Insight Investment

Markets took an optimistic tone in the first quarter of 2021, with the vaccine rollout making solid progress, and hopes that a $1.9 trillion fiscal stimulus package could turbo-charge the economic recovery. In Israel and the UK, two of the countries most advanced in their vaccination programs, data showed a sharp decline in cases and hospitalizations, providing hope that the end of the crisis could be in sight. When we consider how focused minds have become on the anticipated economic recovery, we’re reminded of the famous quote from Scarlett O’Hara in Gone with the Wind: for markets – “tomorrow is another day”.

However, perhaps inevitably, shorter-term issues gained ascendency – Treasury yields leapt higher as a result of the more optimistic outlook, disrupting the upward momentum in risk assets. The impact was especially clear in segments of the equity market where valuations were arguably most stretched, with technology stocks taking the greatest pain.

Fed Chairman Jerome Powell appeared relatively relaxed about the move in yields, calling it a “statement of confidence” in the economic outlook. Despite this, market participants speculated that a further upward move in yields would likely be met with a new iteration of ‘Operation Twist’, where the Fed sold short-term Treasury Bills and used the proceeds to buy longer-maturity Treasuries. For now though, the Federal Open Markets Committee (FOMC) appears content to allow the yield curve to be anchored by a prolonged period of low interest rates, reiterating its plan to remain “patiently accommodative”. As we detail in more depth later in this publication, we believe it is far too soon to anticipate monetary tightening.

	Despite a more optimistic outlook, we believe it is much too soon to anticipate monetary tightening, with the low-yield environment likely to remain in place for some years yet. Underlying this view is the Fed’s adjusted interest rate policy framework, which we believe will result in a lower willingness to preemptively tighten policy.
	In pension news, the multi-employer pension bailout is likely to increase demand for investment grade credit, and the Department of Labor has announced that it will not be enforcing ESG rules until a review has taken place.
	In our solutions section, we examine the potential options for end-state planning, and why a self-managed solution may be more cost-effective than an insurance buy-in.
	Credit markets were supported by central bank purchases in 2020; we examine other technical factors that could become a support for credit markets in 2021.
	The $1.9 trillion American Rescue Plan should provide a significant boost to growth in the coming years and be underpinned by a $1.5 to $2 trillion infrastructure package. A turbo-charged recovery is likely to be highly supportive for risk assets.

Against a backdrop of volatile and rising yields, some investors may have found themselves considering their fixed income strategies. We would highlight that it is important for investors to be cognizant of the fact that the FOMC has significantly adjusted its interest rate policy framework, which will likely mean it has a very different reaction function in this new cycle relative to the historic norm.

Figure 1: Long-dated Treasury and credit yields moved upwards¹

In the past, the FOMC would start the tightening process well before the economy reached full employment as the Philips Curve model suggested that a rise in inflation would almost certainly follow a tightening labor market. However, from 2016 to 2019, unemployment fell below 4% without a meaningful acceleration in inflation, and the Fed’s pre-emptive rate hikes were, in hindsight, viewed as unnecessary.

There is now uncertainty regarding the actual level of full employment, which could potentially be an unemployment rate significantly lower than we had assumed just five years ago. This means that the FOMC is likely to wait until after inflation has already reached its 2% target before viewing interest rate rises as a necessity, as this is the only way the FOMC can be certain it is not prematurely slowing the economy.

Fed Chair, Jerome Powell, has re-emphasized that the Fed will be “patiently accommodative” to support a labor market that is weaker than the headline unemployment rate suggests. Around 10 million fewer Americans are working than before the crisis and, at 57.5%, the employment-to-population ratio is still lower than at any time since 1983. Unless there is an unexpected resurgence in inflation, the FOMC is likely to have few concerns about creating an overly tight labor market, because that will mean more Americans are able to participate in the economy.