Too Much of A Good Thing?

Franklin Templeton Fixed Income Views explores the drivers of the reflation narrative, the potential risks that should not be ignored, and the implication for fixed income investors.

    Sonal Desai

    Sonal Desai Chief Investment Officer,Franklin Templeton

    David Yuen

    David Yuen Director of Multi-Sector Strategy,Franklin Templeton

    John Beck

    John Beck Director of Global Fixed Income,Franklin Templeton

    David Zahn

    David ZahnHead of European Fixed Income, Franklin Templeton

    PREVIEW

    Developments in the first months of the year have confirmed the cautiously optimistic outlook we outlined in our previous Quarterly Views and have shifted the balance of macro and investment risks for the near and medium term. Vaccination campaigns have rapidly picked up pace in the United States and several other countries, setting the stage for reopening businesses in the coming months. In early January, US Democrats took control of the Senate by winning both run-offs in Georgia and have launched the largest peacetime fiscal expansion on record; they approved a US$1.9 trillion fiscal stimulus bill, including a wide range of payments to households and states, and they are now discussing a US$3 trillion infrastructure package. Meanwhile, the US Federal Reserve (Fed) has reiterated that regardless of the magnitude of fiscal stimulus, it will maintain its extremely accommodative stance until the labor market recovery has extended to disadvantaged categories and inflation has been running above target for some time.

    With household finances already at high levels and an economy that has thus far demonstrated its ability to rebound, we believe this unprecedented onslaught of policy stimulus greatly increases the chance that the US economy will overheat over the course of this year and next. The reflation debate, still dormant three months ago, is now in full swing. The consensus still gravitates around the Fed’s reassuring official view: inflation expectations will remain well-anchored, wage pressures will remain moderate, the inflation rebound will be temporary and the Fed will smoothly adjust policies once it has reached its targets. That would be great, but we believe it would now be foolhardy to ignore the risks—the government is providing a staggering amount of stimulus to an already-recovering economy, at a time when commodity prices are already rising, reflecting both the global recovery and supply constraints caused by the pandemic. The inflation rebound might exceed expectations; if it does, and policy remains highly accommodative, inflation expectations might rise beyond what the Fed expects. Meanwhile, a very significant rise in public debt will compound macro uncertainty.

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    Fixed income markets have begun to price in some of these risks. Yields on 10-year US Treasuries (USTs) have jumped, exceeding even our ahead-of-consensus expectations, and most analysts have raised their year-end yield forecasts. Yields have stabilized for now, with markets in a wait-and-see phase, but we think risks remain skewed toward a further above-consensus rise, and limiting duration exposure remains a key element of our investment strategy.

    As we foreshadowed in our last quarterly outlook, the ability to move ahead with vaccination campaigns is proving a key differentiator across countries, giving the global recovery a significant degree of unevenness. Europe in particular has disappointed—its vaccination campaign lags far behind the United States and United Kingdom, and major countries including France, Germany and Italy have been forced to impose a new round of lockdowns that will inevitably delay the continent’s recovery. Since Europe’s fiscal stimulus pales in comparison to the United States, and the European Central Bank (ECB) appears more internally divided and less decisive than the Fed, the eurozone’s recovery will likely be not only delayed but less dynamic. As a consequence, we see less inflation and interest-rate risk in Europe than in the United States. Bond yields will feel some pull from the upward drift in UST yields, but with weaker domestic drivers. Overall, we therefore maintain a constructive view on European fixed income markets and favor a somewhat longer duration profile compared to the United States. We also think that perceived divisions within the ECB might lead investors to misprice rate-hike expectations, creating pockets of opportunity in periphery government bonds. The slow vaccination campaign and delayed recovery also leads us to be more cautious on the European high yield sectors more directly exposed to COVID-19 restrictions; rates volatility could create interesting select buying opportunities in the European investment grade corporate bond market.

    The more robust US macro outlook also makes us more optimistic on the prospects for global growth and for emerging markets (EM). While Europe’s lagging pace of recovery constitutes a drag, stronger US momentum will add to China’s already entrenched recovery, and to the progress already made in Asia in bringing infections under control. The resurgence in commodity prices testifies to the improved global growth outlook, though supply constraints are also contributing. Stronger global growth will help EMs to repair their balance sheets and bolster debt fundamentals; commodity exporters should be especially favored. At the same time though, the likely upside in UST yields represents a significant potential source of stress for EM debt, as already evidenced by the poor start of the year in both hard currency and local currency bonds, which brought back painful memories of the 2013 “Taper Tantrum.”1 Security selection and fundamental analysis will be crucial to identifying the most attractive opportunities for yield pick-up.

    Overall, we expect that the coming months and quarters will see a consolidation of a robust recovery in the United States and in the global economy at large, with Europe catching up in the latter part of the year. Together with vaccinations, fiscal policy plays a key role in this recovery, notably in the United States. Going forward, we believe markets will increasingly focus on whether this can be too much of a good thing—whether the massive fiscal stimulus, enabled by an extremely stimulative monetary stance, will cause the economy to overheat and inflation pressure to build beyond central bank’s expectations and desires. We do not expect inflation to get out of hand, but given that policymakers have now pulled all stops, we suspect that managing their desired inflation rise will prove harder than they think and claim. This could easily bring heightened stress and volatility to financial markets where prolonged massive monetary easing has already contributed to stretched valuations across asset classes.

    We continue to see select opportunities in the market, with the operative word being “select.” As we have noted multiple times since the start of the crisis, active management will continue to play a critical role in walking the knife edge between improving fundamentals and rich valuations. We believe deep fundamental analysis and security selection, along the lines detailed in the Sector Settings section of this outlook, will be required to navigate these markets. Fixed income investors should also remain nimble and prepared to handle heightened volatility ahead, as we get ready to discover whether the much-awaited reflationary recovery could prove too much of a good thing.

    ENDNOTES

    1. The phrase, taper tantrum, describes the 2013 surge in U.S. Treasury yields, resulting from the Federal Reserve's (Fed) announcement of future tapering of its policy of quantitative easing. The Fed announced that it would be reducing the pace of its purchases of Treasury bonds, to reduce the amount of money it was feeding into the economy. The ensuing rise in bond yields in reaction to the announcement was referred to as a taper tantrum in financial media.

    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. AMBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.