the house. But I think, as we said last time, most people are pretty much full of goods in their house, and the old gag is you don't go for a double haircut and you can't go to restaurants three times a week. So that demand is just lost. It’s destroyed. You know, we need to see; we're open minded. We try and be open minded. But I think behaviors have changed quite a bit, and technology has meant that we can behave in different ways.
Hetts: Yes, talking about changing behavior reminds me, Jenna, you mentioned 60/40 a little bit ago, and there's been all that talk about the death of the 60/40 because the correlation between equities and sovereigns could go positive if there is that inflation and rates could start moving positively correlated with equities and not be that negative correlation diversifier. So, I think it's probably safe to assume you disagree with that positive correlation narrative, but could you just talk a little bit more about the death of the 60/40, or lack thereof, in your view?
Barnard: So, I think I mentioned it earlier in the context of logical cyclical rises in bond yields and occasions where bonds are the problem and bonds cause issues for equities and other asset classes. So that was the case in February this year, but it was driven for the reasons we cited earlier. It was the case in February 2018, if you remember, post the Donald Trump tax cut and the kind of peak cycle there. So yes, in every cycle, bonds can be the problem and can cause issues for equities, and therefore not hedge your portfolio. But if those are logical cyclical reasons that we can identify, that's not the death of 60/40. So, let's not confuse this with a structural break.
So, I would say, I put that kind of narrative, the death of 60/40, in the camp of people extrapolating out a cyclical rise in bond yields with a regime shift to higher inflation and the death of the bond market in general. And we're seeing that correlation has moved back to one of bonds diversifying equities since the summer, as we've passed peak, rising past peak inflation. So, I have, you know, relatively little sympathy for those arguments when bonds are just going through a rational repricing because that happens periodically, every couple of years. So I'm not, I'd be a bit wary of jumping on that bandwagon too quickly. And, as I said, bonds have actually gone back to behaving as you would hope from a 60/40 perspective since the summer.
Hetts: John, you mentioned being open minded, so with this…
Pattullo: Try to be.
Hetts: In the attempt to be open minded with this disinflationary thesis that I think you've laid out pretty well, what are you looking for that could maybe quickly flip that on its ear and actually kick off inflation in a meaningful way?
Pattullo: Oh, well I think it would be an ongoing fiscal expansion of the size we had, like forever. I mean, do you know what I mean? I mean it’s just like a complete monetization of the debts and ongoing fiscal expansions for a very, very long time. You know, the whole MMT [Modern Monetary Theory]6 regime change. But it's not, it's not got the political buy-in any longer, so I think that risk has faded. And it was a risk obviously, but I think it's gone away. So maybe there's a massive lurch to the left, and we have an experiment along those lines in a different country. But I think that would be the main argument for that.
Hetts: And you see that policy…
Pattullo: And, I'm sorry, obviously an expansion in money supply and the demand for people to borrow money and spend money, which we haven't mentioned, which we mentioned previous times. Because broadly speaking, the banks are awash with cash because everyone's putting money in the bank. But the bank can't lend the money out on the other side because there's not much demand for credit, in the same way, you know, Japan and Spain and Ireland had massive miracle economies for a number of years, but broadly that was built on unsustainable credit growth. So, you need unsustainable credit growth and a massive fiscal expansion, which could have happened a year ago. But I think the political landscape is tougher. And actually, in the U.K. as I'm sure you've picked up, quite a significant tax rise is coming in next April to pay for social care and health spending.
Hetts: So, I guess we're back to where we started a bit, which is rates low…
Pattullo: A little bit, yes.
Hetts: …and spreads tight. Then, what does become attractive in this environment, or what's the least unattractive? Where do you look?
Barnard: Oh, I think it’s tricky now. Here and now, this combination of low sovereign bond yields and low credit spreads. So, with the easy money of kind of fading the reflation trade in the spring, that's happened. We've had the sharpest pace of year-on-year deceleration of the data over the summer. We're relatively cautious for the coming months.
And then I think the next big opportunity we're trying to think about is kind of next spring/summer. So, you've got the reverse base effects; the base effects that drove inflation up this year will be very hard to beat next year. With inflation over 5% in the U.S., well, as we come through next year, we're going to have very low CPI [Consumer Price Index] prints, and that also goes for payrolls and other elements of economic data. So, I, as a bond investor, I think next year gets really interesting, and maybe we'll get the first inkling of what the structural outlook looks like in terms of inflation, as well. How much is transitory? How much is sticky and structural? And yes, we can have a peak deceleration year-on-year rate change in the data next summer because of these base effects. So here and now, we're not particularly excited. We think it’s a little bit tough, to be honest, for bond investors. But potentially there is an opportunity as we head into the middle of next year.
And also worth bearing in mind is that bond yields haven't typically bottomed in a recession. You get a low in bond yields in the recession for obvious reasons, then you get a reflation trade coming out, because of base effects and commodity-price rises and all the things we've had this year but not typically on this scale. And actually, if you look back to the early 1990s, the low in bond yields comes after that reflation trade. So again, it will be really interesting next year. We definitely are thinking, mulling over whether we get very low bond yields next spring/summer. And we're not in this camp of just assuming bond yields go higher from here from a medium-term perspective.
So, I think it could be exciting for bond investors next year. But here and now, it's pretty challenging, and even when we look at the high-yield credit, there's no cushion there in terms of credit spread. So, we've got to navigate what could be a tricky few months, and then I think look for opportunity next year. I mean it's all a bit of a working hypothesis at the moment, but that gives you maybe a sense of what we're thinking.
Pattullo: Yes, I suppose I might just add, Adam, on the credit selection. I mean if Jen and I were equity managers, we would be growth managers. So, we continue to like the bonds of quality large-cap, non-cyclical digital secular winners, which tend to be things like data center operators and tower providers and even health care bonds are rather desirable as well. And you know, we never really got hoodwinked into what we would describe as the beta trade, or the analog cyclical companies coming back because of COVID. It’s much different for equities. But for bond managers, all you can do, if you like, is just buy generic high yield using credit derivatives and just get the beta and then not get trapped in kind of analog cyclical businesses, which have massive operational and financial leverage. You know, that is not sensible bond investing, and equity people can play that much differently. We always say we like data centers over shopping centers. I mean, who wouldn't? But you know, we were saying that pre-COVID, and I think COVID has just accelerated that trend.
Hetts: Well, it sounds like there's plenty of risk management work to keep you two out of mischief over the winter and then potentially some interesting catalysts and drama come the spring, to Jenna's point. I think we covered a good bit here. Thank you both for joining again.
Barnard: Thank you, Adam.
Pattullo: Yes, well done.
Hetts: Thanks everybody for listening, and as always, you can find John and Jenna's views and the rest of our investment teams’ and thought leaders’ on our website, and please tune in again as we'll bring you more conversations in the near future.
12/10 refers to the spread between two-year and 10-year Treasury bond yields.
2Measures the expected inflation rate (on average) over the five-year period that begins five years from the current date.
3A 60/40 portfolio typically consists of 60% equities and 40% bonds.
4The R-star refers to the real (inflation-adjusted) neutral rate of interest – a rate that is neither expansionary nor contractionary when the economy is at full employment. When central banks set the benchmark rate below the R-star, policy is considered accommodative, and vice versa.
5Short covering refers to buying back borrowed securities in order to close out an open short position at a profit or loss. It requires purchasing the same security that was initially sold short, and handing back the shares initially borrowed for the short sale.
6Modern Monetary Theory [MMT] is a macroeconomic theory that says countries with full control over a fiat currency are not reliant on taxes or borrowing to fund spending; they can, instead, print as much currency as needed.