Institutional Money (27.01.2021) - Despite an accelerating Covid-19 spread into year-end, risk markets concluded 2020 on a strong note as investors took confidence from the commencement of the vaccine rollout in the US and UK.
Positively, 2020 also ended with key agreements being reached in both the US and eurozone following tough negotiations, clearing the outlook for the year ahead. In particular, another Covid-19 fiscal package was approved in the US, whilst the UK and EU finally managed to agree on the terms of a Brexit trade deal ahead of the year-end deadline.
As we look ahead to 2021, we anticipate that the global growth recovery will remain intact as vaccine distribution will allow economies to gradually normalise.
We see the self-enforced slowdown that is set to come in Q1 due to the reintroduction of lockdown measures as a short-term blip in the recovery, rather than anything more sustained or persistent. In addition, we expect monetary policy will largely remain accommodative, despite most of the major easing announcements having passed, with fiscal policy now set to play a larger role following the Blue Sweep in the US, paving the way for another relief package.
Although markets are currently focused on the risks around the Fed tapering its asset purchases, we think it is too soon for such a discussion to take place. Instead, the dovish stance being taken by the Fed was highlighted in its final meeting of the year. For example, the updated dot plot shows that the board sees rates unchanged at the zero lower bound over the forecast horizon, whilst the inflation rate is only expected to get back to target in 2023. This is a clear indication that interest rates are unlikely to lift off in the near future, especially given the Fed’s enhanced forward guidance in which it now aims to achieve inflation moderately above 2% for some time, so that inflation averages 2% over time. The fact that the committee is now focused on its average inflation framework, as well as looking to cover what it describes as shortfalls in employment, rather than just deviations, suggests a more patient Fed than in the past. The Fed will therefore be waiting to see both inflation and labour market pressures build before looking to react with any interest rate tightening. Despite progress on the vaccine front, it was clear from the last press conference that Chair Powell is more concerned about the short-term impact on the economy from the re-acceleration in Covid-19 cases than about the medium-term benefits of the vaccine rollout.
We believe that this environment is one in which there is room for markets to revise up their growth expectations for the year, driven by both the vaccine rollout and more fiscal stimulus from the US. We see the marginal Blue Sweep as a healthy outcome for investors in that it will allow for Biden to push through pro-growth policies such as more government spending and less confrontational plans with China, whilst not having enough support for some of his less market-friendly ideas such as large tax hikes and significant regulatory changes. When we look ahead to 2021, we also see fewer risk events for investors to position for compared to last year. This should keep volatility suppressed, especially given ongoing intervention from the major central banks who we see as having drawn a line in the sand for credit markets, supporting spreads on moments of significant widening. This reduces some of the tail risks for credit, which should also benefit from the backdrop described above of improving growth, less event risk and supportive government policies, allowing investors to continue to pick up the carry.
This constructive risk environment should also allow interest rate markets to continue to breathe and edge higher, led by the long-end in a reflation type move, given expectations for another large pandemic relief bill out of the US and hopes that the vaccine rollout will keep the Q1 slowdown short.
Ultimately though, we would expect the interest rate move to be capped following the initial sell-off as we see any inflationary pressures as temporary, largely driven by supply bottlenecks due to the pandemic, rather than anything more structural. We think that the rise in rates described here will be an orderly one, driven by higher growth expectations and hence credit spreads still able to tighten against this backdrop.
Philippe Gräub
Head of Global & Absolute Return Fixed Income
Go to his Linkedin profile.
Bernard McGrath
Investment Specialist
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