Insights
The Year Ahead for the U.S.: Fundamental Challenges Exist, but Policy Will Prevail
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Market Pulse
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December 02, 2020
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The Year Ahead for the U.S.: Fundamental Challenges Exist, but Policy Will Prevail
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December 02, 2020
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The Year Ahead for the U.S.: Fundamental Challenges Exist, but Policy Will Prevail
The Year Ahead for the U.S.: Fundamental Challenges Exist, but Policy Will Prevail |
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Over the past few weeks we have laid out our expectations for the path of interest rates and their drivers. From a macro perspective, the debate on future growth and the path of rates is now spilling over into credit default rates, and whether or not we experience a second wave of defaults. Let me say upfront that I am optimistic about a procyclical recovery (explained at the end), but let me first lay out the challenges and risks currently in front of us.
The narrative in the market
The current market narrative is that we will see a sharp rebound in growth next year, a viable vaccine will become widely available, yields will rise and all will quickly return to normal – in essence, a reflation view. While I generally agree with this narrative, it’s a coin flip as to whether it is, in fact, actually correct. Here’s the rest of the story.
The quandary
In order for the reflation view to be correct, we need to close the output gap by fully restoring lost aggregate demand, i.e. the shortfall in GDP growth relative to trend, in order to generate sustainable reflation. Making up that shortfall requires approximately 5% growth in 2021 and 2022 (Display 1). And how likely is this? Not very. That is the quandary the market needs to solve to square with the narrative.
DISPLAY 1
It will take time to close the output gap in the U.S.
Market expectations for growth
What is the market expecting for growth? Blue Chip Consensus Economics surveyed 49 economists and consensus growth for 2021 is 3.8% as of Nov. 30, 2020. Closer to home, the Morgan Stanley forecast for 2021 GDP is more bullish at 6.0%, but compare this to the 3.4% forecasted at one of our major competitors. But here’s the real kicker … 2022 GDP forecasts are 2.7% for Morgan Stanley and 3.3% for that competitor. The point here is that, based on these forecasts, the US economy falls short of averaging 5% growth over the next two years and will ultimately struggle to close the output gap.
This indicates that the reflation trade may not materialize as quickly as the market narrative suggests. The implication is that bond yields will rise, but real inflationary pressures will build very slowly as it may take more time to close the output gap - think 2023, but more likely 2024. In addition, a slow return of aggregate demand (i.e. cash flow) makes credit default risk more prominent than what the current narrative might be suggesting.
Why the optimism?
What is laid out above is an economic fundamental argument. What is missing is the technical data from policy support, and I think that matters more. Remember that asset prices in 2020 were driven mainly by policy, not fundamentals, and this will likely continue to be true in the years ahead. Whether it be fiscal policy, monetary policy helping to keep rates low, Fed backstops, “animal spirits”, etc., any and all can help to push asset prices higher. So, once again, incorporation of the impact of the policy response function, which we expect will still be accommodative alongside a recovery (i.e. procyclical), may dominate asset prices. This is why I am optimistic about the future of asset prices and performance despite challenging economic fundamentals.
RISK CONSIDERATIONS
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).
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Managing Director
Global Fixed Income Team
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