Five Wild Cards for 2021
BOND MARKET INSIGHTS

Five Wild Cards for 2021

BlackRock’s Systematic Fixed Income experts examine the five “wild cards” that may determine the direction of markets in 2021, the outlook for alpha opportunities, and the new challenges facing traditional 60/40 portfolios.

2021: Moving from crisis management to recovery

2020 did not play by the typical rules that govern financial markets. Instead of the ebb and flow of the economic cycles we have become accustomed to, a global public health crisis forced activity to a standstill, sparking a sudden and deep economic crisis. Global governments, in an effort to triage the situation, took drastic measures to restart the catatonic state of economic activity through massive fiscal and monetary policy actions. Now with global economies returning to health, markets must grapple with navigating the shape of the recovery in 2021 and the potential long-term side effects that the emergency treatment steps will have on financial markets and portfolio construction.

Jeff Rosenberg: Hi, I'm Jeff Rosenberg of the Systematic Fixed Income group and senior portfolio manager for the systematic multi-strategy fund. Our five wildcards for the 2021 outlook highlight what we think are going to be some of the key issues facing investors in 2021.

Certainly, the first wild card for the 2021 outlook is the outlook for COVID and the outlook for the development of vaccines. We have seen significant positive developments and those developments have been reflected in rising valuations and collapsing uncertainty and volatility measures, particularly in the fixed income markets, returning to their pre COVID levels.

Now, recently we've seen rising interest rate uncertainty begin to boost some measures of interest rate volatility. But overall, when we look at valuations, they reflect a fair degree of optimism around the vaccine and the COVID outlook for 2021. For investors what this means is whether valuations already reflect the good news and whether surprises in some of our other wildcards is we're about to discuss may be a bigger issue for investors and valuations than the outlook for COVID in vaccines.

Our second key wild card for the 2021 Outlook is the outlook for fiscal policy. Last year in 2020, we had seen globally significant fiscal policy expansions to address some of the issues around the global COVID crisis. In 2021, particularly in the United States, we've seen significant changes on the political side usher in heightened expectations for significant fiscal policy.

The Democratic control of all branches of government at the federal level means the expectation and really the realization already of significant fiscal policy initiatives expected by markets to be delivered in 2021. This is a major change to the fiscal policy outlook, which for years has been one in which fiscal policy expectations were disappointed.

And monetary policy was left to be the only policy lever. The combination of both significant fiscal and monetary policy accommodation brings about the possibility of significant structural economic changes that financial markets are grappling with. Hence, this makes it one of our key wild cards for the 2021 outlook.

The COVID crisis brought about historic levels of monetary policy support to help to address both the financial market and the real economy impact from the COVID crisis. In 2021, with the addition of the significance of fiscal policy support, the market is beginning to question whether or not such degree of monetary policy will be necessary. And the exit from the significant monetary policy remains a significant question going forward.

One of the ways in which we see that as how fed policy through the expansion of its balance sheet has been a significant purchaser and support for the treasury issuance that funds, that fiscal policy support.

And as the Fed pulls back, we've already seen the market implication in the form of higher interest rates and steeper curves. Will the Fed be able to avoid the last time it dealt with exits from significant policy support during the global financial crisis in what market participants often called the taper tantrum too remains one of the key wildcards for the 2021 outlook.

While those and the rest of our five wild cards for 2021 describe the outlook for the direction of markets in 2021, equally in our investment process, we focus on returns from alpha or idiosyncratic risk. The outlook for alpha is linked critically to the outlook for the dispersion in market prices.

Think of dispersion as the difference between winners and losers in 2020, the COVID crisis brought about epic historic levels of differences between winners and losers in the equity and in the credit markets. And while we see that we've come down off of those peak levels, we still see an elevated level of differentiation in the markets as we navigate the post COVID environment. This leads to an expectation of sill elevated opportunity set for the delivering of alpha in these micro credit and equity universes.

The post COVID world also poses significant challenges for portfolio construction in the typical 60/40 portfolio construction context, we look at the challenges, this post COVID world places on the fixed income side of the equation.

Rising interest rates, normalization of term, inflation, and real interest rate premia, all posts, good challenges to the return outlook for fixed income in the context of still historic low levels of interest rates. In this world, we look at alternative portfolio construction and alternative forms of diversifiers and suggest a few ways investors can look to modify their portfolios for the post COVID environment.

You can hear more about our outlook, the key wildcards that we see for 2021, the outlook for dispersion and alpha, and our take on portfolio construction challenges in a post COVID world below.

Jeff Rosenberg: Hi, I'm Jeff Rosenberg of the Systematic Fixed Income group and senior portfolio manager for the systematic multi-strategy fund. Our five wildcards for the 2021 outlook highlight what we think are going to be some of the key issues facing investors in 2021.

Certainly, the first wild card for the 2021 outlook is the outlook for COVID and the outlook for the development of vaccines. We have seen significant positive developments and those developments have been reflected in rising valuations and collapsing uncertainty and volatility measures, particularly in the fixed income markets, returning to their pre COVID levels.

Now, recently we've seen rising interest rate uncertainty begin to boost some measures of interest rate volatility. But overall, when we look at valuations, they reflect a fair degree of optimism around the vaccine and the COVID outlook for 2021. For investors what this means is whether valuations already reflect the good news and whether surprises in some of our other wildcards is we're about to discuss may be a bigger issue for investors and valuations than the outlook for COVID in vaccines.

Our second key wild card for the 2021 Outlook is the outlook for fiscal policy. Last year in 2020, we had seen globally significant fiscal policy expansions to address some of the issues around the global COVID crisis. In 2021, particularly in the United States, we've seen significant changes on the political side usher in heightened expectations for significant fiscal policy.

The Democratic control of all branches of government at the federal level means the expectation and really the realization already of significant fiscal policy initiatives expected by markets to be delivered in 2021. This is a major change to the fiscal policy outlook, which for years has been one in which fiscal policy expectations were disappointed.

And monetary policy was left to be the only policy lever. The combination of both significant fiscal and monetary policy accommodation brings about the possibility of significant structural economic changes that financial markets are grappling with. Hence, this makes it one of our key wild cards for the 2021 outlook.

The COVID crisis brought about historic levels of monetary policy support to help to address both the financial market and the real economy impact from the COVID crisis. In 2021, with the addition of the significance of fiscal policy support, the market is beginning to question whether or not such degree of monetary policy will be necessary. And the exit from the significant monetary policy remains a significant question going forward.

One of the ways in which we see that as how fed policy through the expansion of its balance sheet has been a significant purchaser and support for the treasury issuance that funds, that fiscal policy support.

And as the Fed pulls back, we've already seen the market implication in the form of higher interest rates and steeper curves. Will the Fed be able to avoid the last time it dealt with exits from significant policy support during the global financial crisis in what market participants often called the taper tantrum too remains one of the key wildcards for the 2021 outlook.

While those and the rest of our five wild cards for 2021 describe the outlook for the direction of markets in 2021, equally in our investment process, we focus on returns from alpha or idiosyncratic risk. The outlook for alpha is linked critically to the outlook for the dispersion in market prices.

Think of dispersion as the difference between winners and losers in 2020, the COVID crisis brought about epic historic levels of differences between winners and losers in the equity and in the credit markets. And while we see that we've come down off of those peak levels, we still see an elevated level of differentiation in the markets as we navigate the post COVID environment. This leads to an expectation of sill elevated opportunity set for the delivering of alpha in these micro credit and equity universes.

The post COVID world also poses significant challenges for portfolio construction in the typical 60/40 portfolio construction context, we look at the challenges, this post COVID world places on the fixed income side of the equation.

Rising interest rates, normalization of term, inflation, and real interest rate premia, all posts, good challenges to the return outlook for fixed income in the context of still historic low levels of interest rates. In this world, we look at alternative portfolio construction and alternative forms of diversifiers and suggest a few ways investors can look to modify their portfolios for the post COVID environment.

You can hear more about our outlook, the key wildcards that we see for 2021, the outlook for dispersion and alpha, and our take on portfolio construction challenges in a post COVID world below.

Five Wild Cards for 2021

As 2021 begins, many important questions are top of mind for investors. Are lofty valuations and low volatility too optimistic given the timeline for a full vaccination roll out? Will fiscal policy meet the market’s high expectations, or will unintended consequences undermine market enthusiasm? Can Central Banks carefully pull back on the unprecedented level of support or is another Taper Tantrum in the cards? Will ballooning government debts matter to markets? And finally, will massive stimulus overheat the economy?

Vaccinations

Vaccinations

Bloomberg, as of January 2021. Equity, rate, and credit volatility measured by the CBOE VIX Index, Merrill Lynch MOVE Index, and ICE BofA HY OAS Index, respectively. 

Breaking bad (or good)?

The approval of multiple COVID vaccines was a key driver of markets in the last quarter of 2020 as their eventual rollout provides a light at the end of the tunnel for the global health crisis.

But how much of the benefits of vaccinations are already priced in? While equity volatility is still elevated versus pre-COVID levels, both rate and credit volatility have reached pre-COVID lows.

Given tight levels of risk compensation and low measures of fear, investors may come to question their current risk-on positioning.

Fiscal Policy

Fiscal Policy

Refinitiv Datastream, as of January 2021. Based on the annual change in the government structural balance as a share of GDP in percentage points.

Brave new world?

Global governments jumped into action in 2020 by injecting historic levels of fiscal stimulus into their economies.

In 2021, a renewed hope for more fiscal support around the world is boosting expectations for growth.

Given the larger political dependencies of fiscal policy, that means a larger contribution to market uncertainty from political dynamics and relatively less from monetary authorities.

 

Monetary Policy

Monetary Policy

Refinitiv Datastream, as of January 2021. Fed purchases calculated as the 12-month change in Treasury holdings.

Taper Tantrum II?

2020 was also a year of rewriting the rule (and record) book for the Fed in terms of monetary policy and growing balance sheets.

Central banks today purchase most of the net government debt issuance, helping to hold down the interest rate costs governments face.

How and when the Fed can pull back from that support without creating uncertainty or materially shocking interest rates will be one of the key communication challenges for them in 2021 and beyond.

Government Debt

Government Debt

Congressional Budget Office, as of December 2020.

How much is too much?

The fiscal boost provided by governments is funded by debt and 2020 was an expensive year as total U.S. debt obligations now stand at over 100% of GDP—the highest level since World War II.

The combination of growing GDP while restraining the interest costs to government debt can help restore debt sustainability, but it comes at the cost of wealth transference between debtors and savers.

While the debt may not have a sudden or immediate impact on the direction of markets in 2021, there are significant long-term implications.

Inflation

Inflation

BlackRock Investment Institute and IMF, using data from Haver Analytics, January 2021. Note: Orange bars show the discretionary fiscal boost following the GFC and COVID shocks. The GFC measure is captured by the change in the cyclically adjusted budget deficit in 2008 and 2009 calculated by the IMF, and for the COVID shock we use broker estimates of discretionary fiscal measures explicitly introduced in response to COVID for 2020-21. The yellow bars show total government borrowing in the two years following each shock, 2008-09 for the GFC and 2020-21 for the COVID shock using estimates from the IMF World Economic Outlook, October 2020. The pink bars show the cumulative loss in GDP vs a pre-shock trend.

Is it time to get real about inflation?

An unprecedented amount of fiscal stimulus has been pumped into the U.S. economy. While this could help speed a recovery short-term, the long-term effects are unknown.

Compared to the fiscal response to the Global Financial Crisis, the response to COVID has been much greater versus the loss of GDP thus far. Could too much stimulus accidentally overheat the economy?

Excess stimulus, coupled with an eventual reopening of the economy and more discretionary spending by consumers, may start to have real implications on inflation.

Tapping into market “dispersion” not direction

Dispersion is the difference in returns across companies. High dispersion implies a wide difference between winners and losers, while low dispersion implies a narrow difference between winners and losers. We have found that dispersion levels tend to be the most elevated during volatility, especially among levered companies.

Importantly, because dispersion is independent of market direction, if captured effectively, it can provide an uncorrelated and diversifying source of return to a portfolio. In 2021, we see a greater opportunity for higher dispersion than in years past, something that investors may want to consider as an alternative source of return versus market direction alone.

 

Dispersion

BlackRock, CBOE, S&P Indices, Bloomberg, as of February 2021. “Highly levered companies” represented by the top decile of companies in the Russell 1000 Index based on their level of leverage.

Rethinking portfolio construction in a post-COVID world

A protracted period of low long-term interest rates means bonds may offer both lower returns and less equity diversification potential than before. During recessions, the 10-year Treasury yield drops about 300bps on average. With rates so low now, there is simply less room to fall. Going forward, bonds may not provide the same level of ballast against equity downturns. Investors may need to think beyond 60/40 portfolios and look for alternative forms of diversification.

 

Post-COVID world

BlackRock, Bloomberg as of February 2021. U.S. recession periods are defined by National Bureau of Economic Research. Graph displays U.S. 10-year Treasury yield rate changes during recession periods. 10-year Treasury change reflects the biggest move seen from as early as six months before the recession period.

Jeffrey Rosenberg
Jeffrey Rosenberg
Sr. Portfolio Manager, Systematic Fixed Income
Jeffrey Rosenberg, CFA, Managing Director, leads active and factor investments for mutual funds, institutional portfolios and ETFs within BlackRock's Systematic Fixed ...
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