The Year Of Less Uncertainty, More Certainty

Brandywine Global offers reasons for better global growth in 2021.

    Francis A. Scotland

    Francis A. Scotland Brandywine Global

    Jack P. McIntyre, CFA

    Jack P. McIntyre, CFA Brandywine Global

    Macroeconomic Outlook: Post-Pandemic Boom?

    A bevy of traditional macro-indicators point to better global economic growth for 2021. Some of these indicators include the lagged influence of falling bond yields, the cumulative effect of past policy stimulus measures, the low level of energy prices, and high household savings rates in China, the U.S., and Europe, which indicate pent-up purchasing power. Recoveries already have been stronger than expected, but economic policymakers in the developed world want to cushion any economic slippage caused by new social isolation measures and remain laser-focused on supporting a full recovery in employment.

    The pandemic has triggered a major regime shift, which also plays to a stronger outlook, at least for the near term. For 40 years, the macro policy regime of the U.S. was to guard against the return of inflation, work toward fiscal balance, and keep monetary and fiscal policy separate. That regime is over for the time being. Paul Volcker put his stake in the ground nearly 40 years ago with his announcement that the Federal Reserve (Fed) would use the monetary aggregates to crush inflation. Fed Chair Jay Powell has put his own stake in the ground with the commitment to keep rates at zero until inflation rises above 2% and his encouragement to Congress that the risks of too little fiscal stimulus are much greater than too much. The vehicle for achieving the Fed’s goal of higher inflation will be coordinated fiscal spending. This new regime is a politician’s dream come true.

    The only known-unknown standing in the way of this upbeat outlook is the COVID-19 virus and how governments and people react. However, promising vaccine developments significantly strengthen the case for a stronger-than-expected recovery for the year. China has already demonstrated this result. There, the authorities have effectively gained control of the epidemic through rigid compliance on social isolation measures and extensive testing. Within the Chinese economy, many sectors have rebounded back to normal while others are regaining momentum. So advanced is the progress that China’s monetary authorities already are throttling back stimulus. If the vaccines prove to be effective, the world recovery by the end of next year could be very surprising.

    Uncertainty Subsides for Global Bonds

    In determining where bond markets may head in 2021, there are three major developments to consider. First and right out of the gate is the remaining influence of COVID-19 on the global economy. The pandemic will impact economic activity through the first half of the year with a significant shift in the second half. However, this impact will not be linear across all economies. It also will be a case of “it’s darkest before the dawn,” as infection and mortality rates will remain elevated until the vaccine implementation program becomes more widespread. However, we need to consider what scenario is already being reflected in bond market sentiment. The Treasury market appears to be looking into 2021 when the vaccine will be readily available. The prior two times when hospitalization rates were in the vicinity of 60,000 people there was a flight to safety bid in Treasuries. Not this time, despite the hospitalization rate being at 100,000 and likely to rise. This change signals the Treasury market is more forward looking and starting to discount 2021’s normalization, aided by the widespread distribution of the vaccines.

    Title: U.S. COVID-19 Hospitalizations vs. 10-Year U.S. Treasury YieldAs of December 03, 2020

    Sources: Brandywine Global, Macrobond, The COVID Tracking Project, SPDJI, ICE, Macrobond.

    The second key factor to figuring out the glide path for global bond markets involves expanding the uncertainty analysis to also include “political and economic” uncertainty. This factor is more concentrated on the U.S. but has a global reach. In early January, we will learn the outcome of the run-off Senate election in the state of Georgia, which is critical to the U.S. political and economic agendas. When push comes to shove, we will see an orderly transition of power at the White House in mid-January. Unlike President Trump, President-elect Biden is not known to “weaponize” uncertainty, so we expect to see overall political volatility diminish in 2021 and beyond. If the Senate remains under Republican control as expected, there will be less “economic” uncertainty. Gridlock will reallocate power to the “problem solver” caucus, which is a group of centrist politicians.

    The third factor involves the global monetary policy front, where we also expect to see less uncertainty due to two key influences. First, and more important, is that inflation should not be a significant issue in 2021, which will keep global monetary policy biased toward more accommodative polices. This expectation is drastically different from the post-Global Financial Crisis (GFC) experience when there was a collective rush to remove policy stimulus. The use of “unorthodox” policies back then ignited a fear of monetary induced inflation. However, it never happened. Central bankers have since changed their tune on inflation coming into 2021 with a more welcoming attitude toward higher prices. Unlike in the past, they won’t fight it. If market rates were to spike higher, we would expect an increase in rhetoric on the potential use of yield curve manipulation, but we are not there yet.

    What are the market implications of this “step function” lower in medical, political, economic, and monetary policy uncertainty? It means that bond market volatility will remain low, which will support the collective search for yield in 2021. Marry this development with a shortage of yield. There is now in excess of $17 trillion equivalent of negative-yielding nominal sovereign bonds. The bottom line is fixed income securities that offer a risk-adjusted yield relative to this giant pool of negative-yielding bonds will capture outsized capital flows. Yes, spreads have already narrowed across most non-sovereign credit, but there will be more room to go. However, we expect the primary beneficiary of these capital flows to be emerging market local currency bonds. On a real yield basis, they continue to look attractive outright and relative to developed market bonds.


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