Welcome to talking markets, a podcast series from PineBridge Investments. I'm your host Aurelia Sax, Deputy Head of Client Services, EMEA at PineBridge. Every month we'll will cover our take on local political and market trends. In this episode, Markus Schomer, PineBridge Chief Economist and John Yovanovic, Head of High Yield Portfolio Management, discuss their expectations for the markets in the light of the US election outcome, what they expect the Fed might do, and how it is likely to impact the bond markets in particular. Thank you for taking part in this interesting discussion John and Markus, over to you.
Thanks Aurelia. So, what we want to do today is have a conversation between top down and bottom up analysis and demonstrate to you how in PineBridge, we can merge the two together and create better economic analysis for both sides, for both the top down and for the bottom up analysis. And the three themes we want to talk about today are the impact and outcome of the US election, how it intersects with our outlook for 2021. And maybe, not knowing exactly what the precise outcome is, what can we already learn from the information we have so far. The second theme is the outlook for the US economy itself, going through the early stage of the recovery. But there's still some sceptics who believe the recovery may not hold and are worried about how 2021 could play out. And then the third theme we want to touch on is the role of the Federal Reserve, which has been very instrumental not only in underwriting the economic recovery, but also underwriting financial markets and creating the strong rebound we've seen in the equity market so far. And the question, of course, on everybody's mind is will that continue over the next few years?
Well, I think that the day of we saw very sharp moves in the market, I would attribute that to just kind of more of a squaring of positions, as we saw just really violent moves, particularly in the rates market, but when you look at just what the scenarios would suggest from an election standpoint, it was interesting to me just to watch the markets, generally think about blue wave as a very negative outcome, say in September to sort of a base case outcome in the days leading up to the election, and then we end up with somewhat of this divided government outcome, which from a market perspective is actually reasonably positive, where you'll just get some normalcy in just less policy volatility, without enormous legislative changes. So, I thought that the Monday following, I suppose a better view on who was actually going to prevail, really said more about position squaring than any type of long term, market direction, but I, I am not surprised in the day subsequent to that, that we've just seen volatility come down, it's somewhat from what it was pre election.
Let pick up on one thing you said that divided government typically has been viewed as good for financial markets - now keep the government out of the economy and the economy will do well, that used to be the mantra in the past, maybe you could make an argument right now, divided government may mean no breakup of the large tech companies, which so dominate the equity market right now. But I'm concerned that the fact that we have potentially divided government next year, that will create problems providing additional, in my view, very necessary fiscal stimulus. If you don't get another fiscal package, I think we're facing a significant issue in terms of the expiration of unemployment benefits, for example, and you can spin this idea further, divided government will make it much more difficult to agree on any kind of large scale infrastructure program, that has often been talked about, which would be if it were to come to pass, quite beneficial to the economy. Divided government most likely will reduce the likelihood of more fiscal stimulus. I don't think that's a good story for the outlook next year, in at least next year when we need more fiscal stimulus. So once again, I'm surprised that financial markets are glossing over this. Where do you stand on the idea of divided government? Is it still something we should perceive as positive for financial markets? Or is more government necessary right now where we are?
Yeah, I would divide all of what you're highlighting the known knowns and the known unknowns, what Your highlighting is a known unknown that is, I would argue a little bit less forward looking in nature. I agree with you a lot of that depends really on how the Republicans end up faring, and do they switch as the opposition party does, does fiscal policy, actually matter, again to them from the standpoint of controlling the deficit. I mean, that, I think the argument that you're making, and frankly, I'd say too soon to tell on that for a variety of reasons. One is just their support of the working class and the other is that we've still got run off Senate races in Georgia. And while it would be, I think, an outlier probability to think that the Senate could move more toward a 50/50 split, where this divided government theme becomes somewhat unquestioned, it's still very likely, but the other from a market perspective, and from a positioning perspective, while I agree with you that a large fiscal stimulus package is probably less likely, you will get some fiscal stimulus package. But stepping back from that, and just thinking about the longer term policy implications of normalizing trade relations of just not having to worry about massive increases in regulation, I think the markets are much more focused on that aspect of what the government looks like for the next two to four years than they are about the near term fiscal stimulus that is needed to combat sort of the hopefully past the halfway point in the closing leg of the Coronavirus scenarios.
The divided government argument is very much a US specific one and an implication that the election outcome will have for the US economy. Something we've been talking quite a lot about over the last week internally here at Pineridge is what the implications are for the rest of the world. And there, I'm certainly in the camp that the outlook is much more positive. Whatever the Government makeup will be in the US, it probably won't have a lot of implications on US foreign policy. And I certainly expect that, in particular, the trade policy that the US has pursued over the last four years would change quite significantly, certainly in tone, but also in substance. I was always worried that the Trump administration would start to turn its trade guns on Europe, we already have some tariffs in place. But there was a potential to ratchet up those tensions much more. I think that risk has significantly been reduced with a win by Joe Biden. And I would even go so far as to say Asia looks as potentially one of the great winners here. It's quite likely that tariffs on Chinese imports will be reduced over the next few years and the US May rejoin multilateral organizations like the WHO, it may lead an effort to reform WTO. And I'm even dreaming of the US rejoining TPP. Am I a little naive as a multilateralist here? Or do you see some of those positive outcomes as well, John?
I generally agree with you, I certainly think that there's going to be broad re-engagement on trade policy with our historic international allies generally. And I think that that is sort of built into my return to normalcy thesis and I believe that that's generally going to be positive for the economy globally. But there are certain themes that got kicked up in the last four years that I think will have staying power and the concept of some more of a local focus, and certainly an anti-China sentiment, I think are very likely to remain. So, globally, I agree with you about administration is going to be roundly positive for just re-engagement with the world globally and on the climate change issue, we will rejoin the Paris Accord etc. But there are still going to be at the margin, some aspects of the policies that we've seen over the last four years that remain and potentially China could be one of them.
Let's move on to the second theme that we want to talk about today. And that deals more with the outlook for the US economy and whether the recovery that we're seeing right now, whether they will hold and extend into next year. If I look at the economic data that are tracked on a regular basis, it seems to me that the recovery is on track, surveys all point to continued economic growth, continued recovery in the months of September, October. We haven't seen anything yet for November, but going into the fourth quarter, I see nothing in the data that would suggest that we're seeing any problems, that there's a wobble in the recovery as there sometimes is and that we're not going to see another strong GDP growth result for the fourth quarter, it won't be as good as the third quarter number, of course. But it will still be well above what we're used to, in terms of economic growth numbers. So I think we're heading in the right direction, the bigger risk right now seems to be what's happening outside of the US, in particularly in Europe, where the surveys point to the exact opposite. The COVID crisis has really picked up there again, much more than than here in the US. We've already seen a bunch of countries, reclosing the economy and they are running the risk of a double dip recession over there. But in terms of the US, I'm quite confident that we could have at least sail through the fourth quarter. John, is that a sentiment that you can share or maybe confirm with your more bottom up view?
Yeah, I agree with that. And I think that's a valid argument, I actually think that the theme, though, of what you're seeing in Europe, really sort of perfectly encapsulates what to watch. Generally,we've seen the mortality rates from COVID, pretty materially decline from what they were saying first quarter, and in the very beginning of second quarter. You've just seen some of the fear decline and what we've seen in more consumer oriented sectors, is that absent local regulations, the reengagement with anything that's leisure or consumer related, that's near the home, tends to come back really quickly. And so the real risk is that you get spikes in the virus that lead to lock downs, but absent that risk, we see from the bottom up exactly what you're seeing from the top down, which is that as consumers are able to reengage, with the economy from a purchasing power perspective that they do so as quickly as they're allowed to. So I completely agree with you, we see from the issuer level perspective, the same thing that you're seeing from the top down perspective,
One aspect of this recession, also that may not be talked about enough is the fact that it is so different in the timing. I mean, we all focus so much on the extent of the decline in GDP, for example, in the second quarter, or the extent of the rise in the unemployment rate in the month of April and in March, the collapse in retail sales, all these numbers were very impressive, and therefore created a lot of media buzz as well. But the other aspect of this recession is it was a very, very short recession, which in some ways, doesn't allow those negative forces that typically are created in an economic downturn, to create as much damage as they often do in recessions. In the 2008-2009. recession, we had four quarters during which declining economic growth, rising unemployment, created a lot more damage, in particular in the corporate sector. This time round, it is my impression, at least that we didn't really have the time to create enough corporate defaults, for example, before the economy already rebounded. So the default rate, for example, in the corporate sector hasn't risen as much. Would you attribute that also to just the short time of this recession period? Or, is there something else at play, is the corporate sector actually not as vulnerable to the typical recessionary forces as it was 10 years ago, during the great financial market crisis?
The general resiliency of the corporate sector, I think it was generally going to be more resilient, just because interest rates are so much lower than they'd been, in past cycles that the interest burden on companies is just less from a fixed charge coverage perspective. And I know we're going to talk about the Fed a little bit more, but I also think that you can't overstate the Fed's role in very quickly opening up all these different credit market facilities, not for direct support from the Fed, but really to encourage market participants back into the market to create the liquidity lifelines that these companies needed to get through something that was really going to be known from the standpoint of some type of viral epidemic. And the Fed I think very intelligently, decided to defend their employment mandate by creating programs that were going to have the effect of keeping the default rate somewhat under control, because where you create massive unemployment problems, as you did in the global financial crisis, allowing companies to actually go through the default restructuring process allows them to shed a lot more workers, than creating the bridge to keep them alive. And I think, the Fed very smartly created programs to open corporate liquidity up purposely to keep the default rate low to support the employment side of the mandate.
Well, it wasn't even just corporate liquidity, right. It was also programs that directly channeled lending into corporates to create sort of an income bridge between the closing of the economy and the point when, things get back to normal. I think when the Fed and the Treasury create those programs, they thought it wouldn't last as long, we're still here at the end of 2020, we're still talking about the fact that we're not out of the woods yet in terms of the COVID-19 crisis. But the support, the fiscal support that was channeled into the corporate sector was much larger this time around than it was in 2008-2009. Do you think that also played an important role and therefore continuing that into next year is important?
Yes I do. And what's really interesting, and I'm going to focus really more specifically on the two corporate credit facilities, what's been interesting, to me from a high yield bond investors perspective with those corporate credit facilities was two things. One, when they are announced, just the signaling effect, that they had, that the Fed was going to make massive amounts of liquidity available, and basically, was either going to force bond market investors to lend to these companies, or was going to crowd them out, and we chose to lend to them and market access reappeared, both in the investment grade and high yield bond markets, as well as, to some extent in the EM bond markets very quickly during the month of April. And that was really, the intended effect in order to create this liquidity bridge and keep the default rate lower than it otherwise would have been.
So that also brings us to the third theme we wanted to talk about in this podcast. And that's the role of the Federal Reserve as the central bank, sort of overseeing this recovery and being a very important piece so far, but also a very important piece of the future outlook for the US economy and US markets. We've already talked a little bit about this idea of policy coordination, and the concept that fiscal policy and monetary policy should work more in sync. And that's something that we didn't see enough of in the previous business cycle. And I would hope that institutions in the US learned their lesson. In 2010, we very quickly moved to a situation where we had continued loose monetary policy, trying to boost economic growth and boost inflation back to target, while fiscal policy had already switched from being supportive to economic growth to doing the opposite, being headwind to economic growth, and focusing too early on reducing the deficit and addressing the large debt to GDP ratio that we've accumulated during the recession. So far, we're not seeing any signs that we will repeat this mistake. In fact, there's more evidence that fiscal and monetary policy are working more in sync. And I think that's something that's really necessary for the next few years and something I'm certainly as an economist, with my top down perspective, I'm focusing on a lot. As long as I can see continued evidence that policies coordinated this case, fiscal policy and monetary policy, both supporting economic growth, both going in the same direction, that is a positive for the outlook. If there were to be signs that that coordination loosens, or may even revert back to more contradictory policy, I think that would be a problem. And you could see the same kind of more negative perception about the previous business cycle when a number of people started talking about secular stagnation. We were disappointed about the economic growth rate and all that weighed on the way we looked at this recovery and also the way markets reacted to that recovery after the great financial market crisis. So I do think that policy coordination is really an important aspect of the outlook for the next few years. John, do you share my optimism that policy can remain coordinated, or do you already see an impact here coming from the election outcome that the coordination may loosen?
Yes, I do agree with you. I think that from the fiscal side, and the Fed has been very clear in trying to get the fiscal side to cooperate for some time. I think the fiscal side will cooperate but as you've referenced, before and you and I have talked about, I think it's a function of magnitude. I think your question earlier, was really more, aptly thinking about, is the magnitude of the fiscal side going to be enough? And I think that's a valid question to ask, and the answer is, we will see, but I certainly wouldn't expect any type of mistake via austerity. But I do expect that they will remain, relatively coordinated going forward. But it's going to be led by the Central Bank, I do believe that the Fed is very likely to be involved in a longer and more long lasting way than they would be otherwise.
Another topic that people often talk about when we look at the Fed and its policy, is this idea of yield curve control, which is an outward tool, the Bank of Japan is using by announcing a yield target for in that case, 10 year Japanese government bonds, which the market is adhering to incredibly well without the BOJ having to do much. The question is, could we see something like that creeping into US policy, maybe not so much an official announcement, that's probably a step too far, but more in a stealthy way, to let the Fed intervene in the market, to stabilize or maintain longer term bond yields around a certain level, which seemed to be the case until recently, but since the election, not only have equity markets rallied, bond yields have also risen and the 10 Year, is knocking at the door at 1%. We haven't had a one in front of the 10 year yield for quite a while. And to me, this is actually the test, will the Fed allow bond yields to rise in some way normalize? Or will the Fed step in, coordinate with fiscal policy and maintain a very low level of financing cost to allow fiscal policy to continue to support the economy without increasing the risk that rising interest rates would eventually increase the cost of the fiscal stimulus, which could also politically more quickly lead to a reversal of that policy support? So I'm surprised the Fed hasn't intervene yet. I'm waiting to see what happens in the next few weeks. Do you expect that intervention as well? Or do you think we're more on a path of the Fed allowing the bond market to normalize more?
Well, I think that, when you say yield curve control, it sounds like a fairly non market statement. But I think that you end up there anyway, I think the Fed recognizes a couple of things with regard to where the yields in the United States are, and a couple of things that they need, I talked about market access for issuers, for issuers to have access to the corporate bond markets, you need some steepness to the yield curve and the term structure, meaning the short term rates need to be materially lower than the long term rates. You need to reward investors to lend money for longer periods of time. And the term structure of interest rates is what does that so I think that clearly you will see the short end of the of the yield curve somewhat anchored. Although the Fed has said multiple times, in many ways, they have no desire for negative short term interest rates as they've experimented with in Europe. So the term structure is clearly one part but I think the Fed recognizes, you need to have an upward sloping term structure of interest rates. On the longer end of the curve, I also think that they recognize that while that's something they need to watch, and they can influence where the long end of the curve goes, I do think that we have a reasonable bit of room from say where the 10 year Treasury rate was several months ago, to where it is now, that it can move around with market movements, and even go a little bit higher without materially retarding the economy. One of the things that some of our colleagues have noted in the mortgage market, is that mortgage rates never really got that low below 3%, irrespective of where Treasury rates were. And what that would suggest is that Treasury rates, as they get to extremely low levels have somewhat lost their linkage, where they would, impact the economy both positively and negatively. So clearly, the Fed needs to keep the longer end of the curve under control. But I think there's significantly more room for that rate to move around in the US than you would see in Europe or in Japan.
So just to put you on the spot John, at the end of next year, at the end of 2021 will the 10 year US government bond yield be closer to 50 basis points or closer to 150?
If everything plays out as though we think it will, it should be closer to 150. The Fed has tried for a decade to generate inflation and has been unsuccessful and now it has told the market outright, that they will let inflation run above target for an extended period of time. If the economic recovery progresses along the way that we think it will and if you're arguing for more fiscal stimulus, which means in the US, the deficit is not going down, which results in more Treasury issuance, the combination of Treasury issuance, certainly stable inflation, but not lower than it is now and potentially higher, as well as just the overall economy recovering should argue for rates to go higher over time. But I agree with you, that the Fed will intervene if they get higher to the point where they start to retard the economic recovery.
Well, they have it even more likely to be closer to one and a half, then 50 basis points at the end of next year. That was a great example of how top down analysis and bottom up analysis work at PineBridge Investments. The interaction in the discussion of these two perspectives on anything macro and market related, I think is very important. And the feedback that both of us are getting from conversations like this are very important for our own analysis. I certainly as a macro analyst, I always value talking to our market specialists, but also our regional specialists in other parts of the PineBridge world to see whether my views can be reconfirmed by the perspective from the bottom up. We talked a little bit about the election, the fact that there's still some uncertainty about the extent of government control. But divided government is something that markets typically have reacted positively to and may do so again, but from what we know, now, it is more the international perspectives that seem to be more clear, and the fact that regions like Asia, but also Europe could be beneficiaries of the change in administration. The optimism I have about the US economic recovery seems to be confirmed by the bottom up analysis. That's very good. It gives me more confidence to talk about my outlook. And then the role of the Fed is very important. I think we see it from the top down. And you can see from the bottom up, issues like yield curve control are more difficult to implement in the US, I would agree with that as well. It's a kind of market intervention that we haven't seen so far, it may be a step too far for the Fed. And it may even be complicated to get as much control of the Treasury market, which is one of the largest and most liquid markets in the world with a lot of international participation to institute a yield target in that kind of market. So it may not get there. But policy coordination, I think that's something where John and I agreed on that that continues to be very important for the future outlook for the US. So really good at this. I hope some of that conversation was interesting to you. And we hope that you can join us for our next podcast. Thank you very much.
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