Giulio Martini closely follows economic and policy developments in his role as the head of the firm’s multi-asset strategies. He says there are four key factors that enabled the upward trajectory of the markets coming out of the lows reached in late March of this year.  The positive impact of each could potentially support a sustained bullish environment into 2021.

Most important, of course, has been the announcement of multiple COVID-19 vaccines and the unexpected efficacy that has been achieved.  We believe the vaccines provide a clearly visible path towards normal economic activity and social behavior by the end of 2021.  The second factor is the resolution of the 2020 U.S. election cycle and the strong prospect of a divided government, with extreme factions of either party most likely neutralized.  Third is the two straight quarters of unexpectedly strong earnings announcements from U.S. listed companies as well as the highest level of positive earnings surprises we have ever seen historically.  Strong earnings growth is evidence that underlying earnings power for U.S. companies has not been severely damaged by the COVID-19 crisis, and a full restoration to operations and earnings can be expected with the end of the crisis.  Lastly, the robust recovery in China, the second largest economy in the world, has provided the key through which most global supply chains pass and has been a support mechanism for other global economies.

COVID-19 Spread and Stimulus Delay Make for a Bumpy Ride

While these positive forces have helped to support current market valuations and should continue to contribute to a constructive view in the near term, what remains less clear is the road leading to the second half of 2021, when we expect the COVID-19 vaccines to be widely available.  The first half of 2021 could be more difficult if the number of infections and hospitalizations continue to climb at an alarming rate.  Aside from the human toll, which has been tragic, continued COVID-19 spread could further damage the U.S. economy. The extent of the damage depends on Congress agreeing on a fiscal package that preserves purchasing power for unemployed workers, delivers aid to state and local governments with budget constraints, and sustains companies in industries where consumption is inherently social.  If Congress falls short, economic growth could more likely hit a pothole.

Positive Outlook for Second Half of 2021

Regardless, the investment markets will still be reassured by the prospect of a full recovery by the end of 2021 due to the COVID-19 vaccines that are on the horizon.  As the healthcare crisis peaks, and more uncertainty is sure to come, 2020 is still ending with a large portion of uncertainty in retreat and a return to normal social and economic behavior visible down the road.

A Global Recovery from a Global Outbreak

Leah Traub’s role in taxable fixed income requires a sharp focus on currencies and global rates.  When looking at emerging and developing economies, she says the road to recovery in those regions may not simultaneously benefit from the COVID-19 vaccine along with developed economies.

Implications for Developing and Emerging Markets

The global pandemic affected nations and regions at different speeds and magnitudes.  Likewise, the breadth, strength, and timing of economic recoveries among developing and emerging markets have been diverse.  China’s economy, for example, is operating at nearly pre-COVID-19 levels and, in fact, sentiment measures in manufacturing and industrials have exceeded pre-crisis levels.  The outlook for China’s economic strength in 2021 is also reflected in the substantial rise seen in their commodity prices.  The spread of the virus has also been contained based on reported figures that show zero new contractions. This indicates that China has been able to resume close to normal operating levels while dealing with the disease.  Other Asian economies, such as Korea and Taiwan, have been exhibiting similar trends and for those reasons in common, their currency valuations have not appreciated significantly with the vaccine announcement.

Our view, based on this evidence, is that the effect of the COVID-19 vaccine will play a more crucial role in reviving economies in countries where containment has been more difficult, such as the United States and western Europe where a resurgence in virus cases has been more pronounced.

Differentiated Impact and Recovery in Vulnerable Emerging Markets

The virus has taken a greater toll on emerging economies, such as South America, Southeast Asia, Indonesia, India, and Thailand, which have not displayed resilience similar to north Asian economies.  The differentiated effects from the virus and in the lesser capacity to adapt economic activity during the pandemic aligns the importance of the COVID-19 vaccine more firmly to the recovery in these regions; indeed, their currencies appreciated sharply after the vaccine announcement.  Going forward, we believe that the vaccine will continue to have a more significant impact on these countries, and we expect the same in terms of potentially more upward momentum in currency valuations.

Broadening the Cyclical Recovery Among Emerging Markets

Looking deeper into 2021, we are anticipating a more broad-based, as opposed to differentiated, cyclical recovery as more stressed emerging economies benefit from COVID-19 vaccine penetration, which in turn should also provide support to the laggard currencies in those markets.

Global Rates

At the onset of the COVID-19 vaccine announcement, initial sentiment regarding global interest rates was less constructive, based on the belief that central banks would perhaps take a step back from their stimulative policy since a resolution to the virus was near.  That overly optimistic view on vaccine deployment has since abated.  More directly, the U.S. Federal Reserve, members of the European Central Bank and members of the Bank of England have reiterated that monetary policy will remain stimulative for the foreseeable future. Policymakers may actually raise the level of quantitative easing until tangible evidence of a recovery in economic growth and inflation is apparent.  Inflation has been falling consistently short of the Fed’s 2% target (see Figure 1).  Our view on global interest rates going into 2021 echoes these policies and we expect global interest rates to remain lower through most of the year.

Figure 1. Inflation Has Remained Consistently Short of U.S. Federal Reserve’s 2% Target

Source: Bloomberg. Data as of October 31, 2020.  The PCE price index, also referred to as the PCE deflator, is a United States-wide indicator of the average increase in prices for all domestic personal consumption.
 

Fixed Income: Transitioning to a Post-Pandemic World

The economic shutdown caused by the COVID-19 virus resulted in an immediate and steep downward spike in activity that many believed to be a collapse in business operations and social behavior as we once knew them.  The reality turned out to be quite different.  By mid-2020, the “pandemic pivot” was the term used to describe the effective innovations implemented by companies and institutions to rapidly transform processes and adapt to the crisis.  Andrew O’Brien, Partner and Portfolio Manager specializing in corporate credit, gives his expert view on the era of transformation during the pandemic and discusses the outlook for corporate debt in 2021.

Persistent Versus Temporary Change

We have been closely following transformation within corporate operations during the COVID-19 crisis in order to ascertain the difference between structural changes that will persist in the post-pandemic environment as opposed to temporary adjustments.  Looking forward to 2021, we believe a significant portion of the changes will remain as permanent tools used to increase efficiency and reduce costs.  Video conferencing is one example.  Another, more noteworthy lasting effect is the recognition that uncertainty is ongoing, and strategic adaptability remains a part of forward planning.

One of the challenges to investing in 2021 will be the ability to anticipate how the transition to a post-pandemic world will influence adaptations to the crisis.  To a large degree, the sustainability of those changes will depend on the consumer.  During the crisis, e-commerce sustained retailers but entertainment and leisure suffered significantly.  As society emerges from the crisis, we could see a substantial shift in consumer activity away from staples and into the activities that came to a halt this past year.

Bolstered Corporate Balance Sheets Contribute to a Positive Outlook

Corporations have also been adjusting their balance sheets by taking advantage of historically low interest rates to refinance shorter-term debt and lock in low longer-term coupons. Record levels of corporate bond issuance in 2020 contributed to the purpose of improving capital structures, interest coverage, as well as available cash on corporate balance sheets (see figure 2).  Our positive stance on corporate credit takes these factors into account.

Figure 2. Cash on U.S. Corporate Balance Sheets
Cash on corporate balance sheets is near multi-year highs.

Source: Board of Governors of the Federal Reserve System. Data as of 09/30/2020. Based on Nonfinancial Corporate Business; Checkable Deposits and Currency; Asset, Level.

Looking out to 2021, one of the key questions, however, will be how that capital is deployed—either in additional capital expenditures where tax incentives reside, or in the form of share repurchase programs or increased dividends to shareholders.  Recent attractive equity returns may limit the latter but if the equity markets languish in the coming year, pressure from shareholders to return a portion of that capital is possible.  We remain positive on the sector, but also vigilant about the risk-taking posture of corporate management and how they will manage capital structures going forward.

Credit Risk Versus Valuation Risk

Remaining vigilant about potential risks is a substantial part of our investment insight.  Within this low- yield environment, credit spreads have largely retraced to pre-COVID 19 levels, and strong asset performance contrasts with declining long-term GDP expectations.

Kewjin Yuoh, lead Portfolio Manager for the firm’s taxable-fixed income strategies with a focus on liquid and securitized credit, lends his expert views on assessing credit risk and valuations following the strength seen in 2020.

Low Yields and Low Volatility Support Credit

The low to nearly negative real-yield environment within the Treasury sector has created an appetite for risk as investors reach for positive real yields in credit and support valuations.  An additional backstop has been the transparency from the Fed with its intent on maintaining its policy of low short-term interest rates, providing relative stability to the yield curve and low interest-rate volatility which has enhanced risk appetites further.

On a fundamental level, the importance of the COVID-19 vaccine can’t be understated, especially considering the number of jobs that were displaced during the crisis.  Taking the view that potential full employment may be reached by the end of 2021, given successful implementation of the vaccine, we anticipate the economic recovery and return to strong employment levels could be powerful contributors to credit fundamentals in the year to come.

Aside from any unexpected policy shift by the Fed, the environment for credit as we look out to 2021 could support additional spread tightening, within the framework of an economic recovery, lifting credit fundamentals.  Credit segments that may offer relative value in that environment include sectors where yields have not compressed to pre-COVID 19 levels, such as High Yield (see Figure 3).

Figure 3. Spread Opportunity in U.S. High Yield by Credit Rating

Source: Bloomberg. Data as of December 4, 2020. Spreads referred to in basis points (one basis point is one-one hundredth of a percentage point). The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.  Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Past performance is not a reliable indicator or guarantee of future results.

Mortgage Credit – A Tale of Two Sectors

Low yields and low volatility are normally positive influences on the housing and commercial real estate markets.  But in order to assess the securities backed by mortgages for these types of properties, you need to examine how the real estate will be purposed in the future.

Office space has been the focus of much attention recently due to the impact of the pandemic shifting a massive portion of the workforce out of commercial real estate.  Not widely known, however, is that office space in terms of square footage dedicated per individual has been reduced by nearly half over the last ten years.  Imbalance in supply is not an issue.  Regionally, in the Northeast for example, the effects have been more significant as the cash flow to more sensitive properties—retail and hotels for example— was greatly reduced, and clarity on the valuation of these properties disappeared.

The COVID-19 vaccine changes our longer-term outlook over the next year and into 2022.  We believe commercial real estate was given a recovery path by the vaccine going forward and could resume to show signs of upward valuation, but we do expect a lag in the response to improving economic activity.  The commercial mortgage-backed securities affected by the severe downward pressure on cash flows have priced in the negative effects caused by the pandemic.  We anticipate those securities to perform in line with the recovery in the properties just mentioned.

The pandemic affected the residential housing market differently.  Household formation in the suburbs has increased with the migration outside of city centers.   Activity in housing supports economic recoveries and is also a leading indicator of economic growth, and we expect that trend to continue into 2021.

Where we may see less compelling relative value is in the residential mortgaged-backed security sector.  The pandemic nudged buyers who may normally have waited a few more years into the mortgage market, although at low rates, which is a positive for home owners.  Historically low rates on mortgage loans have certainly contributed to mortgage activity either in the form of buying a new home or refinancing to renovate an existing home.  But as a recovery unfolds, as we expect it should, residential mortgage rates may move higher, potentially putting downward pressure on valuations of residential mortgage-linked securities.