Tapering, tightening and transitory inflation — Matt Brill answers the Top 5 questions he’s hearing from clients, and discusses the potential impact on core fixed income portfolios.
Tapering, tightening and transitory inflation — as we enter the home stretch of an eventful 2021, these are some of topics that are generating questions from clients right now. Below, I answer the Top 5 questions we’re hearing, and give some perspective about how these issues may potentially impact core fixed income portfolios.
1. Is inflation transitory?
Yes, we believe current elevated levels of inflation are transitory. But our definition of transitory has expanded. While we initially thought in terms of a three-month time frame, we now recognize that we could see elevated inflation for as many as 12 to 18 months as supply chain and labour market constraints work themselves out.
But though these disruptions could last longer than we anticipated, over the longer term, we expect to return to the same low-inflation environment we have experienced for the last two decades. In our view, the same natural forces that weighed on prices pre-pandemic remain in place today and have arguably been reinforced by the pandemic. These include aging demographics, globalization (i.e., cheaper goods from abroad) and technological innovation.
New pandemic behaviours like work-from-home and the rise of e-commerce, for example, have only accelerated these longer-term trends. We believe they will once again dominate when supply chains and labour markets regain balance.
On top of these forces is a fourth and newer factor likely to keep inflation low: the growing debt burden on global governments. Increases in overall debt levels may be stimulative in the short run as cash transfers are spent, but as governments divert fiscal resources away from growth-oriented programs to pay down debt and raise taxes to finance debt payments, we believe high debt levels will ultimately hamper growth, and therefore inflation.
2. How will the U.S. Federal Reserve tapering impact markets?
Our standpoint is that tapering is not tightening. Tapering may remove some of the euphoria and excess liquidity we have seen in financial markets, but it shouldn’t tighten financial conditions.
The U.S. Federal Reserve (Fed) describes its current bond purchase program as “emergency relief,” so reducing bond purchases gradually at this juncture seems warranted since, from an economic perspective, the pandemic emergency of 2020 is behind us.
We anticipate that the Fed will reduce purchases from $120 billion to zero from December 2021 to mid-2022. During this tapering time frame, the Fed will have purchased more bonds than it did during all of QE2 in the 2010-2011 time frame. Back then, the Fed was criticized by some in the market for being excessive. By that comparison, the current level of tapering certainly isn’t tightening.
We also believe that markets are well-prepared for this move and we don’t expect the same kind of turbulent market reaction that we saw during the 2013 “taper tantrum.” Perhaps most importantly, we expect the Fed to be flexible. If U.S. employment concerns or speed bumps arise in the global economy — for example, in emerging markets — we believe the Fed won’t adhere to its tapering schedule as strictly as it might have in the past, but would be responsive and potentially slow its pace of tapering.
3. What will Fed tightening look like?
In terms of rate hikes, we believe the Fed will remain on hold for at least the next year. As we mentioned above, the Fed has faced strong deflationary forces in the past that have consistently thwarted its goals to raise interest rates, essentially capping the federal funds rate in the 2% to 2.5% range in recent history. We believe this time will be no different.
As we reach the end of 2022 and early 2023, we expect inflation to normalize around its pre-pandemic levels, leading the Fed to consider rate hikes. But we believe the upside for inflation will be limited to the 1.5% to 2.0% range over the medium term, constrained by the structural forces mentioned above. As it has in the past, this environment would likely limit the potential for rate hikes beyond the 1.5% to 2.0% range for the federal funds rate.
We also believe the Fed will be slow to raise interest rates to avoid threatening the economy’s recovery. Having guided the economy this far out of the pandemic, we don’t think it serves the Fed to be too hawkish, unless inflation proves to be more persistent than expected, but that is not our base case.
4. Where do you see investment opportunities?
We recognize that valuations remain challenged across most asset classes. Consequently, the opportunities we see centre on fundamentals and upgrade potential.
In U.S. high yield, in particular, fundamentals are about as good as they have been in recent years, in our view. The high yield default rate, which is a key indicator of corporate credit health, is expected to be less than 1% this year, a very low rate by historical standards. High yield and investment grade debt metrics are also better than they were at the end of 2019, as companies have paid down debt and growth has shrunk their relative debt burdens.
As a result, we expect ratings upgrades to be a catalyst for U.S. bond market performance in the coming months. While U.S. companies have de-levered and boosted their credit profiles, rating agencies have been slow to recognize this improvement. We believe they are taking a cautious approach, waiting for the impact of the pandemic to be fully behind us. Once the coast is clearer, we expect a wave of upgrades that will likely send several high yield names into investment grade territory. This should not only create price appreciation potential but also broaden the potential buyer base for upgraded names. We call this dynamic a positive “market technical” and believe it should favour a number of credits.
In the U.S., three sectors that we believe should especially benefit from “overdue” upgrades are large-cap technology names, home builders and consumer cyclicals (such as autos). We also favour non-agency residential mortgages in the structured debt space, given solid U.S. housing market health.
In terms of global opportunities, we view the recent volatility in Asian markets as a potential opportunity to pick up high-quality credits that may have been unfairly punished in the market turmoil.
5. What is your longer-term outlook for interest rates?
To answer that question, we think you have to think globally. Any increase in yields in the U.S. has tended to be met with strong demand from European and Japanese investors struggling with negative interest rates in their regions. In order for U.S. rates to rise significantly, we believe we would need to see significant rate increases in Europe and Japan, which we don’t expect anytime soon. Europe and Japan face structural factors keeping their interest rates low and, therefore, we expect their demand for U.S. government bonds and credit to remain strong for some time.
We also expect strong demand from large U.S. institutional investors, like insurance companies and pension funds, who would likely welcome higher rates. Together, we believe strong global and domestic demand for U.S. fixed income should have a tempering effect on U.S. interest rates over the longer term.