BACK TO THE FUTURE-FINALLY - VOLUME 5 | FRANKLIN TEMPLETON FIXED INCOME VIEWS January 2021 - Franklin Templeton Investments ...
←
→
Page content transcription
If your browser does not render page correctly, please read the page content below
BACK TO THE FUTURE—FINALLY January 2021 VOLUME 5 | FRANKLIN TEMPLETON FIXED INCOME VIEWS
In this The past year has been one for the history books. The COVID-19 pandemic
issue triggered an unprecedented sudden shutdown of economies across the
world, with widespread restrictions on social activities and travel of a kind we
have not seen in many decades. As if this was not enough, we have seen
massive protests and social unrest in the United States and other countries,
what was probably the most contentious and polarized US presidential
election in recent history, and the formal exit of the United Kingdom from the
European Union (EU). A very difficult year for most people, and a highly
challenging one for investors.
As we enter into 2021, we have reasons for cautious optimism, but we should
not let our guard down. We have a good shot at getting our economies—
and our lives—back on track. In many ways, 2020 felt like a trip back in
history: scared by the virus, we retreated into extreme social isolation,
much like in the plague-ridden fourteenth century. After a long year of
tribulations, it looks like next year we might be able to go back to the future,
finally. But it will take some more hard work.
Pharmaceutical companies have now developed three COVID-19 vaccines with surpris-
ingly high efficacy rates (over 90%). Our Franklin Templeton—Gallup Economics of
Recovery Study 1 identified a safe and effective vaccine as the single most powerful
factor that could lead Americans to resume normal economic habits; the gradual
deployment of vaccines should therefore boost confidence and accelerate the economic
recovery in the United States and elsewhere. Already in 2020, the first stage of
the global economic recovery has proved as strong as we had expected and more, with
the rebound in spending and manufacturing and corresponding decline in unemploy-
ment exceeding most analysts’ expectations. Timely and monumental monetary and
fiscal aid have helped support the economy, and consumers in particular. Policymakers
have made it clear they will continue to provide policy support in 2021 and possibly
beyond. On the political front, the US elections are now behind us; while control
of the Senate will only be determined with two runoffs in the state of Georgia in
January, the likelihood of major tax and regulatory changes that could have an adverse
impact on economic activity appears lower. The prospect of lower policy uncertainty,
continued monetary and fiscal support, and better containment of the virus can be
seen in the buoyant performance of equity indexes.
We will face a number of headwinds and risks, however. First: even with a vaccine,
it will take time to defeat COVID-19. Our joint study with Gallup has shown that only
2 Back to the future—finally
FIRST STAGE OF GLOBAL ECONOMIC RECOVERY HAS BEEN STRONG
Exhibit 1: Quarterly GDP (% change, quarter-over-quarter)
Q4 2018–Q3 2020
OECD—Total G20 United States
12% Q3 2020 Q3 2020 Q3 2020
10% 9.1% 8.1% 7.4%
8%
6%
4%
2%
0%
-2%
-4%
-6%
-8%
-10%
Euro area Q3 2020 Japan China
12% 12.5%
10%
Q3 2020
8% 5.3%
6%
4%
2% Q3 2020
0% 2.7%
-2%
-4%
-6%
-8%
-10%
Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3
’18 ’19 ’19 ’19 ’19 ’20 ’20 ’20 ’18 ’19 ’19 ’19 ’19 ’20 ’20 ’20 ’18 ’19 ’19 ’19 ’19 ’20 ’20 ’20
Source: OECD Quarterly National Accounts.
between one-third and one-half of Americans would be ready to take a vaccine,
with various studies in other countries confirming this trend is not limited to the
United States.
If low vaccine acceptance slows the pace at which societies can achieve immunity,
we might face new recurring economic shutdowns, prolonging uncertainty and economic
stress for businesses and households. Even with policy support, this would drive
more businesses into bankruptcy and turn more temporary job losses into permanent
unemployment, with severe adverse impact on long-term growth prospects. Meanwhile,
prolonged school closures are disproportionately damaging to lower-income and
younger students, curtailing both their lifetime earning prospects and the country’s
productivity and potential growth.
Governments that can accelerate the deployment and uptake of vaccines, and
correspondingly accelerate the phasing out of restrictions to economic activity, will not
only experience a faster and stronger recovery but also enjoy much more robust
long-term economic growth prospects. Providing better information to the public in an
Back to the future—finally 3
objective and transparent manner will play a very important role in impacting attitudes
and behavior, as the results of our Franklin Templeton—Gallup Economics of
Recovery Study have shown. Misinformation and uncertainty depress consumption
and investment.
Overall, our base-case scenario is cautiously optimistic about the macroeconomic envi-
ronment and the prospects for an economic rebound in the year ahead. We expect
central bank and fiscal authorities will remain extraordinarily accommodative, increased
savings rates and pent-up demand will continue to drive consumer strength, vaccine
deployments will bolster consumer confidence, and the US business environment
will not suffer major adverse impact from domestic policy changes. In this baseline
scenario, once the recovery is entrenched and COVID-19 has been brought under
control, attention will need to shift to the medium- and longer-term uncertainties
seeded by this extraordinary period, including the possibility of an inflation pick-up as
activity accelerates, with the attendant impact on yields and high debt levels.
For investors, 2021 promises to be another challenging year, and not only because of
the persisting uncertainties highlighted above. Valuations are a concern across
risk assets, as the market does not seem priced for this level of uncertainty. And prices
across most asset classes seem to assume that extremely low interest rates and
massive policy support will persist indefinitely even as they successfully boost economic
growth. In this environment, picking the right sectors and assets is more important
than ever.
Fixed income continues to play a highly valuable role in investor portfolios as a source
of income and a diversifier, as well as a historically lower volatility asset than equities.
However, we believe an active investment strategy is crucial at this stage. There is not a
single asset that is unilaterally a buy right now, in our view. More than ever, selectivity
by country, by sector, by asset class, and within asset classes by industry and individual
companies is required. The importance of thoughtful, skilled bottom-up research cannot
be emphasized enough in the current environment.
We think the most interesting opportunities are in fixed income assets that provide
more attractive yield pickup without taking on too much duration in this environment of
extremely low interest rates. Against this background of elevated uncertainty and
risks, the biggest opportunities lie in active credit selection to pick the sectors and
individual names with the soundest fundamentals in a market that is now rising
rather indiscriminately.
We recommend investors keep a liquid pool of assets that can be deployed when oppor-
tunities arise. We believe, as there has been wholesale buying of sectors, there
will also be indiscriminate selling on market weakness. Buying opportunities will arise
in such an environment. As we look into 2021, we believe it will be challenging,
but it could be equally rewarding for investors.
4 Back to the future—finally
Sector Overall Risk Outlook US Treasuries US Treasury Inflation-Protected
Securities (TIPS)
Eurozone Government
Bonds
settings
Japanese Government Agency Mortgage-Backed Non-Agency Residential Commercial Mortgage-Backed
Bonds Securities (MBS) Mortgage-Backed Securities Securities (CMBS)
(RMBS)
Asset-Backed US Investment-Grade European Investment-Grade US High-Yield
Securities (ABS) Corporates Corporates Corporates
Euro High-Yield Floating Rate Loans Collaterized Loan Emerging Market (EM) Debt
Corporates Obligations (CLOs)
Emerging Market Municipal Bonds
Understanding the pendulum graphic
Corporates
Bearish Bullish
Moderately Moderately
bearish bullish
Neutral reason Neutral reason
for concern for optimism
Neutral
Arrows represent any change since the last quarter end.
Back to the future—finally 5Franklin Templeton Fixed Income
macroeconomic recap & outlook
An impressive “V”-shaped US The labor market headed into Q4 with those unemployed have been out of
strong momentum, but moderated in work for 27 weeks or longer—the
economic recovery
November as a second large-scale highest level since 2013.4 The rise in
American consumers seldom disappoint,
resurgence in COVID-19 cases and the permanent job losses (as well as the
and as restrictions on activity were
subsequent business restrictions duration of unemployment) is occurring
eased in the third quarter (Q3) of
kept job gains well below market expec- at a time when there are substantially
2020, real consumer spending led an
tations. Overall, out of the 21 million more job openings, which have already
impressive recovery, contributing
jobs lost between February and risen to pre-crisis levels. This indicates
25 percentage points (or a 40.6%
April, roughly 12.3 million (59%) have we might be facing rising structural
quarter-over-quarter [Q/Q] annualized
been clawed back over the past damage/dislocation in the labor force
rate) to overall real gross domestic
eight months. Solid gains in jobs and due to the pandemic.
product (GDP).2
hours worked suggest incomes too are
growing steadily and will therefore Retail sales have continued to climb
The Q3 rebound is particularly note-
continue to support consumption in beyond the pre-pandemic level despite
worthy given the backdrop of a surge in
the months ahead.3 enhanced unemployment benefits (UI)
new COVID-19 cases that were reported
coming to an end at the end of July.
during the summer and the coincident
Though the labor market recovery has
flatlining of a number of high frequency Meanwhile, the US housing market has
been stronger than expected, perma-
indicators. However, despite the been resilient and continues to march
nent job losses are now up 2.4 million
impressive recovery, the US economy ahead on the back of demographic
since February and account for about
still found itself 3.5 percentage trends, limited home supply coupled
35% of the total number of unemployed
points below pre-crisis peak GDP at with strong demand, and historically
persons. Moreover, roughly 37% of
the end of the third quarter. low mortgage rates. Existing home sales
REAL CONSUMER SPENDING LEADING THE US ECONOMIC RECOVERY
Exhibit 2: Real GDP contributions
Q1 2007–Q3 2020
Contributions to change in GDP (quarter-over-quarter, annualized rate)
40%
6.6%
30% 2.2%
3.1%
15.7%
20%
10% 9.5%
0% -3.2%
-0.4%
-0.4%
-10%
-20%
-30%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Real GDP PCE—Goods PCE—Services Fixed Investment—Nonresidential Fixed Investment—Residential Change in Private Inventories
Net Exports Government Consumption—Federal Government Consumption—State & Local
Sources: Franklin Templeton Fixed Income Research, BEA, MacroBond.
6 Back to the future—finallyRETAIL SALES PULL ABOVE PRE-CRISIS LEVEL keep control of the Senate in the
Exhibit 3: Retail sales and unemployment insurance (UI) benefits January Georgia runoffs, but it will still
January 2019–October 2020 be very significant. That said, the
Index, February 2020=100 $ Billions V-shaped recovery in wages and sala-
110 107 $6 ries, the sustained growth in income
excluding transfer payments, and a
105 $5 still elevated level of personal savings
105 (as a % of disposable income) suggest
fiscal relief will be less important
100 $4 for sustaining aggregate spending than
it was in 2020.
95 $3
Major changes to taxation, financial
regulation, climate change and energy
90 $2 policy seem less likely given that
the Democrats now have a smaller
majority in the House and will at best
85 $1
$1.25 billion have a 50-50 balance in the Senate.
Despite the stronger-than-anticipated
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Oct
2019 2020 momentum for the economy at
present, the most recent surge in new
Retail Sales (LHS) Retail Sales & Food Services Unemployment Insurance
(ex. Motor Vehicles & Parts) (LHS) Benefits (RHS) COVID-19 cases has shown that
Sources: Franklin Templeton Fixed Income Research, US Census Bureau, US Department of Treasury, Macrobond. new stringent lockdowns could still
reverse the course of the recovery.
Rapid deployment of vaccines,
rose to an annualized 6.85 million (Fed’s) massive quantitative easing (QE)
supported by transparent information
contract closings in October, the highest initiatives have been particularly
on their safety and effectiveness,
level in almost 15 years, with increases beneficial for interest-rate sensitive
could prove crucial to keep the
in all four US regions and the South sectors such as housing and automo-
economic recovery on track in 2021.
and Midwest increasing to their stron- biles, demand for credit continues
gest pace on record.5 This is significant to decline. Credit card borrowing,
since existing home sales also create for example, declined by more than Inflation—scratching beneath
a downstream impact on durable goods 10% between March and November, the surface
consumption and residential investment after reaching a record high in If the recovery does take hold, markets
(e.g., remodeling). Homebuilder confi- February.7 Likewise, even though growth may be underestimating the potential
dence hit another record high in in mortgage balances—the largest inflationary effect of the unprecedented
November, breaking the 20+ year old component of household debt—have fiscal and monetary stimulus and
record for the third consecutive held firm, the share of homeowners rescue packages, in addition to the
month, and single-family starts jumped drawing on home equity lines (or likelihood of increased in-sourcing
to the best pace since 2007. The cash-out refinancing) to finance and shifts in supply chains that may
number of units authorized but not yet consumption has continued to decline result from the current crisis and
started also suggest construction will in the same period.8 These trends ongoing tensions with trading partners.
remain strong in the coming months, suggest households are reluctant to With spending on goods gaining greater
providing further evidence that the incur additional debt given the uncer- weight (though services still remain
housing sector will continue to support tain times that lie ahead. dominant), the share of inflation from
the economic recovery.6 core goods has climbed. In fact,
While we expect a new sizeable fiscal
core-goods consumer price index (CPI)
relief package before the end of
The challenge is far from over the year, with more to come in 2021;
contributions in August and September
Even though the ultra-low interest rate were the highest since December
the overall fiscal expansion might
environment and the Federal Reserve’s 19989—and this does not account for
be somewhat smaller if Republicans
the rising weight of the goods sector.
Back to the future—finally 7To get a better sense of future inflation Financial Crisis (GFC), this time the forecast, has seen strong “front-loaded”
pressures, we divided the most highly cyclical components of the Core-PCE growth during the early stages of
weighted personal consumption Price Index (PCEPI) did not fall signifi- recovery. The table below shows our
expenditures (PCE) price indices into cantly. Unlike in the GFC, the fiscal updated outlook for US growth through
two baskets—“Flexible” and “Sticky” support programs such as the Paycheck the end of 2021 under two different
(similar to an analysis by the Atlanta Protection Program (PPP) and enhanced scenarios. The first scenario estimates
Fed, which uses the CPI instead). UI benefits more than replaced lost the trajectory for growth, jobs and infla-
Items are classified as Flexible if the incomes (leading to excess savings), tion assuming that there is a divided
frequency of price adjustments is every while monetary stimulus has also been government (and corresponding
3–4 months, whereas for items in several orders of magnitude higher. As a moderate stimulus), while the second
the Sticky category the price adjustment result, broad money growth (M2) has scenario assumes a significantly
occurs only every five months or been far more robust. Households this stronger stimulus under a “pale blue
more. This breakdown reveals that time have “cash-on-tap” (with the wave”—where the Democratic Party
major services categories are “down- potential for additional fiscal support) to retains the House of Representatives
ward-sticky”: prices did not fall when spend once confidence improves. and gains a slim majority in the Senate.
demand collapsed, but rose when
demand recovered. These service These factors skew the odds in favor Divided government (moderate stimulus)
sectors could become a significant of a faster pickup in inflation, which The Democratic Party wins the
source of inflation as demand rebal- even if relatively muted would presidency and retains the House, while
ances towards services with the lifting exceed the very sanguine consensus the Republicans keep control of the
of pandemic-related restrictions. inflation expectations. Senate. Although the Republican-led
Senate had sought to block the House
This downward-stickiness is confirmed US economic outlook Democrats’ plan to inject more than
by the chart below; it shows that, $2 trillion in federal stimulus funds
The US economy has demonstrated
unlike what we saw in the Global (pushing instead for their alternate
remarkable resilience and as previously
REBOUND IN PRICE DYNAMICS CANNOT BE RULED OUT GIVEN BROAD MONEY GROWTH
Exhibit 4: Core PCE inflation: Cyclical vs. acyclical components
January 2007–October 2020
3.0%
2.5%
2.0%
1.5% 0.40%
1.41%
1.09%
1.0%
0.5%
0% -0.08%
-0.5%
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Cyclical Core PCE Contribution Health-Care Services Acyclical Contribution Non-Health-Care Acyclical Contribution Core-PCE
Sources: Franklin Templeton Fixed Income Research, Federal Reserve Bank of San Francisco, BEA, MacroBond.
8 Back to the future—finally$500 billion plan), with the election FRANKLIN TEMPLETON FIXED INCOME GROWTH OUTLOOK
campaign now over, the dynamics in the Exhibit 5: US GDP growth (% quarter-over-quarter annualized rate), unemployment rate
Senate may shift with Republican and inflation rate scenarios
As of December 2020
leadership likely more receptive to a
larger stimulus bill. Senate Majority REAL GDP (% Q/Q AR) UNEMPLOYMENT RATE CPI INFLATION
Leader Mitch McConnell has indicated Divided Pale Divided Pale Divided Pale
Government Blue Wave Government Blue Wave Government Blue Wave
that a stimulus bill needs to be passed (Moderate (Strong (Moderate (Strong (Moderate (Strong
before the end of the year—possibly Stimulus) Stimulus) Stimulus) Stimulus) Stimulus) Stimulus)
before the next federal spending dead- 2019-Q4 2.4% 2.4% 3.5% 3.5% 2.0% 2.0%
line to prevent a government shutdown. 2020-Q1 –5.0% –5.0% 4.4% 4.4% 2.1% 2.1%
McConnell also expressed openness 2020-Q2 –31.4% –31.4% 11.1% 11.1% 0.4% 0.4%
to a package with more state and local 2020-Q3 33.1% 33.1% 7.9% 7.9% 1.3% 1.3%
funding—previously a sticking point 2020-Q4 3.9% 3.9% 6.4% 6.4% 1.1% 1.1%
during the negotiations. House
2021-Q1 7.1% 9.7% 5.7% 5.0% 1.4% 1.5%
Democrats may therefore push for an
2021-Q2 3.7% 3.2% 5.4% 4.7% 2.7% 2.9%
aggregate stimulus package in the
2021-Q3 3.0% 2.0% 5.3% 4.6% 1.7% 1.9%
range of $1.2–$1.5 trillion. However,
political change on issues such as 2021-Q4 2.2% 2.9% 5.0% 4.4% 1.6% 1.7%
climate change, energy sector, financial Gray, italics indicates forecast.
services regulation and taxation Source: Franklin Templeton Fixed Income Research. There is no assurance that any estimate, forecast or projection
will be realized.
will likely be significantly less decisive.
Pale blue wave (strong stimulus) Our growth and unemployment fore- in Q2, with all major economies in the
The Democratic Party wins the casts inform our inflation forecasts region posting record expansion
presidency, retains the House and under both scenarios. To generate infla- rates: France (18.7% Q/Q); Spain
wins a slim majority in the Senate. tion forecasts we have used a Growth (16.7% Q/Q); Italy (15.9% Q/Q); and
A Democratic-led Senate will likely Augmented Phillips Curve. Economic Germany (8.5% Q/Q). The strong snap-
approve a larger fiscal stimulus in the literature finds that link between infla- back in activity in these economies
range of $2–$3 trillion—more likely tion and economic slack has grown was prevalently driven by consump-
toward the higher end of that range— flatter over recent decades. However, we tion—with household spending surging
with plans for spending on infrastructure find that real GDP growth has replaced 17.9% in France, 20.6% in Spain,
upgradation. However, with a slim slack (the unemployment gap and/or the 12.4% in Italy, and 10.5% in Germany.
majority in the Senate (and with an eye output gap) as the relevant gauge of Activity also benefited from an improve-
on 2022 mid-term elections), progress activity and has therefore become a ment in both domestic and aggregate
on building a green energy economy and significant driver of inflation dynamics foreign demand, as both exports and
increasing financial regulation and taxes in the post-GFC period. imports of goods and services surged
will likely be much more staggered than during the quarter, as well as a recovery
it would have been under a stronger European economic in fixed investments.10
Democratic-led Senate. Under this
rebound: So spectacular, After lockdowns pushed the household
scenario, we expect to see stronger Q1
2021 growth relative to the Divided yet so irrelevant savings rate to historical high levels
Government scenario. However, the After the largest growth contraction (24.6% of gross disposable income in
assumption is that Q1 growth brings on record in the second quarter Q2), with the reopening of economies,
forward some of the growth from future (–11.7%), euro-area GDP surprised to August retail sales exceeded pre-COVID
quarters, and therefore sequential the upside in the third quarter, levels and remained elevated through
growth thereafter, is slower relative to expanding by a record 12.5% Q/Q (or a October. Total sales volume is now 3%
the Moderate Stimulus scenario. The 60.2% Q/Q annualized rate) as the higher than the February level.11
annual growth rate for the economy is region benefited from a loosening of
The rebound in output closed part of
expected to be 4.7% versus 4.2% COVID-19 containment measures.
the gap from pre-crisis GDP levels,
under the Divided Government scenario. The recovery was led by the countries
with activity in the euro area now 4.4%
which suffered the largest GDP declines
Back to the future—finally 9below the level from the end of 2019, Unemployment in the euro area Euro-area governments reintroduced
but the recovery has been uneven. increased during the third quarter, rising restrictions to combat the pandemic,
Although most euro-area countries to 8.4% in October from 7.2% in with countries such as France
experienced a similar growth pattern, February, the highest level since the reinstating a national lockdown at the
Spain continues to lag behind its GFC. The rise was generalized across a end of October. On a positive note,
euro-area peers—its GDP still 9.1% ll euro-area countries but has been new containment measures were less
below end-2019. Smaller fiscal buffers, particularly acute in the periphery, with stringent and more targeted than
heavier reliance on tourism (12% Greece at 16.1% (September) and the earlier March-May lockdown and
of GDP) and weaker performance of the Spain at 16.2% (October). Overall, were differentiated across jurisdictions
labor market have contributed to Eurostat estimates that 13.8 million (even within countries), aimed at
Spain’s sluggish growth. Germany, by people were unemployed in October in targeting high social contact sectors
contrast, suffered the smallest the euro area.13 We continue to expect while preserving economic output
contraction in Q2 of any of the region’s unemployment rates to rise from as much as possible. Some countries,
major economies, and output is now current levels as state furlough notably France and parts of Italy,
just 4.0% lower than last year end.12 programs become exhausted in 2021, shut down their retail sectors. Schools
particularly in periphery countries. remain open with integration of
The pandemic crisis has set the distance learning in some cases.
Harmonised Index of Consumer Prices Differing from the first lockdown,
(HICP) on a broad-based disinflationary
Clouds ahead
manufacturing, construction and part of
path. Consumer prices stabilized at The pandemic hit the euro area hard
the service sectors remained open,
–0.3% year-over-year (Y/Y), per again in the fourth quarter. Infection
mitigating part of the adverse effect on
November’s flash estimate, while core rates have been surging since the end of
the economies.
inflation remained at 0.2%, its record the summer in every European country
low, for the third consecutive month. and hospitalizations, ICU utilization, and
fatalities picked up rapidly.
DISINFLATIONARY FORCES ARE HERE TO STAY
Exhibit 6: Harmonised Index of Consumer Prices (HICP) contributions
January 2012–October 2020
Year-over-year % change, percentage points contributions to annual inflation
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0%
-0.5%
2012 2013 2014 2015 2016 2017 2018 2019 2020
Non-Energy Industrial Goods Services Food including Alcohol & Tobacco Energy HICP—All Items
Sources: Franklin Templeton Fixed Income Research, Eurostat, MacroBond.
10 Back to the future—finallyThe euro area faces a double dip reces- CONFIDENCE IS DETERIORATING IN THE REGION
sion, and the timing of the recovery Exhibit 7: Confidence indicators
remains uncertain. The renewed January 2019–November 2020
uncertainty from this new round of Percent Percent
restrictions will also drag down growth 20% 120%
prospects as we head into 2021.
The recently announced vaccines, with 10% 110%
extremely high effectiveness rates,
give reason for optimism; but the 0% 100%
logistical challenges of large-scale
vaccinations and the reluctance of a -10% 90%
significant share of the populations
to trust the vaccine flag a clear risk of -20% 80%
prolonged or repeated lockdowns.
-30% 70%
Although the new contagion-contain-
ment measures seem less damaging,
extended lockdowns could trigger higher -40% 60%
default rates, higher unemployment,
and lower savings accrual, eroding Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov
potential output. Fiscal support has 2019 2020
played a crucial role in supporting labor Consumer Confidence Services Confidence Industrial Confidence Economic Sentiment (RHS)
markets and firms, and further aid will Sources: Franklin Templeton Fixed Income Research, European Commission (DG ECFIN), Macrobond.
be needed in the quarters to come.
High-frequency and confidence FRANKLIN TEMPLETON FIXED INCOME—EURO-AREA GROWTH SCENARIOS
indicators are already showing a weak- Exhibit 8: Real Euro-area (EA) GDP growth forecast (% quarter-over-quarter)
As of December 2020
ening in growth momentum, with
November’s euro-area sentiment, as % Q/Q % Q/Q
well as consumer and services 2019 2020 2020 2020 2020 2020(F) 2021 2021 2021 2021 2021(F)
(% Y/Y) Q1 Q2 Q3 Q4 (% Y/Y) Q1 Q2 Q3 Q4 (% Y/Y)
confidence indicators, falling again
Baseline EA19 1.3% -3.7% -11.8% 12.7% -2.0% -7.1% 0.9% 1.2% 1.5% 1.6% 4.2%
after the summer’s rebound.
scenario
The euro-area composite purchasing Gray, italics indicates forecast.
managers index (PMI) fell back Source: Franklin Templeton Fixed Income Research. There is no assurance that any estimate, forecast or projection
will be realized.
into contraction territory to 45.3 in
November from 50.0 in October.
economy showing a firmer resilience marginal contribution of the Next
The latest PMI figures confirming the
than the more demand-reliant France. Generation EU (NGEU) stimulus in the
uneven recovery across sectors, with
last two quarters of the year (with
manufacturing in expansionary territory In light of the above, we have revised most of the impact delayed in 2022).
(53.8 in November) but services our economic forecasts downwards
falling to 41.7, the third consecutive through year end 2021. In particular,
month of contraction.14 This asymmetry we expect euro-area GDP to contract by
Policy support is crucial, but
will likely persist in the months to –7.1% Y/Y in 2020 (from our forecast implementation risks linger on
come, as the new restrictions do not of –9.1% Y/Y previously), with sequen- The NGEU program (or Recovery Fund)
target factories and global value chains tial Q/Q growth of –2% (from –2.5%) in set an historical precedent for
are recovering globally, underlying Q4 2020 and +4.2% Y/Y for 2021 the first large (approximately 5.5% of
the importance of international trade as as a whole (from 6.6%). Under our EU 2019 GDP) countercyclical
a growth driver. This can translate baseline scenario, we expect some and redistributive fiscal capacity aimed
in an asymmetric performance across social distancing restrictions to remain at supporting and transforming
countries in Q4 and 2021, with in place during the first quarter of the European economies in the
Germany’s more industrial-intensive 2021, limiting the rebound, with some coming years. Its main component,
Back to the future—finally 11the Recovery and Resilience Fund the EC-proposed financial support of allowed, including Greece) should keep
(RRF), is split €312.5 billion in grants, €2.5 billion to Ireland on November 16, delivering strong support to yields
which are exempted from national bringing the overall financial support across the euro area and in particular in
debt metrics, and €360 billion in loans. under SURE to €90.3 billion. To finance the periphery. The ECB also expanded
This initiative, coupled with the EU’s the program, the EC issued three its Targeted Longer-Term Refinancing
long-term budget, will be the largest social bonds totaling €39.5 billion in Operations III (TLTROs), a crucial
stimulus package ever financed through three rounds under the EU SURE instrument to keep accommodative
the EU budget, totaling €1.8 trillion.15 instrument, with proceeds distributed to financing conditions to the real sector
However, some implementation 15 member states including Italy through advantageous terms for the
risks linger. The timeline of the key (€16.5 billion), Spain (€10 billion), banking system.
procedural steps is lengthy, and initial Poland and Romania (€3 billion each).
disbursement of funds likely will Once all SURE disbursements have ECB President Christine Lagarde
not happen before the third quarter been completed, Belgium will also have emphasized that there is no precommit-
of 2021. Governments need to received €7.8 billion.16 ment to fully use the facility but also
obtain approval of their Recovery and did not exclude the possibility of further
Resilience plans in accordance with Demand has far exceeded supply, with expansions, suggesting a state-depen-
the digital, green and innovation prin- the latest installment 13 times dent policy reaction function to the
ciples that the European Commission oversubscribed, and orders totaling pandemic evolution aimed at controlling
(EC) has laid out, possibly being almost €500 billion over the three issu- the yield environment. The APP instead,
subject to delays in the process if a ances, clearly indicating the great with its €20 billion monthly purchasing
member state raises concerns on its hunger from market participants for a pace and the almost exhausted
effectiveness (the so-called “emergency European safe asset. additional envelope of €120 billion
brake”). Refraining from inefficient expiring at year end, has not been modi-
Monetary policy stimulus has been fied this round likely because of its
public expenditure and focusing critical to support the euro area. The
on productivity-enhancing projects will open-ended nature—which makes it
European Central Bank (ECB) has politically contentious during Strategic
be crucial, especially for peripheral prevented financial stress in the market
countries, but a lack of administrative Review periods.
and narrowed spreads across jurisdic-
capacity could make it hard to meet tions via asset purchases under its The ECB downgraded its macroeco-
the milestones and targets that the flagship program, the Asset Purchase nomic projections for the euro area,
EC will set for disbursements of Programme (APP), and the newly with real GDP now expected to contract
installments. The debate that is going created Pandemic Emergency Purchase by –2.2% Q/Q in the fourth quarter
to continue to evolve on the spending Program (PEPP). The December of 2020 vs. the +3.1% envisaged in
composition of NGEU will be closely Governing Council (GC) meeting deliv- September (and in line with our fore-
followed by investors and will deliver ered a series of intertwined measures casts of -2%). For the full year, the
important signals regarding the political to further sustain the euro-area ECB projects real GDP growth of 3.9%
will and effective capabilities to address economy in 2021 and beyond, with a in 2021 (down from 5% in September),
the EU’s growth potential. particular focus on asset purchase 4.2% in 2022 (from 3.2%), and
The temporary Support to mitigate programs’ size and duration. The ECB 2.1% in 2023. Inflation projections
Unemployment Risks in an Emergency expanded the PEPP facility by €500 have been further revised downwards
(SURE) program has shown there is billion, to a total capacity of €1.85 tril- and systematically miss the ECB’s
strong demand for a European financial lion and extended the purchasing “below but close” to 2% target over the
asset. The program funds the furlough period from June 2021 to March 2022. medium term, with HICP forecast at
schemes of the neediest countries with Reinvestments of principal repayments 0.2% in 2020, 1.0% in 2021, 1.1% in
a total firepower of up to €100 billion; have been extended by 12 months 2022, and 1.4% in 2023. While
approved applications to the lending until the end of 2023, clearly indicating including in their baseline scenario a
scheme have already reached €87.9 a monetary policy presence for a rollout of vaccines and the resolution
billion from 17 member states, with longer duration. The PEPP flexibility of the health crisis by early 2022
Italy (€27.4 billion), Spain (€21.3 across asset classes, time (varying pace and the positive impact of the NGEU,
billion), and Poland (€11.2 billion) being according to market stress), and the outlook leaves the doors open for
the largest recipients. In addition, jurisdictions (deviation from capital keys further stimulus in 2021.17
12 Back to the future—finallySector settings
Overall Risk Outlook Despite continued headwinds from COVID-19 disruption facing the
economy, with the uncertainty of the US election outcome
largely settled and positive vaccine news and distribution on the
horizon, we believe the worst is largely behind us. The first stage
of economic recovery proved as strong as expected, with the
rebound much faster and stronger than the post-GFC period. We
believe the market may be underestimating the eventual inflationary
effect of the unprecedented fiscal and monetary stimulus and
rescue packages. With the economy already demonstrating a healthy
capacity to rebound on top of the amount of stimulus and potential
stimulus to come, a rebound in growth and price dynamics could
create potential for yield curves to steepen. In a scenario of rising
rates, several of our favored risk assets could be poised to outper-
form given their low duration and thus, relatively lower sensitivity to
risk-free assets. While many risk assets have already priced in
the recovery, over the next 12 months, we anticipate risk assets
should outperform government assets given strong demand in the
face of an extended low-rate environment and the limited upside
in risk-free assets. Our view balances supportive monetary and
fiscal policy with the potential market disruptions from resurgent
infection rates over the winter and the resultant policy response
which may be even more stringent than previously seen, and for
these reasons we retain a slightly optimistic outlook on risk assets.
The following sector settings reflect our 12-month outlook on each asset class.
Sector Outlook Our viewpoint
US Treasuries With the economy poised for continued recovery from the COVID-19 pandemic
and more positive news on the way in the form of promising vaccines, over the
next 12 months, it is hard to disagree that interest rates will be higher and that
the Treasury yield curve will be steeper. Better economic performance will
spur interest rates to rise, so the duration trade is going to look less attractive.
Given the anticipated steepening of the curve and our desire to avoid adding
duration, we have downgraded our view on Treasuries from neutral to neutral with
reasons for concern. However, with US Treasuries yielding higher rates relative
to other global government bonds, demand may spike as investors look to buy the
yield bump within the security of the asset, which should keep rates from rising
even more.
Back to the future—finally 13Sector Outlook Our viewpoint
US Treasury The record fiscal and monetary stimulus this year along with the anticipated stim-
Inflation-Protected ulus going forward has real potential to stoke inflation. We expect TIPS breakevens
Securities (TIPS) to slowly grind upward over the next year. While the election outcome is largely
determined, until there is an outcome to the Georgia Senate runoff election, TIPS
long breakeven trades should provide some insurance. While we maintain a
modestly positive view of the asset class, the near-term potential economic disrup-
tion from a winter spike in COVID-19 infections will likely temper the start of
any durable inflation. Despite our expectation for rising breakevens over the next
year, we continue to pay close attention to duration exposure, as the TIPS trade has
the dual consideration of breakevens and duration changes impacting performance.
Eurozone With a renewed cycle of lockdowns across Europe over the fall, our expectation is for
Government a double dip in the growth of the European economy which will necessitate addi-
Bonds tional monetary and fiscal stimulus to support the recovery. The large fiscal stimulus
plan passed by the EU over the summer, combined with the ECB’s monetary
support from quantitative easing, and the persistently low-to-negative interest rates
we expect to continue for the foreseeable future have kept the risk premium
low on European bonds. Any additional stimulus in response to renewed lockdowns
should continue to support European bond markets, which should cap yields
because countries can borrow from the EU at a low interest rate and will not need to
issue as much of their own debt. This is especially positive when looking at the
peripheral markets such as Spain and Italy, or the Czech Republic and Romania
(which have euro-denominated bonds). The EU rescue package transformed the EU
into a new supranational borrower, but we expect euro government bonds to
have net negative supply in 2021. While benchmark European government bonds
will continue to offer little in the way of return, we believe there are other pockets of
opportunity on the periphery which should continue to be well-supported.
Japanese With the economy still challenged from the COVID-19 pandemic, the Bank of Japan
Government (BoJ) continues to issue record amounts of bonds and remains committed to
Bonds unlimited purchases of Japanese government bonds (JGBs). The government has
committed to additional easing, as necessary, to support market function and
keep the cost of borrowing suppressed, however, extremely supportive monetary
policy has been largely ineffective given persistently negative policy rates. Demand
for bond issuance has seemingly been supported in the near term by uncertainty
around Britain’s trade negotiations with the EU and US economic stimulus, and we
continue to see JGBs as a hedge against global volatility. JGBs should continue
to be well-supported given the strength of central bank purchases; however, given
current valuations we believe upside is limited and are finding value in other govern-
ment bonds on a relative value basis.
Agency Mortgage- The housing market has rebounded since April and the supply of mortgages is
Backed Securities expected to increase in coming months. Prepayment risk in the MBS market
(MBS) remains elevated as US mortgage rates have reached record low levels 16 times
this year, including the month of November. As the economy normalizes, we expect
prepayments to rise, with 79% of the agency MBS universe having an incentive
to refinance at current rates. Primary and secondary market spreads remain elevated
and while prepayments are their highest levels since 2012, refinance activity
should be much higher. If these spreads were to normalize to historical averages,
99% of the mortgage universe would have an incentive to refinance their loans.
14 Back to the future—finallySector Outlook Our viewpoint
Agency Mortgage- However, forbearance requests have started to taper, which could lead to lower
Backed Securities involuntary prepayments in the coming months. To mitigate prepayment risk over the
(MBS) intermediate term, we prefer to be positioned down in coupon in 2.0% and 2.5%
continued coupons. Technical support from Fed MBS purchases will continue to bolster the
MBS sector, potentially limiting spread widening and keeping spreads rangebound
which will benefit lower coupons and associated mortgage dollar rolls. Elevated
prepayment risk combined with yield spreads near their 10-year averages, led us to
retain our neutral recommendation on agency MBS. While we remain neutral, we
believe there is room to add MBS on market dips and the asset class continues to
provide good carry and could benefit from corporate credit crossover buying. Within
MBS, we prefer 30-year securities over 15-year securities and generally favor
conventional 30-year and conventional 15-year securities prepayment characteris-
tics over Ginnie Mae (GNMA) 30-year securities.
Non-Agency US housing has been resilient despite facing the biggest downturn since the GFC.
Residential Limited home supply coupled with strong demand and historically low mortgage
Mortgage-Backed rates should keep home prices supported over the short to medium term. YTD
Securities (RMBS) through August 2020, home price appreciation stood at 3.82% and our model
forecasts 2.7% home price appreciation through Aug 2021. Supply and demand
forces continue to be supportive for housing. Despite headwinds in the market, we
still expect non-agency RMBS to provide strong risk-adjusted returns and we are
upgrading our 12-month outlook to neutral with reasons for optimism. While new
delinquencies are tapering, roll rates to late stage delinquencies remain elevated.
This was expected as borrowers are likely to take up forbearance plans when facing
hardship or job losses. Forbearance has given borrowers the time needed to get
back on their feet while keeping foreclosed homes from flooding the property
market. Currently, about 2.8 million borrowers are under some forbearance plan.
If we consider all these property owners eventually default and the properties make
their way into the market for sale, the inventory levels would be far lower from the
levels we saw in the GFC (when home prices dropped 30%). Based on current
delinquency pipelines, prepayment speeds and credit enhancement, we do not
expect any losses in fixed severity last cashflow tranches without the natural
disaster language. However, overall deal losses are expected on some transactions.
Commercial The fundamental credit backdrop in the Commercial Real Estate (CRE) sector
Mortgage-Backed continues to be challenged. CRE transaction volumes, a leading indicator for prop-
Securities (CMBS) erty valuations, are, on average, down by 65% Y/Y as of September and it is
evident that there continues to be a widening bid/ask in the commercial real-estate
market. Significant headwinds exist in the short to medium term for CRE.
A resurgent second wave followed by stricter implementation of lockdowns and near
non-existent direct support to CRE sponsors makes matters worse for the sector.
CMBS conduit delinquencies (30+ days) continued to be elevated at 7.9%
as of September and, as expected, hotel and retail delinquencies continue to be
significantly higher than other property types such as office, multifamily and
industrial. AAA last cashflow spreads have continued to tighten and are currently at
the tighter end of historical levels. We believe downside risks outweigh upside
potential at these levels. We continue to maintain a bearish outlook on CMBS, and
we remain positioned up in the capital structure in CMBS transactions with solid
credit fundamentals.
Back to the future—finally 15Sector Outlook Our viewpoint
Asset-Backed The ABS market has rebounded significantly post the COVID-19 selloff with robust
Securities (ABS) primary and secondary market activity and spreads for most prime subsectors at
pre-COVID tights. The Term Asset-Backed Securities Loan Facility (TALF) has been
minimally utilized and we believe requests for TALF loans to finance ABS (auto,
card, equipment, floorplan, premium finance and private student loan ABS) will
remain low as current spread levels for most sectors result in negative TALF yields.
We expect the credit performance of consumer-related ABS sectors to largely
reflect the performance of the broader lending market with performance expected to
vary by loan type. Specifically, we expect higher delinquency and charge-off rates
as COVID-19-related payment relief programs expire, the second round of stimulus
is likely to be smaller and, although it’s expected to continue to improve but at
a moderate pace, the unemployment rate remains at elevated levels. Even so, the
faster-than-expected improvement in the employment situation should result in a
more muted credit outcome for most sectors. We expect overall credit performance
for retail auto loan ABS to deteriorate in 2021 as lender-based deferral programs
end, on top of elevated unemployment. In recent months, a large increase in
payment deferrals has resulted in a dramatic decline in delinquencies and charge-
offs in both the prime and subprime auto loan ABS markets. As borrowers exit these
programs, however, we expect a portion will be unable to resume making payments.
This will likely pressure credit metrics. We expect overall credit performance for
credit card ABS to deteriorate in 2021 due to slower receivable growth and, similar
to other consumer debt sectors, elevated unemployment, the end of payment relief
programs and the likelihood of a smaller stimulus package. Even so, we do not
expect charge-offs to reach levels comparable to the last recession. We remain
neutral on prime consumer ABS as spreads offer little incremental yield pickup
versus cash alternatives and expectations for fundamental pressures on trusts will
remain. Given the relative flatness of the credit curve, we prefer to be up in the
capital structure at the AAA level in both prime auto and credit cards, and we are
avoiding non-benchmark ABS, despite the incremental yield pickup in the lower
quality, albeit thinner, tranches. Additionally, we would avoid subsectors such as
aircraft and container ABS that face an uncertain outlook as well as floating-rate
bonds without explicit LIBOR fallback language.
US Investment- Strong demand is supporting the US investment-grade corporate debt market, as
Grade (IG) investors continue to seek out investment-grade bonds as a relatively safe source
Corporates of yield in what is likely to be an extended period of historically low rates. This
appetite for bonds has allowed issuers to continue to bring record levels of new
issue supply to market, helping companies build liquidity and reduce near-term refi-
nancing risks. Corporate bond spreads have rallied significantly in recent months,
with the bulk of tightening coming on the back of the US election results and the
promising news of an effective COVID-19 vaccine, which mitigated some key sources
of uncertainty for the market. Spreads now reflect a more supportive economic
and risk outlook going into 2021. The market is also counting on a divided US
government to limit significant policy changes. We remain generally positive on
investment-grade corporate bonds, although we believe the opportunity has become
less compelling given tighter valuations and continued near-term macro and policy
uncertainty, particularly as new COVID-19 cases surge. We are neutral on the
sector over the next 12-months, but we remain comfortable with fundamentals and
market technicals. We prefer to focus on select intermediate and longer-duration
bonds, including BBB-rated issuers, while taking advantage of new issues or any
market dislocations to add exposure to the asset class.
16 Back to the future—finallySector Outlook Our viewpoint
European After improving in the third quarter of 2020, euro investment-grade corporate
Investment-Grade fundamentals are expected to deteriorate due to new social restrictions across
Corporates Europe. Although companies are better prepared this time around and the rules are
less restrictive than they were in the spring, earnings recovery will be further
delayed. The news of an effective COVID-19 vaccine is encouraging; however, uncer-
tainties remain on the logistics of rollout and timeline, and renewed or rolling
lockdowns cannot be ruled out in the first half of 2021. Against this backdrop of
uncertainty, we expect European corporates to remain conservative and focus on
deleveraging over the next year, whilst maintaining strong liquidity positions.
Governments have extended support measures until at least March 2021, and new
monetary measures will be announced by the ECB in December. In our view, the
ECB’s demand for investment-grade corporate bonds paired with a decline in
Euro investment-grade supply will be supportive for the sector. The euro IG asset
class remains attractive, although low yields could become an issue for the
sector. Euro IG spreads have retraced to the level at the end of 2019 and yields are
near their all-time lows. Although these rather expensive valuations should limit
upside, we foresee potential spread compression in some parts of the market.
Despite current valuations, we remain slightly optimistic due to deleveraging pros-
pects and continued strong technicals. Over the next 12 months, we maintain
our neutral with reasons for optimism outlook. We continue to favor non-financials
over financials given the strong support from the ECB, and we recommend going
down in credit quality. We believe select corporate hybrids and financials subordi-
nated debt are attractive as hybrid structure-related risks, such as the extension
risk or the coupon deferral risk, are low at this stage. A change in the ECB’s corpo-
rate bond purchase program and any additional lockdowns in 2021 remain the
biggest risks to our outlook.
US High-Yield We expect volatility to remain elevated in the near term in the US high-yield corpo-
Corporates rate bond market, as investors grapple with the dynamics of the promise of
successful vaccines on the horizon paired with a recent spike in COVID-19 cases
that could lead to further economic disruption over the winter months. Looking
toward a Biden presidency with a split or nearly split Congress, we anticipate a rela-
tively manageable impact to the overall US HY market. The new issue market
has remained quite active, and we have generally found new issue concessions to be
an attractive way to pick up yield and spread, although this generally comes
with the trade-off of extending duration. With exchange-traded funds (ETFs) having
a disproportionate impact on the market, the valuation differential between
larger ETF-eligible names and smaller, less-liquid capital structures, has widened.
While the overall market is fairly valued in our opinion, we are finding pockets of
value in individual names, particularly among these smaller issuers. With $17
trillion of negative yielding debt across the globe, we still believe high yield will
attract the interest of investors able to withstand the volatility. The record amount of
new issuance this year has enabled companies to bolster liquidity and extend
debt maturities, which has resulted in a default rate that has been much lower than
thought possible last spring. So even with nominal yields near historic lows,
we still think HY investors are more than compensated for expected default losses.
We also see potential for additional spread tightening over the course of the
next year and believe that the relative yield pickup, along with the lower duration
exposure to a potential rise in rates, will make US high yield an attractive asset class
in the continued low global rate environment we expect going forward.
Back to the future—finally 17Sector Outlook Our viewpoint
Euro High-Yield Despite the extraordinary events that characterized 2020, remarkably, the euro
Corporates high-yield corporate market is expected to close the year not far from where we, and
most market participants, forecasted at the beginning of 2020. We entered
2020 with a modestly bearish outlook as we expected EHY spreads to widen during
the year. We thought EHY default rates were going to rise, albeit from historically
low levels, because of the loss of momentum in the European economy and high
leverage multiples prevailing in some areas of the EHY market. Obviously, none of us
expected the ups and downs of the COVID-19 pandemic. We are entering 2021
with optimism for recovery but are conscientious that the rollout of the various
vaccines approved or likely to be approved will be a long process. As infection rates
remain high across most major countries, we expect at least another quarter
of constrained economic growth, but are hopeful for a turn for the better during the
second half of 2021. Similarly, with the ECB and most major central banks
remaining accommodative and euro sovereign yields likely to persist at historically
low levels, we expect demand for higher-yielding products, particularly in the
euro area, to remain at an all-time high. With such a constructive backdrop,
but also factoring existing tight credit spreads and risks associated with compla-
cency and euphoria, we believe an upgrade from moderately bearish to a
neutral outlook on euro high yield is warranted following the release of the first
Pfizer/BioNTech vaccine.
Floating Rate Over the medium to long term, we are constructive in our outlook on the loan
Loans market. The results of the US presidential election and a US Senate race that has
largely concluded without dominance by one party could help alleviate market
uncertainty as investors now have a better expectation of policy direction. The pros-
pect of sweeping health care regulations and of more actionable scrutiny of
the tech sector carries lower probability than we feared prior to the election which,
broadly speaking, bodes well for performance in these sectors. Pfizer/BioNTech
and Moderna’s positive COVID-19 vaccine results set an optimistic tone for other
vaccines in advanced stages of clinical trial, which may provide tailwinds for
market sentiment and tighter spreads. We are optimistic that the market headwinds
of 2020 will gradually subside throughout 2021. At this point, we feel comfortable
reducing Upper-Tier loan exposure and increasing Middle-Tier exposure. While
focused on fundamentally sound credits, we are looking to position for longer-term
recovery. However, in the very immediate term, COVID-19-related challenges
persist, with rapidly rising case counts in the winter months, which could prompt
periods of volatility and provide attractive investment opportunities. We are watching
industry sectors with material exposure to COVID-19 disruption and are maintaining
a highly selective stance toward credits in these sectors. We are selectively
adding single-B tranches and are looking at both the primary and secondary markets
for the best relative value. We previously had a modestly bearish outlook on
loans, given the volatility we were expecting over the fall. Given the constructive
pivot in our view over the next 12 months, we’ve upgraded our outlook to neutral
with reasons for optimism given that conditions are aligned for further spread
tightening from here due to the changes in the investor base, lack of many positively
yielding fixed income alternatives, and a cyclical upswing over the coming quarters.
18 Back to the future—finallyYou can also read
