M&G’s Leaviss and Lonergan reflect on lessons learned one year on from the market crash

Now that more a year has passed since the pandemic first roiled financial markets, what can investors expect to see over the coming months? Following a recent virtual roundtable with M&G’s CIO of public fixed income, Jim Leaviss and Eric Lonergan, macro fund manager on the global post-pandemic recovery, the commentary below summarises their views on emerging opportunities, fiscal and monetary policy developments, unemployment and the acceleration of existing trends.

Jim Leaviss, CIO of public fixed income:

Should we be braced for post-pandemic scarring?

There’s no denying that the pace of post-pandemic recovery is now extremely strong, particularly in the UK and the US. The Institute for Supply Management (ISM) recently found that the US services sector, for example, recorded record growth in March. There is an increasing sense of optimism and job creation is strong – especially in Covid-19-sensitive areas, such as hospitality. As economies unlock, vaccine programmes progress and lockdown restrictions start easing, people are finding their way back into service sector jobs.

There is some talk about what degree of Covid-19-related scarring we should expect. Could we see a permanent loss of skills due to unemployment? The current recession is very much a services sector recession, where the transferability of skills is much higher than the 1980s manufacturing recession, for example. In other words, if someone loses their job working in a pub, they may still be able to carry over the same skills into a job at another pub or restaurant. This wasn’t the case in the 80s. Back then, if you were in North East England and lost your job manufacturing steel, for instance, you would have had to move a long way to find another steel plant – let alone one that was hiring. So, there is an argument that the degree of scarring this time round will be far less than what we saw in the 80s, and therefore the unbottling of the economy will be stronger.

The counterargument to the idea that there will be no scarring is the fact that, despite huge job creation so far, there are still millions of people out of work. The US Federal Reserve has talked a lot about looking not only at headline unemployment, but also at the U-6 measure, which looks at people not working as many hours as they would like to. There are also discussions around discrimination and the issue of an unequal post-pandemic recovery, with talk amongst the Fed about disproportionate wealth losses for black workers, other racial minorities and people on lower-paying jobs – and whether the Fed should be doing something to address this. I think this will be a key discussion for the Fed over the coming months.

The outlook on Fed rate hikes

The next step in the equation is how quickly the Fed goes back on what it has told people. The Fed has been keen to maintain the idea that flexible average inflation targeting means that it’s prepared to allow the economy to run hot over the next few years. People are now anticipating the tapering of quantitative easing purchases, and we could actually see tapering announcements towards the end of this year. Markets now have almost four rate hikes priced in for the Fed by the end of 2023. The question is whether that is going to be consistent with flexible average inflation targeting. The headline numbers for almost all the economic statistics on a year on year basis for the remainder of 2021 look exceptionally strong, and inflation will be up towards 4 per cent on a headline basis largely as a result of base effects: this time one year ago, the oil price was negative. Moreover, we are due another significant round of economic stimulus. Some form of it is likely to get passed, and while a lot of it will include infrastructure spending, plenty will be spent more quickly than that – stimulating the economy very quickly. However, for the foreseeable future, perhaps the market has got a bit ahead of itself in terms of the number of rate hikes priced in.

US Treasuries look attractive to global investors

The US dollar has been strong this year, which isn’t surprising given the degree of pessimism about the dollar that has gone into markets, coupled with significant rises in US Treasury bond yields compared to European or Japanese bond yields, for instance. So, the relative underperformance of US Treasuries suddenly means US Treasuries look very attractive to global investors, including in markets like Japan, and that in part explains the US dollar strength we’ve seen recently. 

Large cohort of IG bonds vulnerable to falling into high yield

Credit spreads have not done much over the past two months. Corporate bond spreads are back to the levels we saw in 2020, and for many parts of the market we are at all-time record low yields. Recently, credit spreads are the lowest they’ve been since the Global Financial Crisis. Some of the riskier behaviours we saw in the run up to the GFC are starting to re-emerge in our markets now, so there are perhaps some signs of credit ‘bubbly’ behaviour coming back, with valuations no longer looking very attractive. While there doesn’t seem to be a great deal of value in corporate bonds, default rates remain exceptionally low. One development we have seen is that downgrades in US investment grade bonds have outweighed upgrades, and the biggest cohort of downgrades we saw in Q1 2021 included those that dropped from an A to BBB rating, so there haven’t been many fallen angels so far. However, the cohort that is most vulnerable to falling into high yield territory has now increased and is now the biggest cohort of corporate bonds.

Eric Lonergan, macro fund manager:

When reviewing the investment landscape and what has changed over the course of 2020, it’s worth thinking about the main features of markets and global economics before the pandemic, and what has changed – if anything.

In terms of the global economy, I see six defining pre-pandemic characteristics:

Firstly, there has been a secular decline in global real interest rates, with a decline in real interest rates below real GDP growth rates across most jurisdictions. While global GDP (including China) over 20-25 years has been relatively stable, there has been a huge decline in prevailing real interest rate structures. Secondly, financial markets have appeared to be more fragile in response to monetary policy than the real economy. The effects of monetary policy seem to be more market oriented than real economy oriented.

The third pre-pandemic feature was the collapse in the relationship between the unemployment rate and inflation, which rendered most cyclical economic models invalid. Prior to the pandemic, most major developed economies saw the lowest rates of unemployment since the 70s – and in some cases since the 60s – with policy rates still very low in nominal terms, inflation below target in most instances, and patchy recoveries in real wages.

The fourth characteristic was the huge sectoral and regional divergences in profits. If you compare the profitability of US banks in the 10 years post-Global Financial Crisis compared to Japanese or European banks, you can see completely different profit trends. Those geographic and sectoral divergences are very difficult for investors to identify ex ante.

The fifth feature was that we were in a world of repeated euro crises. Whenever there was fiscal divergence, usually triggered by populism and a rejection of European fiscal mandates, there was typically a threat to the bond market, and so the bond market actually acted as a regulator to European populists. And, lastly, the sixth characteristic was the fact that there was a trend of rising neo-nationalism globally.

With regard to pre-pandemic markets, there were four key features:

  • The increasing dominance of technology.
  • The rise in volatility targeting and momentum investing.
  • Flash crashes: If you move to quantitative technology-driven strategies, it correlates investor behaviour, and when you correlate investor behaviour you should get more bubbles and busts, purely within asset price behaviour.
  • A collapse in time horizons: Looking at market structure and behaviour, technology and the availability of data have driven people to even shorter time horizons.

So, what has changed post pandemic?

Not much, in my opinion. In fact, many of these features and trends have accelerated. On a global level, the only thing that appears to have materially changed is the attitude towards fiscal policy. However, the fundamental shift in policy and mindset is predominantly a US phenomenon. Not much has structurally changed in China and Europe. If anything, underlying tensions such as neo-nationalism coming out of China, which has been exercising its geopolitical and economic weight, will be strengthened. Europe’s structural weaknesses have deteriorated but in America, the current market narrative about inflation risks and paradigm shifts in terms of monetary and fiscal policy is broadly US-centric. This is a really important consideration when thinking about bond markets and global asset allocation.

There are three key developments in the US that have triggered this major American policy shift. One is the fact that Janet Yellen – now US Treasury secretary – used to run the Fed. She is acutely aware that conventional monetary policy is now pretty much futile and doesn’t deliver on the real economy in the time scales that are needed. As a result, it has to be fiscal policy. Again, this is a US phenomenon.

The second feature relates to former US president Donald Trump. Current president Joe Biden’s radicalism has to be seen in the context of Trump, who has played a big role in the drive towards neo-nationalism. He has absolutely terrified mainstream policymaking elites in America, and the fact that he brought them to the brink has meant that it’s no longer ‘business as usual’. As a result, policymakers are no longer taking risks in doing what they previously would have viewed as risky. So, the point is, if you don’t make policies sufficiently effective that they actually change people’s lives in a tangible and attributable way, your alternative is Trump. Those factors have dramatically shifted perceptions of the relative risks and role of fiscal policy.

Moreover, it has finally registered among the political class that real interest rate structures have collapsed. Janet Yellen understands the futility of monetary policy, and she is aware of the fact that you can probably drive US unemployment way lower than we ever thought possible before you get real wage growth. She is incredibly conscious that the livelihoods of Americans outside the top 10% of the population have to dramatically be perceived to have improved.

Ultimately, not much has changed in terms of how markets behave and the structural features of the global economy. When it comes to trends in neo-nationalism, declining real interest rate structures, financial market fragility in response to monetary policy, the fact that we can’t generate any inflation, and the phenomenal responsiveness of the supply side of the global economy – many of these features are still there. What I do think has changed is the perception of policy risks, and – specifically in America – the relative roles of fiscal policy. And we need to think about what the implications of that could be. With regard to Europe, I think the continent has doubled down on the preceding trends. Bear in mind that fiscal rules in Europe have just been suspended for another year or so. If nothing has changed after that, it is very difficult to see anything other than fiscal austerity, which would mean a huge reliance on monetary policy again.

Portfolio positioning

The landscape looks like it’s going to be lively and a lot could happen in the next 1-3 years, so flexibility is key. For example, this means having a material amount of cash, alongside a balanced portfolio of diversified global equities and 30-year Treasuries. If something major goes wrong, which precipitates a 15-20% decline in the equity market, I have a relatively high degree of confidence that in that sort of environment, Treasuries will do very well. I think they are now at a level, particularly at the long end of the yield curve, where they do provide some genuine diversification and insurance against anything, other than real interest rates and inflation in America. If something goes wrong, that’s your insurance policy. Similarly, if I look at global equities, when people focus on equity valuations it tends to be very US-centric. It’s hard to identify where earnings growth will come from. So, a mixture of diversified equities, 30-year Treasuries and cash is a strong portfolio against a very complex world, with the flexibility that if something does happen, you are able to rebalance or shift your portfolio in able to take advantage of opportunities.


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