Short & Intermediate Duration Fixed Income: Q1 2021 Themes, Outlook & Strategy

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Short & Intermediate Duration Fixed Income: Q1 2021 Themes, Outlook & Strategy

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Short Duration Fixed Income Team
DEC 31, 2020

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Public Fixed Income Quarterly Commentary: Fourth Quarter 2020

  • Fiscal Stimulus / Growth - An increase in fiscal stimulus is now expected to spur a meaningful increase in U.S. real GDP growth in 2021, however we continue to expect an uneven recovery as many small businesses are slow to reopen and consumers reluctant to return to their pre-Covid consumption patterns. Growth will be pulled forward by fiscal spending which will provide temporary support, not a long-term structural fix to the economy. Fiscal and monetary stimulus lines will continue to blur as coordinated efforts between Congress, the Treasury and Federal Reserve will move to address socio-economic issues. The U.S. federal deficit continues to expand coupled with a sharp increase in the national debt, both representing long-term challenges.
  • Business - Uneven access to capital as well as technology in the current environment continues to disproportionately benefit larger enterprises versus smaller and medium companies. We do however expect large corporations will work to trim costs (labor) in the face of profit margin pressures while small and midsize businesses continue to grapple with staffing challenges. Credit fundamentals for many large companies have begun their gradual repair, which may be slowed by higher costs, margin squeezes, and potential for liquidity buffers being redirected to M&A or increased shareholder payouts. Banking fundamentals continue to be strong, especially for issuers with capital markets businesses. The rollback of the prior administration’s regulatory changes may be marginally less business friendly.
  • Consumer - Additional stimulus should help support consumption and aid households in staying current on their financial obligations (e.g. rent, credit cards, auto loans). Post-coronavirus behavior remains altered as spending patterns have shifted and social distancing persists, which will negatively impact many of the service sectors until a vaccine is widely distributed and herd immunity is reached. Absent requirements that individuals get vaccinated, a reluctance to be inoculated serves as headwind to the consumer sector’s contribution to economic growth. The savings rate will likely remain elevated as high-income earners, who have a lower propensity to spend an incremental saved dollar, are less inclined to spend on services.
  • Employment - The recent drop in the unemployment rate was largely driven by a decline in the labor market’s participation rate and bears watching as it has negative longer-term implications for economic growth. Divergences persist across the economy with a disproportionate number of jobs lost in lower paying service sectors, especially leisure & hospitality and retail. Permanent job losses remain elevated, raising concerns arising from the potential for lasting damage due to diminished job skills and lower productivity growth unless recent trends are reversed. The loss of jobs in industries that tend to pay less than the average hourly earnings rate (AHE) has skewed the distribution of earnings to high wage earners and biased the AHE number higher.
  • Monetary Policy - The Fed’s focus on producing an uptick in inflation through using its policy toolkit takes precedence over seeking improvement in labor market measures. Given the close relationship between Chair Powell and incoming Treasury Secretary Yellen, we expect increasingly greater coordination between fiscal and monetary policy efforts to achieve economic policy goals. Over the near term, the bar for the Fed to taper its post-crisis QE program is high due to continued downside risks to the economy. U.S. monetary policy will not be tightened pre-emptively based on the Fed forecasting higher inflation above its target as it has done in past cycles. The Fed’s adoption of AIT (average inflation targeting) means old models of its reaction function should be discarded.
  • Inflation - U.S. inflation is expected to rise in the short run due to base effects but would not be reflective of underlying inflationary pressures. The focus of the Fed and in turn the market will shift to survey and market-based inflation expectation measures under the Federal Reserve’s Average Inflation Target framework. Lingering labor market slack and low nominal economic growth are expected to temper inflation longer term, however. The future demand outlook for services in a post-Covid environment is clouded and could be problematic. Based on the failure to reach inflation targets in other regions (e.g. Japan and the eurozone), the track record of employing easy monetary policy to drive inflation is not encouraging.
  • Residential / Commercial Real Estate - Low mortgage rates along with tight single-family property inventories from the migration of urban dwellers keep inventories tight, supportive of mid-single digit home price appreciation. Originators continue to add processing capacity and have the ability to absorb the impact of rising interest rates rather than passing them through to borrowers, thereby keeping mortgage rates low and prepayments elevated. Additional fiscal support will delay the expiration of forbearance programs. Supported by strength in industrial and multi-family properties, commercial real estate delinquencies have stabilized, but headwinds remain for retail, lodging and office properties. Overall, we feel benchmark commercial property price indices are likely to show modest declines.
  • International - Global central banks will likely maintain loose financial conditions in an ongoing attempt to generate growth and inflation as the coronavirus and potential mutations linger. More fiscal stimulus in the U.S. and an expanding budget deficit may limit the U.S. dollar’s ability to rebound. Geopolitical risks are expected to rise, posing challenges on multiple fronts including an emboldened China (i.e. Taiwan, South China Sea, IP theft) as well as a more confrontational Iran and Russia, especially with a new U.S. president. While U.S. tariffs on Chinese imports are expected to remain in place, the incoming president is not expected to levy tariffs on European goods and should adopt a less isolationist approach. ESG and climate change will garner more attention, playing an increasingly larger role in driving international policy and business decisions.