Presentation describes an economy coming back down to earth after a post-pandemic bounce with three key questions for fixed-income markets hanging over it
KOHLER, WI, October 08, 2021 /24-7PressRelease/ -- For the 21st year, Baird Advisors recently held its Institutional Investors Conference in Kohler, Wis. Deputy CIO Warren Pierson reflected on the growth of Baird's fixed-income business to $128 billion in assets from $102 billion 12 months ago; a number of awards received by the firm in 2021, including Morningstar's #1 Fund Family Award; and he provided the firm's annual investment outlook. Part market assessment and part economic forecast, the outlook described an economy coming back down to earth after a post-pandemic bounce with three key questions for fixed-income markets hanging over it:
• Why aren't interest rates still rising?
• What is the outlook for inflation?
• When will the U.S. Federal Reserve begin tapering its asset purchases?
Following are highlights of Pierson's remarks:
The post-reflation rate reversal
Going into 2021, the received wisdom on Wall Street was that the U.S economy was primed for a massive post-pandemic rebound and interest rates were poised to increase sharply after years spent near historical lows. Financial market participants even coined a new term—the reflation trade—for strategies designed to capture the anticipated reopening rebound, mainly a rotation out of bonds and into the stock market. And indeed, the economy reflated right on cue. GDP growth has been north of 5% for most of the year and economists expect it to remain in that range into 2022.
But a funny thing happened to bonds on the way to the reopening. Yields perked up in the first quarter of 2021 but by the end of summer they had floated back down roughly halfway to end of 2020 levels. A number of factors are at play:
• Strong demand from investors. A market feature of the last decade or so has been that anytime interest rates start to rise, yield hungry investors swoop in to buy bonds. The strong bids for Treasuries come from both domestic and foreign investors. By September flows into U.S. bond mutual funds and ETFs had already surpassed annual inflows in any of the previous eight years. And non-U.S. investors confronted with relatively lower yields in other developed markets continue buying Treasuries. Case in point—an early September auction of 30-year Treasuries saw 70% of the sales go to foreign accounts.
• An accommodative Fed. The Federal Reserve has continued to err on the side of liquidity in both its monetary policy stance and with its asset purchase program.
• The Delta variant. A third factor not to be overlooked is the renewed concern over Delta and the possibility of further COVID mutations and their potential to dampen or even shut down economic activity going forward.
These factors all contributed to the surprising reversal in what had once seemed like an inexorable back-up in long-term interest rates that would challenge bond investors—at least those tracking the price appreciation or depreciation of their portfolios on a daily mark-to-market basis--for years to come.
A second question that has perplexed market participants is the outlook for inflation. Are the price increases seen over the last year or so simply transitory artifacts of record household wealth built up during the pandemic and supply chains struggling to adjust to resurgent demand as the global economy ramps from nearly a dead stop, or is it a longer-term trend that bond investors should worry about?
The evidence—especially the failure of wage increases to keep pace with inflation--still suggests the spike in inflation may be temporary, but it bears watching. Minimally, investors may want to recalibrate their definition of transitory, since inflation may be around well into next year.
Reading the taper tea leaves
The third big question mark hanging over the bond market is exactly when will the Federal Reserve commence with its long-anticipated taper of asset purchases? The best guess is that the Fed begins to reduce its monthly purchase around the end of the year, but considerable uncertainty around the timing remains. What does seem clear is that the Fed will handle the taper--and any communications about it—with extreme delicacy so as not to trigger a replay of 2013's "taper tantrum," when it roiled the bond market by rapidly curtailing asset purchases.
Because the Fed can be expected to let data drive its approach to taper, carefully monitoring macroeconomic data (as well as the fiscal policy debate in Washington, which the Fed also appears to be tracking closely) is likely to provide the best insight into the central bank's intentions.
The Market Opportunity
Faced with these major questions, where is there value in the fixed income markets and where are the potential traps? There is certainly no lack of choices, as investment-grade bond issuance has maintained a torrid pace and stood at nearly $52 trillion as of the end of the first quarter (notwithstanding a modest slowdown in corporate issuance compared to 2020).
After exploding in early 2020, yield spreads were near historically tight levels going into the year, and they narrowed a further 0.09% through the end of August. Nonetheless, solid corporate borrower fundamentals—steady revenue and profit figures, ample cash on hand and manageable leverage--continue to make corporates attractive and a slight overweight in the Baird Aggregate Bond Fund.
The same cannot be said for U.S. high-yield bonds, where spreads have come in a whopping 0.72% on the year, rendering junk bonds unappealing on a risk/reward basis.
Bonds backed by residential mortgages are an underweight for the Baird Aggregate Bond Fund. There is an old adage on Wall Street that it's never a good idea to fight the Federal Reserve and whenever the taper starts, mortgage-backed securities are likely to suffer.
Municipal finances are in remarkably good shape coming out of the pandemic, largely due to the $1.2 trillion in stimulus money directed their way from Washington already. With state and local governments flush with federal cash, municipal issuance has been light, further supporting prices for outstanding bonds. Healthy balance sheets and the prospect of additional funds likely to come from whatever infrastructure spending package emerges from Congress in the coming months means that for tax-sensitive investors, the muni market is an attractive option.
The big picture for bonds
There is a sense among some commentators that fixed-income markets somehow "dodged a bullet" in 2021—that, with yields near all-time lows, there was only one direction they could go and the reckoning would be painful for bond investors and potentially long-term.
They were wrong even on a near-term basis in 2021. But such an outlook also underestimates the longer term secular themes—an aging global population that thirsts for yield; technology advances that dampen the sort of wage pressures that can cause mild demand driven inflation to turn into a real problem; and central banks that have become increasingly adroit at managing the economy, with bonds representing their singularly indispensable tool—that make fixed-income assets an essential component of any responsible long-term wealth building portfolio.
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A Reflated U.S. Economy at a Crossroads: Baird Advisors Shares Outlook at Annual Institutional Investors Conference
October 08, 2021 at 03:00 AM EDT