Align your fixed income strategies to the post COVID-19 world

How can investors be well positioned in bond markets to succeed in the new global economy as the COVID-19 outbreak continues?

06 Apr 2020

Which four steps can bond investors take now to reflect the current fixed income outlook? As COVID-19 wreaks havoc around the world we look at how investors could be well positioned in bond markets to succeed in the new global economy.

If humans are ever to explore distant planets and the vast outreaches of space, scientists must decide how to keep people alive (and sane) through enormous journey times. Astronauts must arrive at their strange new destinations rested and ready to work, even after years of travel. Current thinking points to a form of hibernation where, at the outset, astronauts are chilled and metabolisms depressed to a fraction of their typical rate – so called ‘hypothermic torpor’1.

So far, so much science fiction. But now governments, policy makers and economists around the world wrestle with a similar problem. How to safely put economies into hibernation so that companies and workers emerge from their sleep pods of isolation fit and raring to go when the COVID-19 crisis has passed?

Tried and tested techniques are of no use. In past downturns, policy makers have relied on approaches that supported current spending; so for example lower mortgage rates and tax cuts. But clearly these will not work today when consumers and business are in lockdown. If more direct life support was not provided, then productive capacity (both capital and labour) would be so damaged that a full recovery from the crisis would take years.

Instead, most countries have rightly taken a far more interventionist approach, and one that just a few weeks ago would have read like economic science fiction for many capitalist and market led economies; an unprecedented peacetime expansion of fiscal spending, tax and mortgage holidays, corporate bailouts, wage subsidies, corporate loan guarantees, unlimited quantitative easing and extensive support for financial markets. The numbers are staggering, with packages in many countries easily reaching 10-20% of GDP if fully exercised. And that is before we can be sure how the crisis will evolve and how the global economy will cope. We should not imagine we have seen the end of the life support.

The immediate problem is dealing with the havoc wreaked by COVID-19 to the demand and supply side. But so large are the numbers, and so frequent the announcements, that it is easy to become blasé about how extraordinary these government programs are and how uncertain the long-term consequences will be. As every sci-fi movie-goer knows, when the sleep pods open and astronauts emerge bleary eyed into a new world, that is usually when the monsters appear.

It is too early to draw real conclusions about how the new global economy will look, but two things are at least are clear. First, free spending by governments today, while necessary, risks unsustainably higher debt levels, higher borrowing costs and higher inflation in the future. Ultimately, deficits do matter and must be paid for. Secondly, central banks must provide immense ongoing support for bond markets. A sharp move higher in government bond yields will undermine the fiscal policy response and therefore central banks will need to keep yields low to support its effectiveness. It is not hard to see some central bank mandates evolving away from today’s inflation targeting towards something that is much more explicit in keeping nominal yields low across the yield curve2.

What steps should bond investors be taking today to reflect this changing outlook? We see four:

COVID-19 is at first order a global public health crisis with extremely serious second order economic and financial market effects for the global economy. Governments and central banks do their best to ease the economic shock, but we are in totally uncharted territory when thinking about the longer-term effects. Bond investors must take steps now, at least to protect themselves against the more obvious longer-term risks, such as higher inflation, while looking for more tactical opportunities in assets that have repriced recently. We believe our flexible bond strategies are well placed to succeed in this environment.

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