Article written by Francis Scotland, Franklin Templeton – 19th April 2021

AMERICA’S U-TURN

The U.S. economy has not had a really big economic boom since the Reagan tax cuts in the early 1980s. However, 2021 is shaping up to be another one, especially if the COVID-19 vaccinations succeed and the variants spreading around the world fail to produce more setbacks. The economy is snapping back, but politicians are drunk on free money and boiling with populism. Unprecedented levels of macro support remain in place. Last year’s extraordinary bust shows many signs of morphing into this year’s extraordinary boom.

Ronald Reagan is probably rolling in his grave. The unprecedented U.S. fiscal spending measures pitted against the public health emergency are set to extend beyond the crisis as part of what can only be described as an historic regime shift. The Reagan-Thatcher revolution emphasized free enterprise and the market economy as the path to prosperity. Reagan’s view was that “Government is not the solution to our problem; it is the problem.” In the 40 years since the Reagan tax cuts, the expansion in world prosperity has been without precedent. U.S. real per capita gross domestic product (GDP) doubled and hundreds of millions of people were lifted out of poverty in China and other developing economies after adopting similar regimes. These advances were supported by a forward-looking, anti-inflationary monetary regime, initially put in place by Paul Volcker, that fostered an inflation rate between 1% and 2.5% for the last 30 years.

Critics of the Reagan era argue that income and wealth inequality have dramatically worsened, both across and within countries and that these factors have deteriorated even further since the pandemic. President Biden built his campaign on this theme, promising a comprehensive program of wealth redistribution and flattening of the income curve. The new view is that big government does offer a solution, and the answer is Washington. The new administration kicked off the quarter by topping up outgoing President Trump’s $900 billion program with $1.9 trillion in spending. There are arguably 20 million Americans who really need support to get through the pandemic, yet up to 287 million Americans could receive a check for $1400. In addition, state and local governments received a windfall, approximating 40% of annual revenues despite budgets only marginally weaker than a year ago, with the restriction that the money is not distributed through a tax cut. The clear intent is to encourage these governments to spend the money. So big is the spending that even a Keynesian economist would blush, Larry Summers referring to it as the least responsible fiscal policy in 40 years. The first part of Biden’s Build Back Better program—the proposed American Jobs Plan—includes another multi-trillion-dollar budget with a corporate tax increase penciled in that would be the biggest in 40 years. By some estimates, the proposed tax increases could make the U.S. statutory corporate tax rates the highest in the Organization for Economic Co-operation and Development (OECD).

The extreme nature of U.S. fiscal policy initiatives and the policy tilt this quarter seem out of line with the thin margin of victory provided by the electorate. However, policymakers are open and direct about their intent to use monetary and fiscal policy to redress income inequality through a combination of big spending programs, redistributive tax measures, and accommodative monetary conditions. For example, Federal Reserve (Fed) Chair Powell has broadened the concept of targeting a low unemployment rate to a more “broad-based and inclusive goal,” which zooms in on segments of the labor market that have taken longer to recover from downturns. These targets include “wage growth for low-wage workers and labor force participation for those without college degrees.” In addition, the Biden administration is taking a page out of the Chinese playbook by embracing industrial policies aimed at greater supply-side self-sufficiency in a range of industries, including semiconductors. This realization will only come about with government support and higher costs to consumers. We have seen this movie before. Semiconductor shortages today will be replaced by a glut in a few years.

We are not sure how it all plays out in the long run, particularly given the higher tax regime that lies ahead. However, the current stimulus supercharges an economy already rebounding from last year’s widespread lockdowns. The March U.S. employment report offered a whiff of what could be in store. A million jobs were created in one month (including revisions). Importantly, the biggest gains were in the leisure and hospitality sectors, which were the hardest hit by last year’s lockdowns and the main cause of the scale of the bust. At this rate, the unemployment rate would be back to pre-pandemic levels by the end of the year. The economic script continues to rhyme with the rapid rebound that usually occurs after a natural disaster, not the protracted recovery that often follows a more traditional recession.

The rebound is playing out around the world, notwithstanding the timing and management of vaccine distribution in various countries. Global import volumes have completely recovered and are above pre-pandemic levels. Purchasing manager indexes are soaring. Europe has struggled with its vaccination programs, but the economic surprises are positive, the data stronger than expected. European fiscal policy is beginning to line up for something very different. Maastricht rules look likely to be suspended this year, and money from the €672.5 billion Recovery and Resilience Facility will start to deploy this year. Even in Japan, a new fiscal urgency is beginning to emerge. Kozo Yamamoto, who played a key role in crafting Abenomics, is readying proposals for Prime Minister Yoshihide Suga, saying Japan needs another big dose of fiscal medicine that is as ambitious as the aid bill just passed in the U.S. Asian industrial production is surging while Australian employment is almost back to its high-water mark.

The outstanding exception to these policy trends continues to be China. Circumspect in its use of monetary and fiscal policy during the crisis, China’s authorities gained control of the virus early, which allowed for a faster economic recovery. The authorities say they do not want to hit the brakes, but they are throttling back. The credit impulse is rolling over, fiscal stimulus is in retreat, interest rates have risen, and the authorities are looking to cool down the property sector.

It is in this context that the selloff in the global bond market has been no surprise to us. The world economy is renormalizing and long-term interest rates with it. The Chinese economy was the first to renormalize and long-term rates followed accordingly. U.S. real GDP effectively recovered to its high-water mark during the first quarter with bond yields returning to pre-pandemic levels. Even repressed markets like Japanese government bonds and German bunds saw some normalization.

The rise in global bond yields has been fairly gradual so far, notwithstanding the jump in yields during the first quarter. The bear market, which reflects the rise in equilibrium yields attendant a renormalizing world economy, has not been restrictive. This view is supported by the behavior in global equities. Here, capital is rotating from long-duration, large-cap growth stocks to deep-value, cyclical sectors. Overall multiples have remained steady as the earnings outlook increases in lockstep with economic prospects and yields. Similarly, despite their third worst loss in 40 years, U.S. investment grade corporate bond spreads remained relatively flat, indicating no financial tightening or economic stress. Higher U.S. yields pulled up emerging market sovereign bond yields, but credit default swap and solvency risks have remained low.

WHAT’S NEXT?

Asset price trends and surveys show that most investors expect the world economy to improve. Reflation is the new buzzword. Renormalization has resulted in global bond price profiles moving to neutral or slightly undervalued currently from extremely overvalued a year ago. This change means that the next big move in long-term rates will be driven by a macro surprise, with the tailwind of mean reversion now spent.

As the previous discussion suggests, we think the bond market selloff has further to run on the back of what we believe could be the biggest economic boom in decades. The boom is likely to include at least an inflation scare. Photos of the mega-container ship Ever Given aground in the Suez Canal provide a visual perspective on backlogs and disruptions in the global supply chain. This problem gets worse before it gets better as economic activity rebounds. Policy stimulus will supercharge the rebound, inventories are already low, orders are backlogged, commodity prices have risen, and breakeven inflation rates are breaking out: the 5-year breakeven inflation rate is higher than any time since before the global financial crisis (GFC). Correlation analysis implies core personal consumption (PCE) expenditures will move well above the 2% inflation threshold over the next 6-12 months.

Another sign of the momentous nature of the current regime shift and the near-term bias to higher inflation is the orientation of the Fed, from forward to backward looking. Fed Chair Powell argues that the failure of the central bank to achieve an average inflation rate of 2% over the last 12 years was due to preemptive targeting. The Fed’s new approach is to be late: aim for an unspecified level of inflation above 2% for an unspecified period but keep expectations anchored. So far, the market believes the Fed is committed to this change of approach. Short-term breakeven inflation rates have risen above long-term measures for the first time since the GFC, but the 5-year, 5-year forward inflation rate is still below levels of a few years ago. The weak demographics, technological disruptions, and globalization forces that were driving secular stagnation before the pandemic have not gone away. Japan is the poster-economy for the effects of these forces and what is possible with macro policy. What is different is that the whole world seems to have embraced the Japanese government’s policies of running big budget deficits and central bank balance sheet expansion. It is one thing when one country does it; it is another thing entirely when the whole world follows, and most market participants have no experience with rising inflation.

The biggest uncertainty is the savings rate. The initial surge in the household savings rate coincided with last year’s collapse in bond yields and spike in unemployment. Since then it has been sustained partially by the relief checks sent during the course of the pandemic. Renormalization has lifted yields since, but if savings rates retreat to pre-pandemic levels, the impact on economic growth will be explosive. If the stock of cash savings accumulated during this period of high savings rates is also spent, the effect would be to drive nominal GDP as far above potential as it fell in 2020. One way of gauging the potential effect of this dispersal of cash is by estimating the impact on GDP of a bounce back in the velocity of money to pre-pandemic levels. By some estimates, this increase would boost nominal GDP 15% above potential.

RISKS

There are probably three main risks to the view of a boom in the world economy lifting bond yields higher and steepening the curve, beyond the threat of an explosion in virus variants hobbling the recovery through widespread lockdowns.

The first is that bond investors panic, and the rise in yields becomes disorderly, resulting in broad-based equity market weakness and a subsequent slump in growth. At some point if economic traction really starts to take hold and policymakers do not react, the bond market vigilantes may go on strike and provoke growth-inhibiting turbulence.

A second risk is a policy mistake that feeds back into a stronger dollar. The dollar is only marginally below its pre-pandemic level despite massive money printing and policy regime shifts. The absence of weakness relative to the scale of the monetary flood speaks to an extraordinary demand for dollars, which we associate with the crisis and the high savings rates. Our economic view implies this demand for dollars should retreat, paving the way for higher nominal GDP and rates. The policy risk is that the Fed begins to taper before the demand for dollars really falls off, which would support the currency and weaken the case for a material rise in bond yields from current levels. Related to this risk is the macro policy orientation of China. There, policy conditions have already become less accommodative. Our expectation is that the Chinese economy may slow a little in the second half of the year but remain firm.

The tail-risk event is that conditions become too restrictive and China begins to slow. China is too big for a downshift in its growth rate not to be felt in the world economy, which could create feedback in the form of a stronger dollar.

A final known unknown is the conflict between the U.S. and China playing out in the South China Sea. Many believe that the probability of a war between the two goliaths is increasing. Taiwan is the focal point of the current tension, the issues being: Taiwan’s status as a semiconductor supply center of the world; U.S. support for Taiwan independence; and China’s resolve to return the island to nationalist control under the Chinese Communist Party. Accidents happen, and a military confrontation seems possible anytime, but the effects of a war are so consequential for both protagonists that conflict seems like a tail risk.

OUTLOOK

Going into the second quarter, the back-up in yields has removed the anomaly of overvaluation that has existed in many markets. In some cases there is even modest valuation opportunity. The tailwind of mean reversion in price is over, which means the case for underweighting duration rests on the macro outlook. In our view, the information risk is skewed heavily to the side of a stronger expansion than discounted currently.

We believe that the extraordinary demand for U.S. dollars propping up the currency in the face of declining U.S. short-term real yields, the external payments imbalance, and the enormous domestic regime shift is related to the high domestic savings rate. The key to a weaker dollar is a relaxation in this dollar demand, which we think will follow as the economy and employment gain traction this year. The risk is that the Fed tapers before these material shifts occur. All the guidance given by the Fed is that normalization will not happen this year.

Definitions:

Keynesian economics, named after the economist John Maynard Keynes, refers to various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output and inflation.

The Purchasing Managers Index (PMI) is a measure of the prevailing direction of economic trends in manufacturing.

Convergence criteria (or “Maastricht criteria”) are criteria, based on economic indicators, that European Union (EU) member states must fulfill to enter the euro zone and that they must continue to respect once entered.

“Abenomics” refers to a series of economic reforms proposed by Japan’s Prime Minister Shinzo Abe.

Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.

Sovereign bond yield is the interest rate paid to the buyer of the bond by the government, or sovereign entity, issuing that debt instrument.

A credit default swap is designed to transfer the credit exposure of fixed income products between parties.

Solvency risk is the risk that the business cannot meet its financial obligations as they come due for full value even after disposal of its assets.

Reflation refers to a fiscal or monetary policy designed to expand a country’s output and curb the effects of deflation.

Mean reversion is a theory suggesting that prices and returns eventually move back towards the mean or average.

The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers’ changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.

Nominal GDP measures a country’s gross domestic product using current prices, without adjusting for inflation.

The velocity of money is the rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time.

Duration measures the sensitivity of price (the value of principal) of a fixed-income investment to a change in interest rates. The higher the duration number, the more sensitive a fixed-income investment will be to interest rate changes.

Real yields are calculated by adjusting stated yields to compensate for inflation expectations over the time period during which the yields are expected to be paid.

WHAT ARE THE RISKS?

Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.

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