It is conventional wisdom that government-directed fiscal policy and monetary policy set by the central bank have great influence on the economy, corporate profits, and ultimately on asset prices. This is particularly true for fixed-income securities, especially considering the variety of flavors available to investors.
With this context, this past week was particularly intriguing as investors awaited U.S. Presidential election results, followed by a Fed policy announcement on Thursday. The absence of a “blue wave” caught many market participants by surprise, but the Fed’s decision to keep interest rates near zero and hold bond purchases steady at a $120 billion monthly pace was widely expected. At the time of this writing, most indicators point to Joe Biden gaining the Presidency, with Democrats maintaining control of the House and Republicans retaining the Senate. While waiting for days or potentially weeks for the final results will test anyone’s patience, ultimately, long-term investors need to discount the political noise and focus more on the trajectory of the economic recovery, which will be driven by Washington’s and the Fed’s ability to engineer continued fiscal and monetary stimuli.
Historically, election outcomes alone have not had a material long-term impact on market performance, and any subsequent volatility is typically short-term in nature. However, the policies that develop in the years following can have a substantial impact on markets.
This election outcome may present potential pockets of opportunity for fixed-income investors. While a divided legislature casts doubt on the size of the stimulus that is expected to prop up the economy as the nation continues to battle COVID-19, this also means that Trump policies, like corporate tax cuts, which helped drive market performance and corporate profits prior to the pandemic, are likely here to stay. The inability of the Biden administration to pass legislation for higher corporate taxes would be a boon for corporate credit markets, whose spread levels have normalized after their March sell-off. In addition, the absence of a large fiscal package and/or infrastructure spending, which the market was anticipating, would serve to limit the excess supply of U.S. Treasurys, and may put downward pressure on yields, particularly on the long end of the curve. Lower Treasury yields could continue to fuel investors’ appetite for higher-yielding fixed-income sectors like high-yield credits and emerging market bonds.
A divided legislature also puts additional pressure on the Fed, which has been a decisive force behind the sharp recovery in risk assets, especially corporate credits. Fed Chairman Jerome Powell has emphasized the importance of additional fiscal stimulus. If action from lawmakers is muted, the Fed might have to take a harder look at its bond-buying program. Further monetary support of credit markets would likely put a ceiling on credit spreads for large investment-grade corporate bonds and large-cap, high-yield credits. Additionally, a more moderate approach to foreign policy under Biden that is conducive to global trade might support the case for emerging market (EM) bonds. A weaker U.S. dollar and an accommodative Fed have historically been positive for EM assets. However, given the heterogeneous nature of this asset class and the varying success of governments in dealing with the pandemic, careful credit selection is warranted.
With regard to mortgage-backed securities, irrespective of the election outcome, prevailing lower interest rates would continue to support higher refinancing activity, which would translate into higher prepayments on the underlying mortgage pools. Finally, municipal bond prices might see some pressure over time, especially if the amount of fiscal stimulus state and local governments receive gets protracted.
Once the noise around the election settles down, attention is expected to shift to the “elephant in the room”—the continuously increasing virus cases, both in the U.S. and globally. According to data compiled by John Hopkins University and Bloomberg, last week the U.S. became the first country to cross 100,000 cases in a single day. Employment numbers reported on Thursday and Friday were positive; however, surging virus cases could adversely impact the nascent economic recovery. The global virus infection count has also not seen much respite. While markets are factoring in a higher probability for early vaccine discovery and distribution, any disappointment could result in bouts of downside volatility for risk assets.
Given this backdrop of uncertainty, in spite of markets displaying moderately positive risk sentiment, we believe that a quality allocation to fixed income continues to be the ballast investors need to have in their portfolios to maximize long-term, risk-adjusted returns.
Navaneeth Krishnan is an investment analyst responsible for conducting research and due diligence on fixed-income managers at Envestnet | PMC.