January 13, 2021
Continued easy policy is key for maintaining stability and bolstering the recovery. David Leduc, CIO of active fixed income at Mellon, goes so far to say the biggest risk would be if global central banks suddenly change their tune. However, he believes this is highly unlikely for the time being.
The initial kick-off of vaccine distribution has helped relieve some uncertainty and provide a more positive outlook for 2021. However, technical factors are buoying markets too, according to Leduc. Central banks have kept policy rates low, sustaining a favorable interest rate environment, which helped propel markets from all-time lows last spring. But any deviation from current monetary policy would be premature and could even be detrimental to the recovery, according to Leduc.
“I think the policy environment has allowed financial markets to look through short-term damage, towards growth, especially with the vaccine roll out,” he says. “But the removal of accommodative policy by the Federal Reserve (Fed), or central banks elsewhere, could cause a problem as there are still challenges in many parts of the economy.”
In the short term, central banks are unlikely to change course unless there is a meaningful uptick in inflation expectations, Leduc says. For example, the Fed announced it plans to let the economy “run hot”, moderately above its prior 2% target for a sustained period of time, in order to make up for years of subpar inflation.1
“For the Fed to become less accommodative, there would need to be a rapid increase in inflation. This would clearly threaten financial asset performance,” he says. “We don’t see this as a risk in 2021 but a sustained rise would most likely trigger a pullback of easy monetary policy.”
Leduc says this isn’t likely to occur until late 2022. While there may be short-term flare-ups in certain inflation indicators, limiting factors are preventing any meaningful increase in inflation, he says. Some of these limitations include leverage levels as well as how personal and corporate balance sheets are currently positioned due to the policy environment. Despite this, there may be blips of inflation, which lead to volatility if the market thinks the Fed is too slow, Leduc says.
“Any time you have market participants well positioned for a similar view, it does pave the way for volatility if that view becomes challenged,” he says. “As we get further into the recovery, the risk may be that markets feel the Fed is behind the curve on inflation.”
Another trend Leduc is watching in 2021 is the climate crisis. Last year, California wildfires burned 4.2 million acres and the state experienced five of its six largest wildfires in history.2 Separately, Louisiana underwent its strongest hurricane 150 years.3 Hitting a new annual record of 22, it was the sixth consecutive year that 10 or more billion-dollar weather and climate disasters affected the US.4
Leduc believes similar events could pose a risk to both municipal and corporate issuers in the year ahead. As a result, taking the climate crisis into account will be an essential component of credit analysis, he says.
“Whether it’s an energy company or a municipal bond issuer, we consider the communities and municipalities most exposed to the ill-effects of climate change,” he says. “If the issuer is in an area subject to wildfire risks, or a coastal area where it’s vulnerable to storms and rising sea levels, we include it in our assessment of credit quality.”
Return to normal
While the climate conundrum is more of a secular issue, Leduc is also considering idiosyncratic risks this year. Specifically, he is wary of long-term risks surrounding the way businesses operate within higher touch industries, like travel and leisure. The policy environment has so far been supportive of assets in these credit sectors, but Leduc says the return to normal could pose its own problems: “Particular issuers in those sectors, whose business models may have changed permanently, may no longer be able to support the historic financial leverage they had prior to the pandemic.”
As a result, Leduc is monitoring credit quality and challenging corporate debt levels to conclude whether or not issuers will be able to sustain those financial structures as they return to normal. Additionally, the pandemic caused an uptick in the amount of credit downgrades last year, which Leduc says should continue throughout 2021 as companies figure out what the new normal looks like.
While corporate balance sheets may not be appropriately leveraged, and this increases the potential for more credit downgrades, this does not mean Leduc is pessimistic about the fixed income landscape in the year ahead. In fact, he says 2021 will be opportunistic for security selection within fixed income.
“There’s a lot price dislocation that occurs when credits get downgraded to high yield, which is actually a structural opportunity that we can exploit. We believe this will be a direct source of alpha in 2021,” he concludes.
1 CNBC: Powell announces new Fed approach to inflation that could keep rates lower for longer. August 27, 2020.
2 CalFire: Top 20 Largest California Wildfires. November 3, 2020.
3 Forbes: Record Setting is theme for top five weather events of 2020. December 11, 2020.
4 National Centers for Environmental Information: Billion- Dollar Weather and Climate Disasters. Accessed January 2021.
Leverage: The amount of debt a firm uses to finance assets.
Alpha: The excess return of an investment relative to the return of a benchmark index.
Idiosyncratic risks: The inherent factors that can negatively impact individual securities or a specific group of assets.
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