The course of the pandemic, and prospects for a vaccine, will likely hold national economies hostage. Meanwhile, the fiscal responses of governments will ultimately determine the scale of new debt being issued into the market. To that end, there is an apparent sharp recovery underway, as many macro-economic indicators are pointing to scenarios that are considerably better than during the earlier COVID-driven market chaos. US economic activity is improving, and domestically the Reserve Bank of Australia (RBA) is suggesting the worst of the data has passed. As the states slowly open up, with additional stimulus and ongoing fiscal measures, 2021 may not be as dire as many had predicted.
In Australia, with the supply of bonds both forecasted, and already delivered by the Australian Office of Financial Management (AOFM), some would argue bonds are already quite expensive.
So, putting aside the RBA’s yield curve control (YCC) measures, it would take some pretty dire economic figures for bonds to rally markedly further, given this deluge of issuance. If you subscribe to bonds being expensive and struggling to markedly rally further, outside of central bank YCC-mandated buying, being overweight investment-grade credit, or senior unsecured banks, is a trade that could potentially work very well. At State Street, we are cautious of investing in sub-investment-grade names as there is still plenty of potential for downgrades and indeed defaults. On the emerging market debt (EMD) front, our preference is for local currency EMD.
From a funds management perspective, there should be increased availability of Australian Commonwealth Government Bonds (ACGB) issuance, deeper ACGB issuance and larger issues. That bodes well for liquidity of an ACGB portfolio, and the Australian bond market as a whole.
Hopefully, the current substantial monetary and fiscal policy stimulus can work effectively to underpin a pick-up in economic activity. And, with yields at some point being too low, having a larger and deeper bond market should benefit portfolios that wish to shorten duration or indeed short bonds.
We expect the Federal Reserve (Fed) to maintain its zero lower bound (ZLB) policy indefinitely to achieve both lower unemployment and higher inflation. Similarly, we expect the RBA will continue to run very easy monetary policy in the medium-term as they also try to achieve a much lower level of unemployment. RBA governor Philip Lowe has consistently said that the inflation target cannot be achieved until progress is being made towards full employment.
The inflation dragon is slumbering deeply for now. In the year ahead, some of the warning signs that bond markets should be watching out for include: a rebound in leading indicators; and a shift from both underemployment and part-time jobs, to full-time employment. This should spark a rebound in gross domestic product (GDP) which can only add to current benign inflationary pressures.
Fed policy should be a stabilising factor for credit markets. With such extraordinary liquidity measures added to global money markets after the COVID-19 pandemic realisation in March, credit has performed very impressively. In Australia, there is a continued appetite for high-grade, senior unsecured bank debt as investors realise the strength and stability of bank balance sheets. With the RBA offering an extended term funding facility measure to domestic banks, the likelihood of seeing senior unsecured bond debt issuance through the primary market is low. This has, and likely will, drive a secondary market bid for existing issuance. When YCC measures are eventually wound back and we see an entrenched economic recovery and inflation, there may be increased demand for floating rate debt, as investors move away from fixed-rate instruments that have rallied impressively for several years.
When inflation does start to appear, there is the potential for many fixed-rate instruments, both issued with very low coupons and bought by investors at very low yields, to notch up substantial capital losses. This is where highly-rated, senior unsecured floating rate notes could see an even greater allocation to portfolios.
Simon Mullumby, senior portfolio manager, State Street Global Advisors
