As we look toward 2021, positive news on the vaccine front and a Biden presidential win with a likely split US government open a path toward declining pandemic and political risk. The monetary and fiscal policy decisions resulting from these developments will likely yield a fixed income market that is supportive of credit risk, enjoys better relative fundamentals in emerging markets – particularly for Asia credit – and continues to see ultra-low government bond rates that remain largely range-bound, albeit with a steepening bias.
With valuations already at or near normalized levels, we see limited upside beta return potential, and for most assets, achieving even a low coupon level of return will be a favorable outcome. Yet we believe supportive conditions and the removal of the most severe downside risks will result in a reset of fair value risk premia. This could cause credit spreads to pierce through post-financial-crisis lows sometime within the next 12 to 24 months.
While the push for yield has the potential to create excesses and asset bubbles, this is not necessarily a concern for 2021. Rather, it’s a dynamic that will warrant close monitoring and management within portfolios over the next few years. But in the midst of relatively unexciting total return expectations for 2021, we expect continued dispersion across securities, industries, and geographies to create incremental opportunities to enhance alpha.
A Biden presidency and the likelihood for a thin Republican Senate majority in the US should result in a more supportive outlook for credit risk assets in 2021 and beyond, along with a more range-bound yield curve that will steepen at a gradual pace. Treasury yield curves registered the most immediate impact: After steepening in the leadup to the election based on expectations of a blue wave, and thus a forceful $3 trillion stimulus package, a divided government will result in a much smaller stimulus. This change will dampen the pace of recovery at a time when the near-term rise in virus infections may add additional pressures to the economy in the form of renewed but more targeted shutdowns. However, the prospects for an effective early vaccine offset the negative short-term impact of a fiscal stimulus shortfall.
While the world’s focus has been primarily on the US elections, a range of political risks are unfolding, from near-term Brexit outcomes to upcoming elections in Europe. Political polarization around the globe, fueled in large part by the rise in income inequality, isn’t going anywhere, and the resultant trend toward nationalism and resistance to freer global trade, particularly with respect to China, will likewise persist. Even so, the US election outcome will help reduce tensions, including the risk of a potential trade war on a second front with Europe.
Within the US, the new political regime will need to enact more centrist legislative policies, along with actions that can be implemented via executive order. First and foremost, we expect few material changes to the US tax code. Given the explicit Democratic platform of raising corporate tax rates and the highest marginal individual rates, expectations for a Republican-controlled Senate will have a favorable near-term impact on corporate earnings and cash flows and on all risk assets. Financial markets are also embracing the expectation that the divided government will not usher in substantial increases in regulatory oversight and restrictions. While this development has implications for various industries, key beneficiaries include financials, which represent the largest component of investment grade corporates. The energy sector will also benefit, though we expect more restrictions on carbon production and greater support for renewables, and both winners and losers will emerge within health care and technology. Businesses that are tied to municipal financial health are the likely losers, as the shortfall in fiscal aid could result in substantial cuts in services and employment.
Overall, the political outlook creates a more favorable intermediate-term backdrop for credit over the next 12 to 24 months, until the next mid-term elections, but offers less of a short-term benefit through the first half of 2021, though it may relieve some pressure on the yield curve.
The world has been digesting dueling news on the pandemic in recent weeks, with rising infection rates threatening both Europe and the US but positive signals on the vaccine front, with efficacy data for more than one of the top contenders strongly beating expectations. The ongoing virus surge will likely result in additional economic damage and a delayed recovery of the service sector, which has taken a direct hit. While the pandemic will continue to have broad macroeconomic effects, the transition toward reining it in will create more specific risks and opportunities within both industry segments and specific companies.
A number of leveraged businesses in the theater, travel and leisure, and retail/restaurant categories that were already running low on liquidity, despite having accessed capital markets earlier this year, will face severe stress or default in 2021 if the recovery is delayed. But if expectations for widespread distribution of an effective vaccine in 2021 are realized, a recovery path will open up for businesses with the liquidity to bridge the gap through 2022; however, they would add to their debt burdens during this period. There will also be beneficiaries as the pandemic wears on, notably certain technology segments, broadband providers, and other areas that will benefit from wider consumer and business reliance and changing habits that could endure post-Covid.
Indeed, structural and behavioral changes could have a permanent impact on certain segments and businesses. Commercial real estate is squarely among those at the top of this list. What we see is not the beginning of the end of business offices, but rather a shift in their function and location. Their future footprint is likely to be smaller, with work-from-home and flexible options becoming more prevalent, but we also expect a transition from urban centers to more suburban areas, as well as ongoing support for residential real estate and its functionality. Covid will also hasten the ongoing secular migration of retail from brick-and-mortar toward e-commerce. Change and transition don’t necessarily create a poor investment outcome – rather, they promote rising dispersion among winners and losers, which presents both opportunities and risks.
Overall, as the pandemic overhang dissipates in 2021, corporate credit will receive a tailwind, while yield curve steepening pressures should increase. But no matter the pace of this transition, emerging markets – Asia, in particular – are fundamentally better positioned. Asia has exhibited superior control of the virus, and a large swath of the hardest-hit emerging countries are in the southern hemisphere and heading toward the warmer summer months. Emerging markets also benefit from stronger underlying structural growth and younger populations. For these reasons, we favor Asia credit and emerging market corporates but also maintain a positive outlook for developed market corporates. (For more of our views on Asia debt markets, see our 2021 Asia Fixed Income Outlook.)
Political developments and the pandemic’s course heavily influence policy outcomes, and none of these factors can be viewed in isolation. But for fixed income markets, the extraordinary influence of global central banks – the Federal Reserve in particular – and their massive and growing monetary stimulus for 2021 will have the greatest impact. Regarding stimulus, the expectation of a much smaller fiscal package combined with a Fed that will most likely extend most of its programs should restrain additional yield curve steepening triggered by vaccine optimism. We therefore expect a more incremental steepening to play out in 2021, as much of the anticipated impact has been pulled forward.
Policy rates are firmly anchored, and it seems clear that the world will operate in a negative real interest rate environment for the next three to five years, if not beyond. So the question in the near term is whether curves will steepen, and by how much? We think the answer is simple: The yield curve will go where the Fed and other central banks want it to go in 2021. Longer term, we may return to a world where yield curves reflect expectations for growth, inflation, and appropriate term premia. But over the next few years, they will largely be dictated by central banks and their goals – whether they are explicit targets, as the Bank of Japan has set, or implicit ranges, as with the European Central Bank and the Fed.
These policies dictate our strategy of “trading the range” of the risk-free curves while again favoring credit, although the upside potential for additional credit spread compression has diminished with prevailing valuations.
As we evaluate 2021 positioning in the context of transitions in politics, the pandemic, and monetary and fiscal policy, we are tilting portfolios toward credit risk exposure, with the following convictions:
Holding a relative bias toward Asia and emerging market credit
Maintaining our positive outlook for both investment grade (IG) credit, particularly BBBs, as well as below-IG leveraged finance credit in developed markets, but with less risk appetite within the lowest leveraged finance segments; we favor the single-B space
Seeking to generate security selection alpha from dispersion and divergent risks and opportunities, particularly across select Covid-impacted companies
“Trading the range” of longer-end segments of government yield curves, but with the view that yields will not break materially out of the range; rather, that they will migrate up incrementally while exhibiting transient periods of volatility
Through swift and forceful actions, central banks have effectively cut off left-tail risks and will likely accommodate negative real interest rates for years to come. As a result, the major secular shift we expect in 2021 is the lowering of risk premia, a trend that is likely to persist for the next five to 10 years.
For more PineBridge views on what to expect across economies and asset classes in 2021, visit our 2021 Outlook page.
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Last updated 3 June 2021