Today—although the labor market has rebounded better than most anyone expected—unemployment remains elevated and we think it will struggle to return to its pre-Covid levels. It leaves significant slack in the system. Ultimately, Covid was a disinflationary shock. Until the economy rebalances, in our view only then can inflation begin to materially accelerate. Furthermore, we think secular disinflationary factors, such as aging demographics, technological disruption and global trade also need to be overwhelmed.
But What If We Are Wrong And Inflation Returns?
There are a number of ways core or core plus strategies could aim to benefit from rising inflation. An example would be floating rate instruments, which upwardly adjust their coupons when rates rise.
Higher exposure to spread assets would also be worth considering. Inflation would erode the real value of existing corporate debt loads. It would potentially be easier for companies to grow Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) relative to their debt burdens and delever, which would potentially mean lower default probabilities and stronger credit metrics.
Don’t Fight The Fed
Absent an inflation threat in the short term, we feel the Fed’s stimulus will remain a fixture in markets for years to come. Even when the time comes to unwind its balance sheet, it will likely be a slow, protracted process—weaning the market off QE may not be easy.
The Fed’s buying and selling could have a significant impact on market technicals and investors need to consider the central bank’s activity carefully.
The Treasury additionally faces a $2.8trn deficit, likely necessitating more Treasury issuance—we expect this to increase the Barclays “Agg” weighting to Treasuries by 3-5%.
This of course also depends on non-government issuance patterns. Indeed, corporate issuance since the Covid crisis in March has been record shattering. 2020 issuance year-to-date exceeds the total in most calendar years, at ~$1.5trn (Barclays, October 2020). This has largely been a result of companies taking the opportunity to raise liquidity and term out maturities to ride out the uncertainty.
But importantly, most of this activity has now been done, and so corporate bond investors are starting to enjoy a tailwind from falling supply.
QE Doesn’t Mean There Will Be No Losers
Although QE will continue to support the functioning and performance of financial assets, the current crisis is still widening the divide between the winners and losers.
Default rates are projected to rise in sectors directly impacted by Covid-19 such as leisure and is accelerating the decline of already-struggling sectors such as brick-and-mortar retail and related commercial real estate.
We believe investors need to emphasize balance sheet strength and staying power of potential investments. As bond investors, we need to assess the credit worthiness of every credit, including the sustainability of its capital structure, the stability of its underlying ratings and ultimately the probability of a worst-case default outcome.
Of course, these factors are always important for fixed income investors, but they are crucial in periods such as these, amid high macro uncertainty and elevated corporate leverage ratios with an underlying economy that is still in the recovery phase.
Gautam Khanna is a senior portfolio manager at Insight Investment.