Global Head of Fixed Income Jim Cielinski discusses which themes matter most as markets try to determine where we are in the economic and credit cycle and whether central banks will hold the line on being data-driven.

Key Takeaways

• While structural deflationary trends should ultimately win out, strengthening demand and substantial fiscal stimulus have created a risk that inflation remains stickier for longer. Still, past mistakes are likely to keep the U.S. Federal Reserve (Fed) from overreacting to near-term strength.
• By replacing lost income, policymakers held the traditional downturn at bay for much of the economy, rushing us past the classic repair phase. While signs of overexuberance already exist in markets, there should be more good news to come.
• The noteworthy shift in the fiscal and monetary policy toolkit – to explicitly protect heavily indebted companies – has far-reaching implications for the pricing of assets and how we manage money.

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Is rising inflation a given?

Jim Cielinski: Well, inflation is definitely rising. It is a topic everyone is concerned about. And in the short term, there is no question that prices are rising both because we are getting back to work, the vaccines, supply chain bottlenecks, but importantly, the base effects. We were in deflation this time a year ago. And as we recover, the year-on-year numbers make it look highly inflationary. That said, it is more than just those things. Those were the things that would tell you that it was absolutely transitory. But I think demand is stronger, fiscal stimulus is stronger than even policymakers expected. So I think for them they are going to have to play a little bit of wait and see. There are still a lot of really structural and powerful deflationary trends in the marketplace. I think they win out and inflation stays under control. But there is strong demand and I think there is a risk, that it is higher than it was perhaps even a few months ago, that inflation is stickier for longer.

Will the Fed hold the line on being driven by data?

The Fed will do their absolute best to look at the data and call inflation transitory. That said, the data is already stronger than they predicted and so they are in a bit of a tough spot. And the market is pricing in the possibility now that the Fed is wrong. And if they are wrong, that has fairly significant implications for the future path of policy, for the future path of interest rates and probably for the future path of risky asset pricing. They have seen this before. Inflation has been over-predicted for the last three decades and they have made big mistakes, not just the Fed, but other central banks, like the ECB, in overreacting to near-term strength. So I think they will try their best. They have dug their heels in, it will take a lot for them to move, but we have to remind ourselves that they control the short-term interest rate. And if the market feels the Fed is wrong, they will ultimately force the Fed’s hand, but expect the Fed to push back very hard for as long as they possibly can.

Have we skipped rapidly beyond the repair phase?

People are always asking today where are we in the cycle, the market cycle, the economic cycle. Normally following a recession you have a long drawn-out repair phase and then you get overexuberance and expansion. This is not a cycle in any traditional way, however. Cycles are defined by loss of income. People lose jobs, they lose income. And if you look at what policymakers did this time around, they replaced lost income. And so many parts of the economy never went through kind of the traditional downtrend. And so I think to look at this like a normal cycle is a mistake. It is not. Some parts of the economy are still hurting, and they will have to do the classic repair phase. But that is now probably 20% at best. The rest of the economy is clearly past the repair phase, they are expanding. You are seeing signs of overexuberance already in markets, so I would really caution people not to get too caught up in looking at what a traditional cycle looks like. This is nothing of the sort.

How much good news is priced in?

I mentioned earlier that this is not a normal cycle. It is not a normal cycle in what prices have done on risky assets either, and much of the good news is in the price. But equally there is still a lot of good news to come. Importantly, real interest rates are still very low and so that tells me that things like defaults will stay low. Credit problems, which were probably a third of what people expected even in the pandemic, are likely to really dissipate even further. There is lots of good news to come. That typically is a supportive backdrop. But we have kind of pulled forward, I think, a lot of the return. So we are expecting modest returns for risky assets, particularly in fixed income, but there is more to go, I think. And the backdrop is still quite favorable.

Is the post-pandemic world forever changed?

There has never been a crisis that didn’t evoke some permanent changes and the pandemic will be no different. It has accelerated a lot of trends that were in place already, that will accelerate, for example, the adoption of online purchases, the demise, perhaps, of bricks and mortar retail. It changes how we work and how we spend. So there is always a lot of these cultural shifts that will occur. I think one of the biggest shifts, though, when I look back at this, will be probably two key things. One, the growth in sustainable investing has been particularly noteworthy in the last year, not just driven by investors, but I think companies as well are now trying to see how they can adopt more than just one objective. It is not just profits, but sustainability is another objective that most companies are adding to the mix. The other thing that I think has really transpired is the [monetary] policy toolkit is different. And this has a lot of ramifications. We have so much debt today that it is almost beyond the point of no return. There is no appropriate policy response now, other than protecting heavily indebted companies. We saw that last year, they [policymakers] directly intervened in the corporate markets, they purchased corporate bonds, they held rates extremely low. And so the next round, I think you just have to do more of the same. So defaults, which will decline further this year, may remain lower historically than they have been for this level of growth, just because we know that policymakers are there as kind of a last offense. And this changes how we have to manage money, how we evaluate what the appropriate risk premiums are. So it has far-reaching implications, I think, for the pricing of assets. So, to me, you always get big shifts. The policy shift here, 2020/2021, is the one we are going to look back on and really remember as being noteworthy.

 

Deflation: A decrease in the price of goods and services across the economy, usually indicating that the economy is weakening. The opposite of inflation.

Fiscal policy/Fiscal stimulus: Government policy relating to setting tax rates and spending levels. It is separate from monetary policy, which is typically set by a central bank. Fiscal austerity refers to raising taxes and/or cutting spending in an attempt to reduce government debt. Fiscal expansion (or ‘stimulus’) refers to an increase in government spending and/or a reduction in taxes.

Inflation: The rate at which the prices of goods and services are rising in an economy. The CPI and RPI are two common measures. The opposite of deflation.

Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.

Real interest rate: An interest rate that has been adjusted to remove the effects of inflation.

Risk premium: The additional return over cash that an investor expects as compensation from holding an asset that is not risk free. The riskier an asset is deemed to be, the higher its risk premium.

Sustainable investment: An investment considered to improve the environment and the life of a community. A common strategy would be to avoid investing in companies that are involved in tobacco, firearms and oil, while actively seeking out companies engaged with environmental or social sustainability.

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