Policy-makers hit the fiscal accelerator


Monetary and fiscal policy have both been aggressive in 2020. Earlier this year, policymakers built a bridge that carried investors over the first wave of COVID-19. Now policymakers are again being asked to step up, both as some of the earlier stimulus rolls off, and because second and third waves of the virus threaten to derail the tentative economic recovery we have seen. Looking beyond the pandemic, it is clear the global economy will look very different and even more unbalanced moving forward.

One of the key differences is likely to be the policy mix. With monetary policy having almost reached its limits, fiscal policy is likely to take over as the dominant macroeconomic policy lever. Having said that, central banks will remain critical: first, in supporting financial conditions; and second, in accommodating the necessary fiscal expansion. Around the world, central bank balance sheets and asset purchases aren’t going to shrink anytime soon. If anything, they’re likely to get bigger before they get smaller.

The implications for fixed income

Fiscal dominance as a permanent policy feature in the years ahead becomes an important consideration for fixed income portfolio construction. Being flexible enough to both capture opportunities and manage risk will be even more critical. Fiscal policy may lead to more volatility in the business cycle, given fiscal support is always reactive rather than proactive and does tend to be uneven, depending on how stimulus is delivered. There are also political risks associated with fiscal spending, as we have seen recently in the US, and implementation may have lengthy delays.

Further down the line, the sustainability of government debt will be another source of volatility, as more vulnerable countries may come under pressure. While interest rates remain low, the government debt load seems to be less of an issue, as global central banks have stressed the importance of keeping monetary policy accommodative through the recovery.

US inflation subdued as Australia joins the QE club

The prospect of a divided US government limits the pace of fiscal expansion for the time being. Although we think the US yield curve can steepen, as monetary policy anchors the short end and fiscal policy drives longer yields higher, we’ve moderated our view. The underlying economy is weak, inflation is unlikely to rise materially anytime soon, and monetary policy will likely be required to do more work yet.

The RBA has recently joined the global quantitative easing (QE) club, announcing a $100 billion bond purchase program over the next 6 months. The cash rate target, 3-year yield target and lending rate were also cut by 0.15% to 0.1%. Low rates have played an important role in supporting the economy and will continue to do so as the recovery unfolds in Australia. As rates remain low for an extended period, we are focused on maintaining our long duration position in the mid part of the curve where the RBA is likely to put further downward pressure on the structure of interest rates.

Our portfolio position

With yields likely to move lower, we remain focused on delivering high-quality income from a broad opportunity set. As the yield pickup for extending maturity on government and government-related bonds continues to compress, we are likely to continue rotating away from this sector into high-quality corporate bonds that still offer attractive valuations, albeit not as attractive as we saw in the peak of the crisis. Corporate bonds should continue to perform in an environment of very low rates as the recovery starts to broaden, albeit at a slower pace.

Within the fixed income universe, Australian credit remains our preferred asset class, with a bias in our investment grade allocation towards non-financial corporates versus financials, which are displaying much weaker fundamentals and have performed extremely well. The reopening of the Australian economy should also bode well for the non-financial corporate sector, including sectors such as airports and property trusts.

An alternative view is that credit markets are divorced from fundamentals, implying that credit risk is expensive and credit-worthiness is weak. The central bank footprint has been the key driving force behind this disconnect between markets and fundamentals. In some ways the US election outcome is pivotal to 2021 credit fundamentals and performance. With Biden claiming victory but Senate counting still ongoing, a Republican-controlled Senate is the most likely outcome. With Republicans preferring a smaller fiscal package, the potential for slower growth and higher unemployment coupled with a less supportive Treasury policy leaves corporates vulnerable to a higher level of downgrades and defaults. We are monitoring this closely and have begun to take some protection out in US high yield. We still favour Asian credit and US securitised debt, which both offer better value and diversification away from global credit markets that have performed strongly.  

Effective diversification in this low yield environment is paramount, as it can lead to better income outcomes. Investing across multiple fixed income sectors helps us to navigate uncertain markets and seek yield in our fixed income portfolios. We are well positioned to capture opportunities as they arise, in addition to managing risk.

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