It is fair to say 2020 has been an extraordinary year. Given the severity of the health and economic crisis, the strength of financial markets has been remarkable. This is largely testament to the unprecedented degree of policy accommodation employed to support the economy through the virus-induced recession.
It showed the power of monetary and fiscal policy working in harmony. One of the key macro developments this year has been the relative shift in balance from the former to the latter, and the positive impact this has had on economic outcomes. Monetary policy provided the platform, but fiscal policy became the increasingly important marginal driver of growth.
The crucial question for the outlook for bonds going into 2021 is whether this shift in the relationship is permanent. Will fiscal policy be forever more willing and able to drive the economic cycle? Or will the emergency measures enacted in 2020 be seen as an isolated response to a once-in-a-century public health crisis?
Fiscal policy becoming the key factor
We see this as the beginning of a long-term, structural change. Monetary policy will be a less important driver of the economic cycle. Instead, relative swings in fiscal policy will be far more consequential. Central banks will, of course, remain highly relevant for financial markets, but the era of their actions being the dominant driver of the macroeconomic cycle is ending.
Fiscal policy is being driven by political considerations, as opposed to the more technocratic nature of monetary policy. This will give rise to greater divergence in economic outcomes, and thus opportunities, as countries tread different paths.
Despite the different medium-run choices countries will make with regards fiscal policy, we expect developed markets to remain sufficiently fiscally supportive into 2021 to allow the recovery to gain traction. Budget plans submitted by eurozone countries suggest continued support next year. Negotiations are ongoing in the US, but we expect further fiscal stimulus either in the lame-duck Congress or very early in the new administration.
Green sectors instrumental to continued recovery
Given the risks from climate change, there is no shortage of potential projects that could be beneficial in both boosting short-term demand and raising long-run productivity and sustainability. Although some of this investment will likely be substituting from other less environmentally friendly infrastructure, we expect it will still amount to a net increase in government investment, with a resulting boost to demand and the global inflation outlook.
Research from the IMF suggests green infrastructure investment creates more jobs than other traditional types of investment. The International Monetary Fund October 2020 Fiscal Monitor said:
In advanced economies, job intensity appears to be greater for green investment than for traditional investment. For example, job intensity – net of job losses in traditional industries – is estimated at 8 jobs per $1 million invested in green electricity, 2–13 jobs in efficient new buildings such as schools and hospitals, and 6–14 jobs in green water and sanitation through efficient agricultural pumps and recycling.
We will be closely watching the outcome of the two Senate elections in Georgia in early January. A win for the Democrats in both would give them control of the upper chamber and significantly increase the scope for a green infrastructure package, a key objective of President-elect Biden. Even without this the global shift towards greater green investment is just beginning.
Brighter economic outlook
Notwithstanding the rise in Covid-19 cases in the second wave in both Europe and the US, the economic outlook has brightened over recent months. We have seen both a stronger rebound and more pent-up demand than looked likely during the summer. This, combined with the positive news on vaccine efficacy, brings forward hope for an end to the most acute problems of the health crisis and a return to something closer to “normal” everyday life.
This should prove especially beneficial to the services sector which has been so badly disrupted by the necessity for social distancing.
Optimistic sentiment and strong recent market performance indicate that this brighter outlook is now to some degree “in the price”. But we continue to see areas that do not fully reflect the improvement in circumstances or the speed by which a more “normal” world may resume, particularly growth-sensitive currencies like the Norwegian krone, the Canadian dollar and the Mexican peso.
An asset class that particularly fails to appreciate the strength of the cyclical rebound in our view is government bonds. Here, we think yields can rise as a more optimistic medium-term outlook gets priced in, especially in the US.
That’s not to say we are bearish toward government bonds in the long-term though. After all, the Federal Reserve (Fed) seems nowhere near the point of considering removing accommodation or tightening financial conditions. The labour market has been badly damaged by the crisis and looks particularly parlous for those on lower incomes, which is a growing area of focus for the Fed.
At current valuations, however, a more hawkish Fed isn’t required for yields to move higher. If the cyclical recovery and expansive fiscal policy measures can achieve around target inflation on a sustainable basis, this should be enough. The Fed has indicated its desire for higher inflation with the average inflation targeting regime.
We believe inflation expectations will rise in the US, given this growth and policy outlook. This should push breakeven levels higher (market-based inflation expectations) and cause the interest rate curve to continue to steepen.
Optimistic on Europe
We remain optimistic on the growth outlook for Europe. The EU’s Recovery and Resilience Facility (RRF) to help member states with investments and reforms in the wake of Covid-19, creates a more robust economic bloc. It is targeting fiscal policy at areas of high importance with potentially big multipliers, such as environmental and digital transformation (where an initial investment effectively sparks a chain of further demand, spending or job creation).
The European Central Bank (ECB), however, faces a much harder challenge to sustainably deliver inflation close to its target of just below 2%.
Going into this crisis, Europe was already struggling to generate inflation given long-term downward forces such as demography, technology and falling expectations. The recession has exacerbated this.
With a reasonable growth outlook, but the necessity for a still very dovish central bank, we are effectively neutral on the outlook for the euro over the medium-term.
Instead we prefer to take a continued positive view on European currencies such as Czech koruna and the Polish zloty, against the euro, which should benefit from the global upswing, including in Europe. We would expect peripheral bond yields, those of Italy and Spain particularly, to narrow relative to those of Germany and others, as the ECB remains determined to keep financial conditions extremely accommodative.
China retains crucial role
We will be closely watching the actions of policymakers in China in 2021. We have seen a strong rebound in Chinese activity throughout 2020, thanks to a combination of better control of the virus, policy stimulus and rebounding global demand, with some indicators now above pre-pandemic levels, such as industrial production.
With this rebound in growth, however, Chinese policymakers are beginning to refocus on deeper-rooted problems such as debt levels and the property sector, and are starting to tighten monetary policy (see chart). While at this stage the degree of tightening appears moderate, we think it is highly likely to continue, potentially weighing on growth further down the line.
We remain of the view that a buoyant Chinese economy is a crucial and leading driver of the global cycle, and will watch keenly for any indication that tightening is leading to slowing growth, especially in the manufacturing sector.
Better growth outlook for EM, but tighter policy constraints
The outlook for emerging markets is certainly brighter as a result of the rebound in the global cycle and the extremely loose monetary stance of the Fed. Meanwhile the victory for President-elect Biden reduces uncertainty and volatility around future trade policy.
There has also been significant fiscal support for EM in 2020 that will fade in 2021. Unlike the majority of the developed world, who borrow at ultra-low rates in their own currency from their own central banks, emerging market countries are more constrained, with a greater need for fiscal credibility. We therefore expect a larger fiscal drag in emerging market economies than in the developed world. This will act as a moderating force on growth. Diverging fiscal positions should also present relative value opportunities, for instance favouring Mexico over Brazil.