Fixed Income’s most challenging year yet?
14 March 2021
Could 2021 be fixed Income’s most challenging year yet? There’s the possibility of pain ahead but Central Bank policy could alter the market equilibrium, says James Athey, investment director at Aberdeen Standard Investments
If you go to the casino with the intention of winning you are likely to come away disappointed. Casinos make money for a reason – the odds are stacked in their favour. However, not all casino games offer the same bad deal to the prospective player. It therefore pays to choose your game, and your playing strategy, wisely.
Let’s imagine how these choices would differ if the casino offers to refund 10% of losing bets. All of a sudden, player strategies change. Odds turn slightly in their favour and choosing to play marginally unprofitable games becomes a choice to play marginally profitable games. Knowing this gives the player comfort to place larger wagers, with the expectation that, over time these wagers would accrue profits not losses.
This analogy may be a little simplistic, but it’s not entirely without merit. Financial markets have increasingly come to resemble a casino where the house is offering a backstop. Except in markets, it isn’t the house – it is the central banks.
For decades now the world’s central banks have acted as the market’s white knight. With each unforeseen shock or economic downturn, they have stepped in to provide monetary stimulus when markets find that the floor has fallen from beneath them. Appearing justified at the time, they give investors and market participants the impression that markets are rigged, backstopped and underwritten. This has the effect of changing investor behavior, increasing risk taking and increasingly setting aside any realities which investors don’t like the look of.
2020 is case in point. Following what was the largest global negative economic shock since WW2, we find equities near, at, or through all-time highs and investor confidence and bullishness at decade-long extremes. And the narrative is along the lines of – 2021 will be a better year for growth, but even if it’s not, central banks will be compelled to provide more stimulus through liquidity provision and asset purchases. Either way, equities go up. In this model of the world, the price being paid for risky assets such as equities, isn’t very relevant. The central banks have our back so feel free to place your bets accordingly.
What does this mean for fixed income?
Whatever models central banks use to calibrate responses, the outcome will be that any future easing will continue to be dominated by asset purchases. That’s not a time to be bearish fixed income. We may see governments respond too, which means bigger deficits and more government bond supply. However, the government responses are likely to be in tune with the economic picture unfolding, at best. To get a bigger fiscal response we will need a greater degree of economic negativity. In that world, the weak growth and disinflationary forces will overpower any concern about government finances or finding buyers for the increase in government bond supply.
If the market is correct, however, and we see rising growth and inflation, that can be a painful combination for fixed income investors. It’s normal to expect yields to rise and yield curves to steepen in such an environment. This expectation is not entirely without merit. The vaccine rollout is beginning apace and with high expected efficacy it’s reasonable to think we can see economies returning to more normal modes of operation.
There is also a chance we see inflation rising. Small and medium sized businesses are likely to experience bankruptcies throughout the year. This reduction in supply, particularly at a local level, could easily pressure prices higher – particularly if consumers put to work the ‘war chest’ of savings built up in 2020.
The oil price is also likely to be a major contributor to headline inflation. Other commodity prices are also rising due to the expected recovery in demand, as well as supply constraints and disruptions due to the COVID pandemic, high debt levels among miners and producers, and the government’s enforced lockdown measures.
What of Central Banks?
Monetary tightening seems out of the question. The economic recovery has a long way to go and there’s still economic damage which lies beneath the high-water line of the post-crisis liquidity tide. Central banks will be even more cautious at removing monetary accommodation than they were after the Global Financial Crisis.
Higher inflation and improving growth, however, can act as a constraint on additional monetary easing. In an over-indebted world facing rising funding costs that might give equity investors serious pause for thought, might we see the equity market’s underlying fragilities exposed once again? I don’t discount it – and that certainly wouldn’t be a bad environment for government bond investors at all.
It makes me wonder how stable the consensus market equilibrium really is. After decades trying to generate inflation, might inflation itself finally be the reality which forces central banks to un-rig the casino?
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