A Fixed Recovery
by P. E. Kelley
Measuring the impact of COVID-19 on our economy, indeed on the entire global picture, can be at times illusory. While the damage done is dramatically clear, as nightly headlines reflect alarming levels of loss, panic and uncertainty, a clear road forward is coming into view.
The components of economic forecast, particularly U.S. Equities, corporate earnings, GDP and the interplay of growing debt, have begun to reflect more positive insights. Still, the non-partisan Congressional Budget Office is projecting only a modest 4.3% growth in GDP over the next decade. As for any substantive hit the market may have taken in 2020, many believe that investors simply ‘prepaid’ a return to normal.
In its 2021 Global Insight special report, RBC Wealth Management validates these market views, and even asserts that ‘equities should deliver for the investor as long term forces take back control’. Tom Garretson is senior portfolio strategist with RBC Wealth Management. He shares a macro view of the recovery, with governments now playing the role of ‘capital allocators.’ He spoke with us about how the burden of recovery will fall to the Fed, whose policies should act as an anchor on Treasury yields; about the prospect of a shallow and glacial rate of growth and about the viability of current fixed-income valuations.
PEK: One of your primary 2021 Outlook observations is that the role of governments as ‘capital allocators’ is accelerating markedly and incurring greater debt along the way. Even though rates remain so low, how sustainable is this, and what is the outlook for GDP regeneration and corporate earnings?
TG: This issue is back in focus, as is typically the case with each downturn, but we continue to stress to our clients that on the list of things for investors to worry about, it shouldn’t make the first page, and probably not even the second or third. To be sure, the numbers seen as a result of the pandemic are higher watering, but while the pace of debt accumulation relative to GDP accelerated sharply in 2020, 2021 will see a moderation as the pace of government debt growth slows, and as the economy recoveries, narrowing that gap as the U.S. economy comes back online and the need for fiscal support wanes. After what we expect will have been a -3.5% drop in GDP in 2020, we currently forecast that the US economy will grow by +4.4% in 2021.
With respect to sustainability, low rates in the US and globally often gets blamed on central banks, but we would remind investors that central banks manage short-term policy rates around broad market forces. For example, one reason rates have been falling for 40 years now has been a basic supply and demand problem: aging global demographics has meant an increase in demand for safe assets, with markets telling us that there still might not be enough supply even amid swelling government debt as rates remain historically low.
Finally, and from a systemic risk perspective given that the financial crises is still front of mind for many ten years later, debt has largely shifted from consumer balance sheets to the government’s balance sheet. Just before the 2008 financial crisis, consumer debt peaked at more than 130% of disposable incomes, as of the second quarter this year that number was just 88%, the lowest since the mid-1990s. US government debt-to-GDP levels have essentially moved in the exact opposite of that. Governments have far more capacity to raise and service debt, thus reducing systemic risk unlike in 2008. Therefore we think the rising debt simply isn’t a major risk at the moment, and with our outlook for yields to remain low, sustainability concerns simply aren’t anywhere on the horizon.
PEK: Looking forward, as the economy struggles to reopen, where is inflation going and how do we gauge its important role in recovery?
TG: On a near-term basis, there will most likely be illusory inflationary pressures simply due to math. We saw three consecutive months of declines in consumer prices during the depths of the pandemic beginning in March, so when we get to the second quarter of 2021 those low baselines will make it appear that inflation is gaining steam when measured on a year-over-year basis—we currently expect Q2 headline CPI at around 2.9%, with similar gains for core prices excluding food & energy—well-above the Fed’s 2% average target, and far beyond the subdued 1.2% pace that we expect this year. But after that spike in Q2 inflation, it should moderate back to an annual pace around 2.1% by the end of the year.
However, policymakers at the Fed will largely look through this, expect a return of the Fed’s previous use of the word “transitory”, and the longer-term disinflationary pressures that Fed Chair Powell recently highlighted at the December FOMC meeting will continue to be of greater concern than inflationary ones for some time.
But inflation will still hold the key, both in terms of gauging the recovery and in determining the path of monetary policy. Inflation won’t return until the economy is running above capacity, and labor markets are operating beyond “maximum” employment. And the Fed won’t entertain the idea of raising rates until those conditions occur, which is almost certainly going to be a multi-year process.
PEK: The 2021 Global Insight Outlook states that ‘what worked in the past for fixed income may not work in the future,’ and reconsiders the roles of safety and income-generation. What’s on the horizon for fixed income, coming out of this stifling environment?
TG: After a year when Treasuries are on pace to deliver total returns of nearly 8% for investors, and investment grade corporate bonds nearly 10% based on Bloomberg Barclays indexes, the setup for fixed income in 2021 is going to be a challenging one. Treasury yields will open the year still near historic lows, while the ongoing recovery and optimism on the outlook has also pushed credit spreads on corporate debt—or the yield compensation over Treasuries for credit risks, back towards historically low levels. So realistically, fixed income investors can only hope to earn their coupons as there’s little scope for yields to move lower, or for credit spreads to tighten—the two key drivers of those strong total returns this year.
Unfortunately, we don’t see the yield environment improving notably in 2021. On the Treasury yield front, we expect only modestly higher yields over the course of 2021 with the benchmark 10-year Treasury note yield seen only rising to around 1.25% by year-end, up from current levels near 0.90%. Credit markets should remain well-supported as the economic recovery takes hold, but volatility is likely to remain elevated, bouts of which may give investors opportunities to put money to work at relatively more-attractive valuations and yields.
Ultimately though, fixed income serves as a source of portfolio ballast and capital preservation during periods of economy uncertainty and market turbulence, and we expect this to remain the case in 2021 despite historically low yields.
PEK: Can the economy absorb all that COVID has thrown at it, and if so, what are the implications for continued equity growth, a strengthening corporate sector and reviving jobs market?
TG: As is always the case, whether in nature, societies, or economies—there is strength in diversity, and the COVID pandemic has simply proved the resiliency of the highly-diversified U.S. economy. Of course some sectors have benefitted while others have not, but the ability for economic activity to shift around, and so rapidly, helped to blunt the broad impact on the overall economy while fueling the sharper-than-expected bounce back in Q3 GDP of +33.4% annualized.
With respect to the labor market, the decline in the unemployment rate has been faster than most had expected, including the Fed. We currently forecast the unemployment rate falling further in 2021 to 5.7%, but that will remain well above the 2019 low of 3.5%, and the Fed’s current estimate of “full employment” of 4.1%. Part of the reason is that much of the progress mad thus far has come from falling temporary job losers, while the number of permanent job losers has actually only grown since the onset of the pandemic. In a sense, the easy part has already passed and the path back to maximum employment will be a prolonged process, and as is typically the case after any major market disrupting event, the labor force will morph as the economy adjusts, and workers will have to be retrained for new jobs, the process of which can be aided by Fed policy support, and more forcefully by ongoing fiscal support.
PEK: Are there any lessons to be learned about recovery from COVID from what we went through in the 2007, with regard to recovering GDP growth and subsequent growth rate?
TG: In some ways, we are perhaps fortunate that there aren’t many insights to be gleamed from financial crisis recession as it relates to the current one. The 2008 recession was a balance-sheet recession as a result of economic imbalances—the recovery from which was abnormally long as consumers needed to time to repair balance sheets, while the policy response was in many ways far less significant than what we have seen this year.
However, the key lesson learned from 2008 relates to capital markets and the importance of ensuring that they continue to operate as seamlessly as possible as to avoid amplifying any economic disruption. And that’s what we saw the Fed apply with a great degree of success in terms of simply maintaining market functioning, particularly as it relates to its efforts to backstop credit markets. That response alone may be the key differentiator and why this recovery should be faster.
Put simply, given that the COVID recession is arguably “artificial” because the economy needed to be shut down in pursuit of public health, and that though strained, consumer balance sheets are in far-better position than in 2008, and a far-greater policy response than in 2008, we believe that the economic recovery will be both quicker and at a faster subsequent growth rate this time around.
PEK: What is the dynamic for global competition going forward, as the fight for market-share becomes even more intense? Your 2021 Outlook recognizes that while capital spending is good for profits, only the big companies can really do that efficiently. Is the competitive landscape necessarily changing to favor the big?
TG: It could be too early to say, and recent market dynamics suggest that may be precisely the case. While the big story of the year was the big market capitalization companies, small caps made a strong fourth quarter comeback and look poised to outperform this year. Through September, the S&P 500 was outpacing the Russell 2000 by nearly 15%, but since the latter has run up by over 30%, while the S&P 500 has advanced just 10%, potentially giving small caps the victory for 2020.
So perhaps the big companies were simply seen as better-able to weather the COVID storm given greater resources, and access to resources, as gauged by the initial market reaction this year. But though the pandemic will undoubtedly leave lasting impressions on the competitive landscape, the knee-jerk reaction may not actually portend a permanent shift in the competitive landscape.
PEK: Care to offer an opinion as to how the market has performed so far above expectations in 2020? Is Wall Street simply looking beyond COVID?
TG: If there was one word used most frequently in 2020, it was likely “unprecedented”. So when we talk about expectations it’s probably fair to say that there was no consensus expectation—it was anyone’s guess as to how a pandemic would impact globally-intertwined economies and markets, as well as what any market or economic recovery would look like. But it’s probably fair that few expected that stock markets would be setting new record highs barely six months removed from the depths of the pandemic in March.
It’s also hard to square the strong market performance with the real economy when so many are still struggling. But perhaps we can all take some comfort from the fact that markets are always forward looking, and based on that unexpected performance, markets are likely looking forward to a post-COVID world, along with the rest of us.
Could markets have it wrong? Of course. But markets are still one of our best tools for gauging what the future holds, and for now at least they suggest reason for optimism as we turn the page on 2020.