Fixed income's challenging year?

Global Outlook

If you go to the casino with the intention of winning you are likely to come away disappointed. Casinos make bucket-loads of money for a reason – the odds are stacked in their favour. Not all casino games however offer the same bad deal for players. Games of pure chance such as craps, roulette and slot machines vary greatly in the implied odds they offer. The punter is only a very marginal underdog in craps and roulette. On the other hand, with slot machines the chances of being profitable are much lower but winnings can be very large compared to wagers. In blackjack, players can certainly improve their chances of winning with the application of a little skill. So if your intention is to walk away as a winner, it pays to choose your game, and your playing strategy, wisely.

Just for a moment though let's imagine how these choices would change if the casino was offering to refund 10% of all losing bets. All of a sudden the way players attack the casino would probably change. Suddenly those slight odds against would turn into slight odds on. Choosing not to play marginally unprofitable games would become a choice to play marginally profitable games. Knowing this might give the player comfort to place larger wagers. Those small, incremental profits from games such as blackjack could even be used to fund additional bets on riskier games such as slot machines or wheel-of-fortune. More conservative players may choose to eschew larger potential fortunes and merely be happy to sit for days on end at the blackjack table churning out the little wins. Either way, many would likely stick around a lot longer and bet a lot more compared to before the new 10% refund offer.

The analogy is a little tortured, a little simplistic, and possibly even a little crass. It is not entirely without merit however. Financial markets have increasingly come to resemble a casino where the house is offering a backstop. Except in markets it isn’t the house – it is the central banks. For decades now the world’s central banks, in particular the US Federal Reserve (the Fed), have acted as the market’s white knight. With each unforeseen shock, with each economic downturn, the Fed and others have stepped in to provide monetary stimulus, which has supported risk assets. These actions always appear justified at the time, but over time they can give investors and market participants the impression that markets are rigged. This can have the effect of changing investor behavior, increasing risk-taking and increasing setting aside of any unwelcome realities. Markets give off the appearance of robustness but periodically demonstrate their weakness and fragility. Central banks keep taking action to quell that fragility – however this can drive the same behaviors which created the fragility in the first place.

2020 has been another case in point. Following what was the largest global negative economic shock since at least the Second World War we find equities near, at or past all-time highs and investor bullishness at decade-long extremes. Incongruous? Well the narrative goes something like this – 2021 will be a better year for growth and even if it’s not then central banks will be compelled to provide more stimulus through liquidity provision and asset purchases. Either way equities go up. In this model of the world, the price being paid for risky assets such as equities isn’t very relevant. The central banks have your back, so feel free to place your bets accordingly.

So what does all this mean for fixed income?

Whereas equities can pick either narrative and call it a bull case, those two worlds could look vastly different for fixed income assets. If the market is wrong and 2021 isn’t quite so rosy and cheerful as most seem to be expecting, then it is near inevitable that central banks would step in again. With further bond purchases very likely, this would not be a time to be bearish on fixed income. Yes we may see governments respond too, resulting in bigger deficits and more government bond supply. However weak growth and disinflationary forces would overpower any concern about government finances or finding buyers for the increase in government bond supply.

If the market is correct however, and we see rising growth and inflation, well that tends to be a painful combination for fixed income investors. In such an environment it would be normal to expect yields to rise and yield curves to steepen. That’s very much the consensus expectation for 2021. And it is not entirely without merit. Vaccine rollout is beginning apace and with high expected efficacy it’s reasonable to think we can see economies returning to near-normality in the second half of the year. There is also a chance we see inflation rising however. Small and medium sized enterprises, local shops, high street names and local service providers are likely to see significant bankruptcies through the year. The resulting reduction in supply, particularly at a local level, could very easily push prices higher. The oil price is also likely to be a major contributor to headline inflation. From around the end of the first quarter, the low base of the previous year should mean much higher year-on-year inflation. Other commodity prices are also rising significantly. Partly as demand is expected to recover and partly as a result of supply constraints and disruptions due to the pandemic.

In such a state of the world however one must ask – what of central banks? Monetary tightening seems out of the question. The economic recovery has so far to go and there is still so much of the economic damage which lies beneath the high-water line of the post-crisis liquidity tide. Central banks will be even more cautious at removing monetary accommodation than they were after the 2008 Global Financial Crisis. However higher inflation and improving growth can certainly act as a constraint on additional monetary easing. In an over-indebted world facing rising funding costs this might give equity investors serious pause for thought. Might we see the equity market’s underlying fragilities exposed once again, but central banks less able to help? I would not discount such an outcome, which certainly wouldn’t be a bad environment for government bond investors at all. All this makes me wonder how stable the consensus market equilibrium really is. After decades trying to generate some inflation might inflation itself finally be what forces central banks to un-rig the casino?

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