Global Head of Fixed Income Jim Cielinski discusses the economic recovery, the diminishing returns on – but still pivotal role of – monetary policy, average inflation targeting and corporate balance sheets.
- Consumer confidence in their income outlook will be critical to maintaining a V-shaped recovery; much corporate borrowing has been precautionary or bridge financing that should help to lessen defaults, allowing companies to repair balance sheets in 2021.
- Average inflation targeting by the U.S. Federal Reserve (Fed) is more than just a cosmetic change as it should help limit the risk of a second “taper tantrum;" however, it is questionable whether the U.S. or other major economies will suffer inflationary pressures beyond those attributable to temporary base effects.
- Monetary policy is likely to face diminishing returns but remains pivotal in keeping financing costs low and depressing volatility; it is this suppression of volatility that will be key to tighter spreads.
Jim Cielinski: Can the V-shaped recovery last? I think that's an important question for markets. It's interesting to me that a minority of participants actually think that we're even in a V-shape, even though the economic numbers would tell you quite strongly that we are. My own view is that you've had such enormous fiscal stimulus: it added about 4% to global growth in the second quarter. As we move into 2021, that shifts to a minus of about 1% or 2%.* So, for us to continue to exhibit V-shaped behavior in that environment, I don't think that's likely, you will still have job losses. And what I would expect then is growth to slow, the trajectory to slow, but it will still be positive and that will still mean easy money, accommodative policy and a growing economy.
As people return and earn incomes, I think that is really the critical factor, I think, for whether we can live with the virus or not, because the stimulus has helped us replace lost income. As that fades, we need to now find a second cure, if you will, for replacing that lost income and that's really going to be the true test. But we shouldn't also forget that a vaccine, if it does come say around year-end, would have a meaningful impact on people's expectations of income in 2021. And that's really what drives confidence. It's do you expect your job to be there? And do you expect to be making the income that you did in the past, in the next year? And if you are, you will go spend. And I think that's the one thing that is still missing here.
Every crisis brings a lot of change. And my feeling has always been that it will probably take two years for us to truly know what has permanently been shifted. But it's not too early to know that some things are dramatically different. Number one, the expected policy response. I think we've already moved into new territory. So, the expectation if something else were to go wrong, what they could then do. You know, MMT, all these things that were, I think, lunatic fringe two years ago are now kind of front and center if we need to kind of pull on additional policy levers. So, I think that's different. I think the wealth inequality situation globally is very different. And so, there are some things where I think we can already see the shift occurring. ESG, the focus on social investing, and that kind of fabric across the landscape. It's going to be stronger, not weaker. So, I think there are some things that we know, but some things that we just simply don't. One other shift that we've been keeping an eye on, not just related to COVID, but before COVID was globalization and it looked to have reached a peak in the Trump era. I think as the COVID crisis has continued to rumble on, what we're seeing is the beginning of regionalization. So not a complete breakdown, but perhaps an Asian bloc, a European bloc and a U.S. bloc. I think this is what is likely to persist and that will permanently alter, I think, how economies behave and how trade works globally.
Monetary policy is largely exhausted, not completely. It's just in that space now where the law of diminishing returns has taken over. You can always do yield curve control, you can always do more QE, but that exacerbates as many problems as it probably solves. So, for me, it's not completely done but if fiscal policy isn't there to pick up the slack, we're in trouble. A little bit of fiscal now will do as much as a lot of monetary and so the balance has to shift, I think, if we're going to see sustainable growth.
The Fed recently adopted average inflation targeting, which implied that if inflation overshoots their 2% target, they're going to stand pat and not overreact because they want to see that number realized over time. And I think it's more than just cosmetic. And the reason for that is in the first half of 2021 , we had a sharp fall-off in inflation, deflation around the pandemic. It's now bouncing back and could easily overshoot that 2% target. I think by removing any risk of a “taper tantrum” or any expectation that the Fed would react to that, they probably have I think quelled volatility in the markets, which is good for risk assets. So, I think the real test is ultimately whether the 2% target even means anything and whether central banks can actually ever achieve that. The answer in Europe is no. The answer in Japan is no. The answer in the U.S. is cyclically, perhaps, yes.
There is a view in the market that companies have been bingeing on cheap debt, starting with too much already, and then borrowing more because we've seen borrowing hit record levels in 2020. I would call it a binge if they had borrowed and then gone on to spend that. But if you look at a measure of net debt, which is the cash plus the debt on the balance sheet, what you see is that they've just borrowed and let it sit there as a precaution. So, I think what they'll now do is employ some caution. I think they will pay down debt and deliver over time. And if they can do that into a growing economy, it's not a binge, even though the absolute level of debt has gone up. Interest service is really affordable. These are record low rates. So, interest cover ratios, if we can get earnings coming back shortly, will not, in my opinion at least, threaten companies and lead to a sharp spike in defaults.
What does this all mean for fixed income? I think you've seen a phenomenal rally in risky assets, including credit, including emerging markets (EM). But if you step back and say, where are we today? I think what you've really seen is the removal of volatility. And central banks can't really inject a lot of stimulus or growth now into an economy, but they can in markets, really depress volatility. And that's the same as risk. And they can keep doing that. What that means is that rates are not moving around very much. That is likely to continue and they're low. So, couple that with what it means for markets like corporate credit or EM, you'll see a similar suppression of volatility and that is synonymous with tighter spreads. So, I think that is what you see unfolding.
*Source: JPMorgan, Global Economic Research, global fiscal thrust estimates for 2020 +3.6% and 2021 -1.7%, as at September 2020.
V-shaped recovery: A type of economic recession and recovery that resembles a "V" shape in charting as it involves a sharp rise back to a previous peak after a sharp decline in economic measures.
Fiscal policy/stimulus: Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.
Monetary policy/stimulus: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
Modern Monetary Theory (MMT) is an unorthodox macroeconomic theory that proposes governments that control their own currency can spend freely, through the creation of money, to grow the economy to its full capacity.
Environmental, social and governance (ESG) are three key criteria used to evaluate a company’s ethical impact and sustainable practices. ESG or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
Yield curve control involves a central bank targeting a longer-term interest rate and pledging to buy or sell as many bonds as necessary to hit that rate target.
Quantitative easing (QE): A government monetary policy occasionally used to increase the money supply by buying government securities or other securities from the markets.
Inflation: The rate at which the prices of goods and services are rising in an economy. The opposite of deflation.
Deflation: A decrease in the price of goods and services across the economy, usually indicating that the economy is weakening. The opposite of inflation.
Taper tantrum: Markets’ reaction following the US Federal Reserve Chairman’s comments in May 2013, which suggested that the US was considering tapering (slowing down) the rate of its bond buying programme (quantitative easing).
Volatility: The rate and extent at which the price of a portfolio, security or index, moves up and down. If the price swings up and down with large movements, it has high volatility. If the price moves more slowly and to a lesser extent, it has lower volatility. It is used as a measure of the riskiness of an investment.Net debt
Interest coverage ratio: a measurement used to determine how well a firm can pay the interest on its outstanding debt.
Spread/credit spread: A measure of how much additional yield an issuer offers over comparable “risk-free” assets such as U.S. Treasuries. In general, widening spreads indicate deteriorating creditworthiness of corporate borrowers, tightening spreads are a sign of improving creditworthiness.