What are your thoughts on US growth in this recovery phase?
We are seeing strength in Q1 economic data. Some GDP estimates are running as high as 7%, 8% or even 9% for Q1. So we’re steaming ahead despite the fact that we just came off the third or fourth wave of Covid-19, which was pretty damaging in terms of shutdowns. The service sector is still really suffering, but with that said, we do think that we are probably moving faster than many people anticipated towards the re-opening of the US economy.
What about inflation?
The combination of increased demand as the US economy starts to re-open, pent-up savings, the ability to spend once again, and the fact that there were ongoing supply issues will likely drive imported price inflation much higher. Over the intermediate term, inflation could move towards 3% or higher before easing back into the mid-2% area on headline inflation.
Have technology breakthroughs eliminated ‘70s-style inflation fears?
Clearly, we’ve seen a lot of supply destruction from Covid-19. We think that as the economy starts re-opening, there will be a pinch point that pushes prices higher – when we experience greater demand with less supply. That’ll be enough to push prices higher, but not 1970s style inflation of 6% to 9%.
Businesses in the services industry, like restaurants, have been very innovative and have found ways to operate with less labor. For example, we’ve seen innovation in online ordering, takeout delivery, etc. which are all innovations that could continue to impact competitive pricing. However, we’re already starting to see some significant upward directional trajectory of their ability to hold down expenses and pass through savings to their customers. We anticipate some upward pressure on service costs as the US economy reopens this summer.
Today, we’ve got China leading the recovery with the US right behind it. These two major economies – which account for more than half of global growth – are really hitting their strides and the rest of the world is following suit. I think 3% to 4% inflation for a period of time is certainly possible and I think the Fed may welcome it.
What are you anticipating from the Fed in 2021?
We think that the Federal Reserve is going to be cautious about pulling back policy accommodation too quickly. I don’t foresee any tapering in 2021 – I think it is more likely to occur in early 2022. I don’t think the Fed wants to disrupt the recovery.
Historically, the Fed’s focus was on preempting inflation. Today, the Fed seems focused on unemployment as well as wage inequality. They are actually looking at the demographics of who has come back to work and making sure that those most adversely affected by Covid-19 are finding jobs in the service industries that have been hit hardest including leisure and hospitality. I think the Fed recognizes that the bottom 20% of the US workforce has experienced stagnant wages for the past five years running. The next 20% has seen only about a 6% increase over that time. We think this all results in a hold on traditional central bank tightening until probably sometime in 2023. The Fed had been signaling late 2023 / early 2024, but that is likely to be brought forward given the strength of the US recovery and the massive fiscal package just passed. The Fed will want to push back against overly hawkish market sentiment that has gained traction most recently.
What is your interest rate outlook?
Our official forecast, which we established in February, is for 1.6% on the 10-year Treasury in the base case and 1.9% in the economic “bull” case. We seem to be tracking closer to that bull case scenario. Year-to-date, we’ve seen rates move 60 to 70 basis points higher in the long end and about 80 basis points in the 20-year part of the curve. However, we’re hesitant to push our forecast materially higher than that 1.6% to 1.9% range because it would require us to bring forward our expectations for a change in Fed policy too aggressively, which we don’t think we’re going to see this year.
What do you consider the biggest potential risk factor?
Re-opening momentum suggests that interest rate risk is something to be mindful of. The fact that equity and risk markets have thus far been incredibly resilient to the recent backup in yields although at some point the fundamentals should start to catch up and cause some repricing of risk assets.
We do feel that all risk markets are vulnerable and we’ve started to de-risk and store up some liquidity to be able to re-deploy into risk markets at better valuations.
Are you seeing any trends in credit quality?
We have started to see credit ratings move higher again in the high yield market. People are not talking about fallen angels anymore and instead are looking for potential migration of names back into the investment grade space. This is a pretty favorable backdrop for the US high yield (HY) market. This is particularly notable given that investment grade (IG) credit trends have continued to be less favorable. So the combination of incremental carry and more favorable credit fundamentals makes us prefer the high yield, bank loan and HY emerging markets over the IG market – at least at current spreads.
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