Back to the future – finally.

Q1 2021 Global Fixed Income Outlook.

    Franklin Templeton Fixed Income

    PREVIEW

    The past year has been one for the history books. The COVID-19 pandemic triggered an unprecedented sudden shutdown of economies across the world, with widespread restrictions on social activities and travel of a kind we have not seen in many decades. As if this was not enough, we have seen massive protests and social unrest in the United States and other countries, what was probably the most contentious and polarized US presidential election in recent history, and the formal exit of the United Kingdom from the European Union (EU). A very difficult year for most people, and a highly challenging one for investors.

    As we enter into 2021, we have reasons for cautious optimism, but we should not let our guard down. We have a good shot at getting our economies – and our lives – back on track. In many ways, 2020 felt like a trip back in history: scared by the virus, we retreated into extreme social isolation, much like in the plague-ridden fourteenth century. After a long year of tribulations, it looks like next year we might be able to go back to the future, finally. But it will take some more hard work.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    Pharmaceutical companies have now developed three COVID-19 vaccines with surprisingly high efficacy rates (over 90%). Link:Franklin Templeton—Gallup Economics of Recovery Study Link:Franklin Templeton—Gallup Economics of Recovery Study Link:Our Franklin Templeton—Gallup Economics of Recovery Study1 identified a safe and effective vaccine as the single most powerful factor that could lead Americans to resume normal economic habits; the gradual deployment of vaccines should therefore boost confidence and accelerate the economic recovery in the United States and elsewhere. Already in 2020, the first stage of the global economic recovery has proved as strong as we had expected and more, with the rebound in spending and manufacturing and corresponding decline in unemployment exceeding most analysts’ expectations. Timely and monumental monetary and fiscal aid have helped support the economy, and consumers in particular. Policymakers have made it clear they will continue to provide policy support in 2021 and possibly beyond. On the political front, the US elections are now behind us; while control of the Senate will only be determined with two runoffs in the state of Georgia in January, the likelihood of major tax and regulatory changes that could have an adverse impact on economic activity appears lower. The prospect of lower policy uncertainty, continued monetary and fiscal support, and better containment of the virus can be seen in the buoyant performance of equity indexes.

    FIRST STAGE OF GLOBAL ECONOMIC RECOVERY HAS BEEN STRONGExhibit 1: QUARTERLY GDP (% Change, Quarter-over-Quarter) / Q4’2018—Q3’2020

    Source: OECD Quarterly National Accounts.

    We will face a number of headwinds and risks, however. First: even with a vaccine, it will take time to defeat COVID-19. Our joint study with Gallup has shown that only between one-third and one-half of Americans would be ready to take a vaccine, with various studies in other countries confirming this trend is not limited to the United States.

    If low vaccine acceptance slows the pace at which societies can achieve immunity, we might face new recurring economic shutdowns, prolonging uncertainty and economic stress for businesses and households. Even with policy support, this would drive more businesses into bankruptcy and turn more temporary job losses into permanent unemployment, with severe adverse impact on long-term growth prospects. Meanwhile, prolonged school closures are disproportionately damaging to lower-income and younger students, curtailing both their lifetime earning prospects and the country’s productivity and potential growth.

    Governments that can accelerate the deployment and uptake of vaccines, and correspondingly accelerate the phasing out of restrictions to economic activity, will not only experience a faster and stronger recovery but also enjoy much more robust long-term economic growth prospects. Providing better information to the public in an objective and transparent manner will play a very important role in impacting attitudes and behavior, as the results of our Franklin Templeton—Gallup Economics of Recovery Study have shown. Misinformation and uncertainty depress consumption and investment.

    Overall, our base-case scenario is cautiously optimistic about the macroeconomic environment and the prospects for an economic rebound in the year ahead. We expect central bank and fiscal authorities will remain extraordinarily accommodative, increased savings rates and pent-up demand will continue to drive consumer strength, vaccine deployments will bolster consumer confidence, and the US business environment will not suffer major adverse impact from domestic policy changes. In this baseline scenario, once the recovery is entrenched and COVID-19 has been brought under control, attention will need to shift to the medium- and longer-term uncertainties seeded by this extraordinary period, including the possibility of an inflation pick-up as activity accelerates, with the attendant impact on yields and high debt levels.

    For investors, 2021 promises to be another challenging year, and not only because of the persisting uncertainties highlighted above. Valuations are a concern across risk assets, as the market does not seem priced for this level of uncertainty. And prices across most asset classes seem to assume that extremely low interest rates and massive policy support will persist indefinitely even as they successfully boost economic growth. In this environment, picking the right sectors and assets is more important than ever.

    Fixed income continues to play a highly valuable role in investor portfolios as a source of income and a diversifier, as well as a historically lower volatility asset than equities. However, we believe an active investment strategy is crucial at this stage. There is not a single asset that is unilaterally a buy right now, in our view. More than ever, selectivity by country, by sector, by asset class, and within asset classes by industry and individual companies is required. The importance of thoughtful, skilled bottom-up research cannot be emphasized enough in the current environment.

    We think the most interesting opportunities are in fixed income assets that provide more attractive yield pickup without taking on too much duration in this environment of extremely low interest rates. Against this background of elevated uncertainty and risks, the biggest opportunities lie in active credit selection to pick the sectors and individual names with the soundest fundamentals in a market that is now rising rather indiscriminately.

    We recommend investors keep a liquid pool of assets that can be deployed when opportunities arise. We believe, as there has been wholesale buying of sectors, there will also be indiscriminate selling on market weakness. Buying opportunities will arise in such an environment. As we look into 2021, we believe it will be challenging, but it could be equally rewarding for investors.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

    Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

    ENDNOTES

    1. Franklin Templeton-Gallup Economics of Recovery Study. Results from this study are based on self-administered web surveys from an opt-in sample provided by Dynata of 5,002 US adults, aged 18 or older. For details about how Dynata recruits respondents in the United States, please see http://info.dynata.com/rs/105-ZDT-791/images/Dynata_Panel%20Book_2.19.pdf. The survey was conducted between July and October, 2020.