As bond market professionals seek to divine the contours of a recovery likely to look very different from rebounds most Americans have seen in recent decades, a number of issues confound them. The strength of the economy and the inflation-versus-deflation debate top the list of many observers.

If modern history is any indicator, the economy’s comeback would be muted over the next year. That’s precisely what happened in 1991, 2001 and 2009.

But the circumstances today are quite different: The Covid recession was orchestrated by a government trying to control a public health crisis. The only downturn with a similar pathology was the 1981-1982 recession. It was engineered by the Federal Reserve in order to expunge inflation and accompanied by massive fiscal stimulus in the form of tax cuts and defense spending. Furthermore, the U.S. entered this recession without the egregious asset bubbles in housing or equities.

Heading into 2021, several fixed-income experts believe the easy, or V-shaped, phase of the recovery is already winding down. “We were surprised by the V we got [over the last four months], but we are getting to an inflection point,” says Michael Collins, managing director at PGIM Fixed Income.

Going forward, he anticipates a slow but steady recovery characterized by temporary mild, virus-related shutdowns, but “nothing like March.” America’s GDP is running at about 95% of its pre-recession pace. On a global level, the speed of the rebound varies. China alone has already regained more than 100% of its lost business activity.

Unfortunately, the other shoe is starting to drop, as temporary layoffs threaten to become permanent and small business delinquencies turn into defaults, Collins fears. If past experience repeats itself, white-collar workers in corporate America and high-wage earners in the strapped public sector could be vulnerable to layoffs.

Just because the next few quarters are likely to be challenging doesn’t mean the economy “has to slow to a crawl,” according to Erik Weisman, chief economist and portfolio manager at MFS.

But there are obstacles. The path to a coronavirus vaccine is the biggest unknown in the minds of many economists. And the presidential election aftermath could be almost as important as the vaccine approval, Weisman argues.

Financial markets usually favor divided government over one party controlling both the White House and Congress, since gridlock provides checks and balances. This time could be different. Weisman believes either a Biden victory and a Democratic Congress or a Trump re-election and a GOP Senate would create an environment where badly needed stimulus is more likely to pass. “If Biden wins and the Republicans keep control of the Senate, they are likely to give him [very] little,” he says.

A recovery that’s slower for longer may be a popular narrative, but it’s not a universally shared view. The financial crisis 12 years ago was marked by a blame game. Many Americans were furious at having to bail out Wall Street banks and there was scarce sympathy for borrowers who acquired houses more expensive than they could afford.

But this time around is different. It’s difficult to resent small business owners and their employees when they were forced to shut down by government mandate. Without all the finger-pointing, there could be a more constructive resolution for this most recent recession.

Consumers Are Stronger This Time
Consumers also entered the 2020 recession in much stronger financial shape than they did when the housing crisis struck. “Behavior has changed,” says Anwiti Bahuguna, senior portfolio manager at Columbia Threadneedle. “People are not willing to take on large amounts of debt.”

Housing is one of the few sectors that is booming, she notes, but people are taking out mortgages at record low interest rates. More than a few home buyers are moving to more rural areas where they often pay less for more space.

The savings rate was running at an annual clip of nearly 8% for several years before Covid-19 hit, and the lockdown temporarily sent it spiking to 19%. But Bahuguna claims this behavior was bifurcated: Some people were saving at rates resembling China’s, while unemployed, low-wage workers in industries like hospitality and retail were quickly burning through their savings and were forced to subsist on government aid. Still, at some point after a vaccine is widely available, she says the global economy should see a burst of pent-up demand.

Odds of a stronger-than-expected recovery are about 60%, according to JP Morgan Asset Management chief investment officer of global fixed income Bob Michele. That view incorporates the belief that there will be more fiscal stimulus regardless of who wins the election.

The spirit of forgiveness extends to the debt markets, in Michele’s view, making the outlook for corporate insolvencies more favorable than it was after the housing bubble burst. He expects downgrades and default rates in the high-yield bond market to fall short of the 2008-2009 figures.

“Ratings agencies have decided to give companies 18 to 24 months to get their balance sheets back in shape,” he said in an October webcast. “Ninety-nine percent of corporate borrowers should be fine.”

Tolerance in the debt markets for afflicted borrowers was evident in the spring when companies in shut-down industries like cruise lines raised capital easily through debt, equity and convertible bonds. Michele told clients that distressed debt funds “are waiting to step in and restructure” companies that run into debt-service problems.

The cheap cost of debt issuance, however, could create its own set of issues. Corporate debt stands at about 48% of GDP, and Michele said it could rise to 60%. No matter how cheap it is, there is always the question of how much debt a company wants to carry.

Michele told the October webcast attendees that the biggest long-term fear is a resurgence of inflation. Globally, there has been $18 trillion in fiscal and monetary stimulus, as many central banks have embraced what academic economists call a form of Modern Monetary Theory, or MMT.

Loomis Sayles Vice Chairman Dan Fuss isn’t buying into the deflation argument promulgated by certain economists who project the Japanese and eurozone experiences onto the U.S. “Prices will be higher in four years,” he says. “How much no one knows.”

Like some others, Fuss believes that prices may be rising faster than the government is reporting. “In general, you are going to see purchasing power slide,” he says.

Weisman at MFS offers an example of this statistical mirage. Ordinary Americans are watching home sales surge and housing prices rise in many regions. But the housing factor that dominates the Consumer Price Index (CPI) is owners’ equivalent rent, not home prices, and the former is falling.

So what’s a fixed-income investor to do? The Federal Reserve has indicated it intends to keep interest rates at anemic levels for a long time, and would let inflation run at 2.5% without reacting. Then again, central banks spent most of the last decade trying to induce inflation with no success.

Collins at PGIM says Treasurys and agency mortgages should be avoided as they sport negative real yields. “The next few years will be the golden age of credit,” he argues.

Given the accommodative stance of the Fed, many professional bond investors see opportunities in the high-yield bond sector. While the Fed has purchased junk bond ETFs, it has said it won’t buy the debt of insolvent businesses. In a fast-changing economy, differentiating between leveraged companies that can pay their debt and those that can’t could prove challenging.

In a world starved for income, Bahuguna at Columbia Threadneedle notes demand for high-yield bonds is coming from inside and outside the U.S., where yields are even lower in some places. If the confluence of factors promoting credit creation might worry some investors, the markets remain receptive to each wave of new bond issues.

Much has been written this year about the inability of a classic 60-40 retirement portfolio to meet the needs of retirees and pensions. But Bahuguna believes it remains viable. Like Fuss, she slightly favors equities over bonds.

Fuss, who consults with pension clients for Loomis Sayles, says he is still comfortable with a 70-30 portfolio tilted toward income-oriented stocks like Merck and Pfizer that can “increase the dividend a little each year.” Yield-oriented stocks have one major advantage over bonds—their liquidity.

But he is telling pension funds they might want to lower their return expectations to the 3.7% to 4.0% area for the next 5 years. That might not be what advisors’ clients want to hear these days.