Accelerants of growth: Fiscal spend and policy

A Q&A with Rick Rieder

Q: What is your outlook for 2022 for your asset class?

In our view, demand for fixed income will continue to exceed expectations, generally holding yields in check at higher levels than we have been used to over the past couple of years amid historically high inflation, but when the dust settles, we’ll see real rates that are still at historically low levels. That’s partly because corporate pension funds are sitting on the highest average funding status in almost two decades, prompting a reallocation out of risky assets and into risk-free securities, like long duration Treasury bonds. At the same time, nominal growth is also the highest it has been in decades, driven by an immense stock of liquidity, meaning risky spreads can stay well contained for longer since corporate default fears can be kept at bay due to rising earnings.

We think the Bloomberg-Barclays U.S. Aggregate Index, a hybrid of both risk-free and risky assets, should rightfully back up in 2022, in sympathy with strong growth, which we’ve already started to see early this year. So, it’s hard to see a promising return coming from this index in 2022. Still, with both risk-free yields and risky spreads staying relatively contained, due to other supporting factors, it’s also hard to see investors suffering a crippling loss in this broad index. So, we’re still optimistic about an astute investor’s ability to generate a positive return in fixed income, despite the Aggregate index likely not straying too far from flat, but it’s going to require a well-calibrated, and active, approach and the ability to engage market segments beyond those included in the index.

Q: How will fiscal policy and focused spending in the U.S. (can acknowledge other countries as well) impact markets and drive growth, and what are some of the knock-on effects (i.e., inflation, tightening labor markets, debt levels, etc.)?

As my colleague Bob Miller has recently argued, new fiscal policy support may no longer be likely, but in our view the probability of fiscal tightening in the next three years is near zero. That places the burden of refining policy on the Federal Reserve, and policy normalization in 2022 will be in the context of a second consecutive year of impressive nominal GDP growth (see graph below), making the composition of that growth, namely the quantities and prices components, of critical importance for investors.

Expectations for nominal growth in 2022 are historically high

The supply of labor will determine the evolution of the labor market, rather than demand. Conservatively, assuming 200k-400k monthly nonfarm payroll gains over the course of 2022, wage growth that is in-line with that of the last 12 months, and no change in hours worked, we would witness an aggregate income gain for the labor force of about 7% over the course of 2022. And remarkably, in that event aggregate income would have grown by more than 14% since the pandemic began in February 2020. Yet this also means that about three million people will need to be added to the labor force – an effective “passing of the income baton” from fiscal stimulus to wages, a process that is well underway. While the numbers are volatile, non-seasonally adjusted payroll data suggests that more than a half million employees are being added to payrolls each month in 2021, which would likely be even stronger absent supply constraints.

While we are seeing early signs of moderation on supply-chain stresses, economic velocity is now gaining support from increased commercial and industrial lending, and consumer lending, which can keep upward pressure on prices for several more months. Our projection is for Core PCE inflation to ultimately migrate back to the 2.5% to 3.5% range by year-end, as commodity prices plateau near these elevated levels and as many of the logistical bottlenecks loosen up. However, we are preparing for more headline-grabbing inflation data points that could send the media, and some traders, into a tailspin. Moreover, there’s also clearly some inflation-stickiness from persistently higher wages and a corporate sector that is in the luxurious position of being able to raise prices almost at will.  

Q: How do you expect fiscal spend and monetary policy forecasts to impact your remit, both from a tactical & a long term perspective? Tactically, where is the market mispricing risk?

Very important to 2022’s market path is how the Fed responds in the months ahead, especially in the face of these potentially uncomfortable inflation readings. The Fed’s policy response to the pandemic was heroic, and their ongoing accommodation has been instrumental in enabling the real economy to withstand waves of new Covid variants. But with real-economy confidence now sufficiently restored, the Fed needs to migrate monetary policy back toward neutral; before pausing to determine if more restrictive monetary policy is required. In our view, one of the market’s riskiest blind spots for this year will be navigating portfolio allocation changes as the Fed evolves its policy stance. Historically speaking, in terms of monetary policy, “tightening,” or “over-tightening,” was about corralling excessive credit growth (demand that was fueled by credit). However, today’s conditions are precisely the opposite: U.S. consumers have been paying down credit for a decade. There has been very little credit growth, much less excessive growth, largely due to an influx of cash via pandemic stimulus measures (indeed, there is about $2.5 trillion of excess savings on consumer balance sheets right now).

From our perspective, the Fed’s policy toolkit should consist of rate hikes as well as some reduction in the central bank’s balance sheet. On rates, targeting the pre-Covid level of 1.50% as an initial destination seems prudent, with the mantra of ‘data dependence’ setting a high hurdle to adjust to either more accommodative, or restrictive, levels. We subscribe the economic theories that policy “works with long and variable lags,” and that inflation itself tends to be a lagging indicator. With that perspective, we support the Fed setting a course to an achievable resting place as a good first step on this policy journey.

The velocity of money is set to bounce from historic, pandemic-induced lows

The modern history of US M2 Velocity

Stepping back from the policy path, we think the real economy has some tangible momentum behind it.  Indeed, we think M2 velocity is set to bounce sharply from its lowest level in history (see graph above), buoyed by still strong sentiment in both the real and financial economies. In fact, the equation of exchange suggests that a small mean-reversion in velocity, in light of the recent large increase in the monetary base, can create gaudy nominal growth outcomes over time. The return of velocity may have already begun as October was the first post-Covid month without any new excess savings (but cumulative savings remain around $2.5 trillion), and after an anemic 18 months for consumer and real estate loan growth, a $1.6 trillion gap in bank lending has developed. Therefore, there is ample space for credit creation to pick up the growth baton once QE ends in 2022, in our view.

In short, the Fed operates on top of the most dynamic, and self-correcting, economy in the history of the world. Cushioning the system is critical when a major shock occurs (e.g., a historic and unpredictable global pandemic), but otherwise, the Fed’s stated destination of price, market and economic stability is probably best reached by operating with policy stability, while allowing the vibrant, innovative and flexible U.S. economy to recalibrate organically.

Q3: Which asset classes and sectors are best positioned to benefit from the investment in new technology and energy infrastructures underpinning the net-zero transition?

While global growth will be robust, parts of the tech sector are set to grow exponentially over the next decade. Virtual reality, augmented reality, and the metaverse are going to be concepts that we hear more and more about, and in which early investors will likely be rewarded. Technology continues to permeate the healthcare industry too: medical investment is set to soar in a post-Covid world.

Last but not least, as you asked about energy infrastructure in the context of the net-zero transition, this is going to be an important secular investment theme and we’re undoubtedly going to continue to get weather events to reinforce that theme. In our view, staying in front of these structural forces is imperative, but especially in the equity segment of the capital structure Ever evolving climate-focused policy initiatives will continue to play a very large role in dictating where investment dollars are allocated, with a significant feedback to how and where prices are set, and profits are earned.

Q: What are your top positioning ideas heading into 2022?

Given our view that the Aggregate index is likely to end the year in moderately negative territory, we think it’s important to be able to engage market segments beyond those included in the index, including those below investment grade. More specifically, some of the yields available in U.S. and European credit sectors are not terribly far from being able to reach that 3% to 5% target, especially if one is willing to dip into high yield segments. Further, emerging markets yields are even higher, but emerging markets positions need to be sized appropriately, given their volatility. And while Emerging Markets were best avoided last year (excluding China), the proactive increases in policy rates from EM central banks to fend off inflation have now created an attractive opportunity set of real rates to buy in 2022, albeit with patience and tactical entry points needed as noise from Fed tightening can cloud the vision here.

And as markets have evolved over the past month, we now see more decent value in the short-to-belly segment of the U.S. Treasury market, where tightened policy is fairly priced, and yields offer some protection against downside for the first time since the onset of Covid. Of course, we must remain aware of the potential for an overly aggressive Fed to overshoot, which could press these yields still moderately higher. Additionally, the very back-end of the Treasury curve, while it can be a more volatile trading vehicle, nevertheless can provide a decent entry point today to defease liabilities for long-term managers.

Bank loans can also perform well with a strong economy and modestly higher rates. And bespoke securitized assets in commercial real estate, consumer credit and CLOs should round out investors’ fixed income portfolios, with meaningful support from vibrant economic cash flows and an enormous pool of cash that needs attractive returns in a still low-yielding world.

The liquidity injections of 2020-21 underpin a sticky high growth rate, or the “g” variable in the terminal value equation. As a result, organic growth in 2022 will be enough for equity markets to post a decent return for the fourth consecutive year, but as mentioned likely a lower return than the exceptional performance of the last few years. Still, too many market participants are solely focused on inflation, but if there’s a 1970s parallel that’s useful today, it’s how extreme policy actions can influence market returns for a long time (see graph below). In 1980, a high discount rate made the risk-free rate a superior investment for years afterward, and in 2022, the liquidity injections of the last two years will likely keep growth, and asset prices, high for several years hence.