Vanguard’s Top Strategist’s Outlook for the Economy and Credit Markets
Anne N. Mathias is a senior strategist for Vanguard and a member of the firm's Fixed Income Group, with a focus on global macroeconomics, interest rates, and foreign currency.
With 20 years of experience in global investment strategy, she develops big-picture, top-down views on interest rates, currency valuations, economic developments and political risks for the firm's portfolio managers and investment staff. She is a leader in capital market/economic insight, writing frequently and speaking regularly to investors and the media.
I spoke with Anne on October 29.
The Fed announced in September that it will shift to average inflation targeting. This means that the Fed may manage inflation by allowing it to run above its 2% target to make up for times when inflation falls below 2%. What does this new approach to inflation mean for interest rates and for credit markets?
Paradoxically, it first means that interest rates are likely to stay somewhat lower than they otherwise would. With this new policy—which is an extremely important development and a major change in how it manages the economy—the Fed is basically saying that it is not going to raise rates early to ward off potential inflation. It is telling us it is going to leave the Fed funds rate, the beginning of the interest rate world, very low for a very long time.
Advisors understand that the term structure of interest rates is based partly on very short-term interest rates. If that interest rate, which is the Fed funds rate, is zero or near zero for an extended period, it acts as an anchor on longer-term interest rates on 10-year yields and beyond.
Interest rates are likely to rise somewhat, but Fed policy does keep a lid on them.
Secondly, the new approach is highly accommodative, which supports the economy. Keeping interest rates low when inflation is rising spurs investment because it means that real yields stay fairly low.
That's what the Fed is after. The Fed wants an economy that runs hot, as you mentioned, and it wants to create a situation where economic activity is moving at a rapid clip and people's inflation expectations over the course of the whole cycle rise. Over long periods, such as during the financial crisis and now the coronavirus, when interest rates are low and the Fed funds rate is basically zero, people's inflation expectations tend to come down. When that happens, people don't act and the economy doesn't move as quickly as it normally would. That's the thing the Fed is fighting.
Because the Fed is committed to keeping interest rates low for a long time, some of the investment banks have famously said that the classic 60 percent stock/ 40 percent bond portfolio will no longer be helpful to investors. Others have questioned whether fixed income is a wise investment at all. Do clients still need fixed income, and if so, why?
We're believers in fixed income and in active fixed income. The core tenets of a fixed-income allocation in an investor's portfolio continue to have merit: capital preservation, income, diversification, and, to some extent, inflation protection.
The upside is not as great as it would be if yields were higher and you could have, in addition to your income stream, capital appreciation. But the downside is not as large, and that sounds like protection, which has always been part of fixed income investing. It continues to be important in this new world.
We've had this conversation with advisors many times over the past 10 years and yields have grinded lower and bonds have continued to offer capital-preservation, income and diversification. . With this lower yield environment, investors need to be more realistic about what they can expect from their portfolios, and understand the interplay between interest rates and economic growth.
Bonds showed their fortitude during the market meltdown in March as well as during more recent periods of volatility. Indeed, the yield on the 10-year is about 100 basis points lower than it was at the beginning of the year. What is Vanguard's philosophy on active, fixed-income management and how will that approach provide value in the current environment?
We have had a successful period managing our active, fixed-income funds through the virus crisis. That is a result of our philosophy and approach to active management. We believe in active management. There are market inefficiencies that can create opportunities for skilled investors to outperform the benchmarks.
To be in a position to outperform the benchmark, you have to have strong risk management and careful asset allocation, which we do. We focus on generating consistent alpha with lower risk of large drawdowns. When we have opportunities and dislocations like we did around the virus, we have the ability to make investments. We're not at the limits of our tolerances during times of market, and that's an important part of our philosophy. We have dry powder to deploy in those situations.
Finally, we focus very much on our funds being “true to label.” When markets are volatile, financial advisors can understand and be confident that the funds that they have used for investor portfolios will deliver the risk exposures and the alpha that they have promised. We’re not hiding behind a label and doing something completely different. True to label is very important for us.
What changes do you see coming as a result of the pandemic-related lockdowns to the economy, particularly those that are structural in nature and will be long-lasting? How might those changes affect the global credit markets?
It's too soon to say what all of the major changes are going to be post-pandemic. We’re certainly seeing a shift away from face-to-face, service-sector-type activity in the economy to business models that provide more remote access to goods and services and to remote interactions.
That's a theme and a trend that's likely to continue.
The change away from a lot of face-to-face, consumer activity is going to be difficult for certain sectors—travel, tourism, entertainment. Those areas may struggle if we do not have a vaccine in the near future and a level of immunity in the population that allows people to congregate. That's probably the biggest change—where people congregate less or people normally would have congregated, but cannot now.
Before this pandemic, the Fed was contemplating its change in inflation-targeting methodology. Now it's in place and it's It said it's going to wait five years before it reviews the policy. We're in a period where asset prices and risk assets will be well-supported by monetary policy for quite some time.
To follow up on that, what tools does the Fed have at its disposal to continue to support the markets and the economy?
This is a really interesting question because in some sense, there's a bit of a baton passing, like in a relay race. In the initial phases of the virus, at the beginning, the central banks other than the Fed—the European Central Bank, Bank of Japan, Bank of Canada and other developed-market central banks – started the race. They immediately cut interest rates, created lending facilities and did everything they could to ensure market operations and liquidity and to provide stimulus.
Then you had a shift to fiscal spending, particularly in the United States, with several large packages helping people with unemployment. Then there was a swing back to monetary policy with the Fed implementing its new inflation-targeting framework. The baton for the near term is in the hands of the fiscal policymakers. Nonetheless, the Fed is not out of ammunition. The Fed can do a more targeted quantitative easing program—go out and buy bonds of different maturities or different types—with the goal of driving down interest rates for particular types of securities.
Another thing it can do is essentially an “operation twist,” which is a maturity-extension program where it would take its purchases and target them toward longer-dated bonds to keep longer-dated interest rates low. That would happen if we have a scenario where longer-dated interest rates started to rise too fast. But in terms of putting money in people's pockets and supporting consumer spending, that's a baton that the fiscal policy makers have to run with.
Many fear that the surge in the federal deficit, which has been driven by pandemic-related fiscal measures, is a sure sign of coming inflation. But the economy has a large output gap, high unemployment, and a glut of capacity in industries such as travel and, as you mentioned, entertainment and restaurants. How should advisors view the potential for inflation and its impact on the credit markets?
Inflation is one of the most hotly debated topics. The Fed is not going to move in advance of inflation. So there are natural concerns about the prospect for runaway inflation.
It is not a likely scenario because the large macro factors that have kept inflation low continue to persist – demographics and technological changes, including new online platforms that keep prices low and transparent. Because of these, demand-driven inflation is less likely.
You have to ask yourself the question, “Would we have a supply-driven situation where there are supply constraints that prevent the delivery of goods or force the prices of goods go up?” There are not enough to create a consistent, extremely high level of inflation. Inflation from here is likely to rise somewhat, and we still see value in inflation-protection strategies in portfolios.
We had a successful active strategy around the virus in our TIPS funds, and we continue to see TIPS as attractive and interesting. Over the next month or two, we're in the seasonal, negative-carry period for TIPS. Inflation is more fairly priced in the markets today than it was in the depth of the crisis, when you had negative break-even inflation rates on some of the shorter-dated instruments.
But it's definitely an appropriate strategy for fixed income portfolios. Inflation is reasonably priced. It's definitely not a screaming “buy” the way it was five months ago, but something that advisors should continue to allocate to in their portfolios and focus on.
The other thing that investors are facing is a lot of uncertainty about the upcoming election, including the potential for delays in learning what the results are. How might the results of the election, for example, the election of Joe Biden and a Democratic Senate as well as Democratic House, affect the bond markets in 2021?
Investors should focus on their medium- and long-term views and use any transitory period, if asset valuations get out of whack, to rebalance toward their desired asset allocation. It would be an opportunity almost irrespective of which way asset valuations go.
Over the longer term, any federal fiscal aid package is likely to push economic growth up and may push inflation up somewhat – but not to runaway inflation territory. Looking at and thinking about inflation protection in advance of that scenario is an important thing to do.
What is your outlook for high-yield and emerging market credit as we look into next year? Does your team consider those sectors to be strong opportunities for the bond market?
Our general view is fairly positive in the midst of all the uncertainty and negativity around the virus and the elections. Ultimately some form of vaccine will be developed and we will see a resumption in the growth trends that we were seeing before the virus. It may be at a more muted level and may take quite a while to recover.
But our medium- to long-term outlook is fairly positive, especially in the context of this accommodative monetary policy. High yield is something we find fairly attractive. High yield has recovered somewhat since the dislocation during the worst of the virus, and it's going to stay in a pretty tight range for the next few months. The interesting thing is that the dispersion among different sectors within high yield remains pretty high. That creates selection opportunities for active investors.
High yield would do poorly if there were a significant risk-off event, where expectations for defaults meaningfully rise. But financial conditions are not tight, so that's less likely. As we've talked about, if the Fed sees tight financial conditions, it is likely to act with more quantitative easing. That's on the fundamental side.
We could see a tailwind on the technical side. There's less likelihood of a tremendous amount of supply.
If we go into some sort of double-dip recession, that would be a negative-tail scenario for high yields. But that's not something that we're predicting.
Emerging markets are the same as high yield in a way. Emerging markets will benefit from accommodative monetary policy in the developed central bank markets. Also, emerging markets are likely to benefit from a stable to slightly weakening dollar, which is our active foreign currency view. A weaker dollar, given a lot of emerging market debt is denominated in dollars, is a positive for emerging markets.
We are constructive on both high yield and emerging markets, although we are not allocating a tremendous amount of our portfolios to those areas at the moment.
Advisors have put a lot of money in short-duration funds and ETFs. Some of that is a reaction to low interest rates. Many are just concerned about the risk of going further out on the yield curve. What guidance would you offer to those advisors?
Advisors are concerned that interest rates will rise dramatically in the intermediate-- to longer-end of the yield curve. Interest rates may rise, but as we discussed earlier, the Fed's goals and its monetary policy behavior is likely to act to cap longer-term interest rates at lower levels.
Advisors may be acting appropriately to put money into shorter duration funds while they wait out some of this uncertainty. But if it's just a move to try to avoid capital loss, it makes less sense.
Advisors should think about balancing what they will be giving up in terms of carry by staying at the very short end of the yield curve. Keeping all of those risks and opportunity costs in mind is important when making these allocations. Make sure that you're not just making a knee-jerk allocation to a shorter duration exposure because you're worried that interest rates will rise. Think clearly and deeply about what you might be giving up in terms of income and carry by pulling away from longer duration positions.
What is your key takeaway for those reading this interview?
These are the times that try our souls, but these are also the times that provide opportunities for active, fixed-income investors who are doing the strong credit research necessary to try to identify the best companies in the various quality spectrums and across the various geographies. We'll continue to have those opportunities going forward.
Take a deep breath for the next few weeks. Think about your medium- and long-term views and react to the circumstances with those views in mind.
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