The top five questions clients are asking us now

Tapering, tightening and transitory inflation. As we enter the home stretch of an eventful 2021, these are some of topics that are generating questions from clients right now. Below, I answer the top five questions we’re being asked, and offer some perspective on how these issues may impact core fixed income portfolios.

1. Is inflation transitory?

Yes, we believe current elevated levels of inflation are transitory. But our definition of transitory has expanded.

We initially thought in terms of a three-month time frame. However, we now recognise that we could see elevated inflation for as many as 12 to 18 months as supply chain and labour market constraints work themselves out.

While these disruptions could last longer than we had anticipated, over the longer term, we expect to return to the low-inflation environment we have experienced for the past two decades.

In our view, the same natural forces that weighed on prices pre-pandemic are still in place today and have arguably been reinforced by the pandemic. These include aging demographics, globalisation (i.e., cheaper goods from abroad) and technological innovation.

New pandemic behaviours, like the rise of e-commerce and working from home, have only accelerated these longer-term trends. We believe they will dominate once again when supply chains and labour markets regain balance.

A fourth and newer factor is also likely to keep inflation low: the growing debt burden on global governments.

Increases in overall debt levels may be stimulative in the short run, as cash transfers are spent. However, as governments divert fiscal resources away from growth-oriented programmes to pay down debt and raise taxes to finance debt payments, we believe high debt levels will ultimately hamper growth, and therefore inflation.

2. How will Federal Reserve tapering impact markets?

Our standpoint is that tapering is not tightening.

Tapering may remove some of the euphoria and excess liquidity we have seen in financial markets, but it shouldn’t tighten financial conditions.

The Fed describes its current bond purchase programme as ‘emergency relief’. Given that the pandemic emergency of 2020 is behind us from an economic perspective, gradually reducing bond purchases at this juncture seems warranted.

We anticipate that the Fed will reduce purchases from $120 billion to zero between December 2021 and mid-2022. During this tapering period, the Fed will have purchased more bonds than it did during QE2 (2010-2011). Back then, some parts of the market criticised the Fed for being excessive.

Compared to this, the current level of tapering certainly isn’t tightening. We believe markets are well prepared for this move, and we don’t expect the same kind of turbulent reaction we saw during the 2013 taper tantrum.

Perhaps most importantly, we expect the Fed to be flexible. If US employment concerns or speed bumps arise in the global economy, for example in emerging markets, we don’t believe the Fed will adhere to its tapering schedule as strictly as it might have in the past. Instead, we believe it will be responsive and potentially slow its pace of tapering.

3. What will Fed tightening look like?

In terms of rate hikes, we believe the Fed will remain on hold for at least the next year.

As mentioned above, it has faced strong deflationary forces in the past that have consistently thwarted its goals to raise interest rates, essentially capping the federal funds rate in the 2-2.5% range in recent history. We believe this time will be no different.

As we reach the end of 2022 and early 2023, we expect inflation to normalise around its pre-pandemic levels, leading the Fed to consider rate hikes. But we believe the upside for inflation will be limited to the 1.5-2% range over the medium term, constrained by the structural forces mentioned above.

This environment would likely limit the potential for rate hikes beyond the 1.5-2% range for the federal funds rate.

We also believe the Fed will be slow to raise interest rates to avoid threatening the economy’s recovery. Having guided the economy this far out of the pandemic, we don’t think it serves the Fed to be too hawkish, unless inflation proves to be more persistent than expected. But that is not our base case.

4. Where do you see investment opportunities?

We recognise that valuations remain challenged across most asset classes. Consequently, the opportunities we are seeing centre on fundamentals and upgrade potential.

In high yield in particular, fundamentals are about as good as they have been in recent years, in our view. The high yield default rate, which is a key indicator of corporate credit health, is expected to be less than 1% this year, a very low rate by historical standards.

High yield and investment grade debt metrics are also better than they were at the end of 2019, as companies have paid down debt and growth has shrunk their relative debt burdens. As a result, we expect ratings upgrades to be a catalyst for bond market performance in the coming months.

While companies have deleveraged and boosted their credit profiles, rating agencies have been slow to recognise this improvement. We believe they are taking a cautious approach, waiting for the impact of the pandemic to be fully behind us.

Once the coast is clearer, we expect a wave of upgrades that will likely send several high yield names into investment grade territory. As well as creating price appreciation potential, this could broaden the potential buyer base for upgraded names.

We call this dynamic a positive market technical and believe it should favour a number of credits.

In the US, three sectors that we believe should benefit from overdue upgrades are large-cap technology names, home builders and consumer cyclicals (such as autos). We also favour non-agency residential mortgages in the structured debt space, given solid US housing market health.

In terms of global opportunities, we view the recent volatility in Asian markets as a potential opportunity to pick up high-quality credits that may have been unfairly punished in the market turmoil.

5. What is your longer-term outlook for interest rates?

To answer that question, we believe you have to think globally. Any increase in yields in the US has typically been met with strong demand from European and Japanese investors struggling with negative interest rates in their regions.

In order for US rates to rise significantly, we believe we would need to see significant rate increases in Europe and Japan, which we don’t expect anytime soon. Europe and Japan face structural factors keeping their interest rates low. As such, we expect their demand for US government bonds and credit to remain strong for some time.

We also expect strong demand from large US institutional investors like insurance companies and pension funds, who would likely welcome higher rates. Together, we believe strong global and domestic demand for US fixed income should have a tempering effect on US interest rates over the longer term.

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