15 Dec 2020
December 2020 | Ariel Bezalel and Harry Richards, Head of Strategy, Fixed Income and Fund Manager, Fixed Income
In the 1990s, the role of independent central banks was to act as global policemen stamping down on inflation whenever it flared up. But following the Great Financial Crisis the referees became players while in 2021 the boundary between independent central banks and their governments will look increasingly blurred. What sort of a world are bondholders likely to face, ask Ariel Bezalel and Harry Richards.
Some people are worried about the return of inflation. They can see the phenomenal response to the pandemic by governments, they know major central banks continue to engage in significant ‘money printing’ and they can see that the gold price, traditionally a hedge against inflation, has shot up.
And yet, rather than inflation, we think many of the developed economies will continue to face a cold world of sluggish economic growth. Why? In recent decades the rate of economic growth has been slowing down and, worryingly, this has required ever-higher amounts of debt to deliver the necessary stimulus. Very high debt burdens hinder growth.
There are other powerful deflationary pressures too: globalisation, the relentless downward pricing pressures of the internet, ageing populations and falling fertility rates – with the latter pointing to lower rates of economic growth. Central banks in Japan and the EU have both tried to get inflation up to 2%. Both have failed. Why should it be any different in the UK or US? Central bankers know precisely what to do about inflation, it is deflation that keeps them awake at night. Nor do bond markets expect inflation. When stock markets jumped for joy on promising vaccine news, bond markets barely raised an eyebrow. Furthermore, the daily prices of index-linked bonds can be used to show what longer-term rates of inflation are expected – these expectations remain subdued.
Covid is accelerating a lot of trends. The move to online shopping is hollowing out the high street while working from home leads to emptier offices and falling rents. Consider the impact on tourism, which accounts for almost 10% of world GDP. Travel restrictions mean fewer holidays, conferences and cruises, with fewer flights and visits to hotels, galleries and restaurants. Some of this business is gone for good. Of course, demand will come back but perhaps slower than expected. It will take a while for people to regain confidence.
This makes the corporate credit market something of a minefield. Since the advent of money printing, we’ve seen that while central banks have been able to provide a degree of support for corporate bond prices they have not been able to prevent the recent rise in company default rates. Yes, central banks are able to provide that rising tide of liquidity to lift all boats but there are still a lot of whirlpools out there which in 2021 could drag down some companies because of the weakness of their balance sheets. In particular, those highly-levered companies that are very exposed to the economic cycle could struggle.
However, at the same time, we’ve seen a lot of government schemes and loans to help out the corporate sector – and a number of these may be extended further as the government seeks to backstop the corporate sector. This could postpone some potential insolvencies and bankruptcies.
Furthermore, although the debt burden may be worryingly high, the interest payments on that debt are comparatively low and central banks will want to keep it that way – which is why we expect them to act to keep a lid on bond yields. They have the tools to do so. And, since a sharp rise in taxes could snuff out the recovery needed to reduce the debt burden, we may see governments turn to central banks to provide money directly for some of their spending plans at some point way down the line. This is effectively Modern Monetary Theory1 which is something we don’t see happening for a while yet and in fact may require a change in the Federal Reserve Act2.
With bank base rates pinned like Gulliver to the floor in so many countries, buying the entire market may disappoint. Investors will need to look harder for returns. We see select opportunities in the lower end of investment grade bonds as well as in some of the higher-yielding, higher-risk bonds issued by defensive companies. There are also some cherry-picking opportunities in government bond markets: Chinese government bonds currently look interesting as do Russian government bonds and certain emerging market bonds.
Finally, we think there is room for the yields on longer-dated Australian government bonds to converge with lower Western yields and this could provide a sizeable capital uplift. In our view, some people miss this because they only see yields at all-time lows. But if the vaccines produce less of an economic boost than is currently expected, those yields could potentially go even lower.
1 A controversial form of government financing appropriate only in exceptional situations, where economies are far from full employment, deflationary pressures are evident and interest rates are close to zero. In a slump, where raising taxes for spending may be counterproductive, governments can – up to a point – print money to pay for goods and services directly.
2 An Act that defines and underpins the structure and operation of the US central bank.
Please note: Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the author at the time of writing, are not necessarily those of Jupiter as a whole, and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
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