Opportunities for bonds in a post-COVID world
2020 was a year of immense change with the effects of the global pandemic and widespread lockdowns felt on a global scale: jobs were lost, incomes were affected, and company profits were slashed.
With hopes that a vaccine-led recovery will allow more businesses to reopen and recover and economies to repair, we look forward to a positive 2021 and 2022 outlook.
There are sectors that will continue to experience growth in the short, medium, and longer-term despite negative short-term impact because of their resilience and innovation during the pandemic.
As corporate profits rebound, and support measures from governments and central banks continue to be implemented, we anticipate the outlook for growth prospects is bullish, and in the immediate term, these could be some of the strongest growth years since before the Global Financial Crisis (GFC).
GLOBAL GROWTH OUTLOOK
We believe there are a number of positive trends supporting a strong recovery in economy:
Improvements in employment: As the vaccination rollout continues and COVID-19 case numbers decline, we expect the reopening of economic activity to lead to labor sector recovery, with job growth shifting higher and unemployment rates gradually trending lower as labor force participation increases.
Sharp rebound in spending: One of the trends we are seeing is the rubber band snapping back in goods and services consumption. The pent-up demand in pandemic-sensitive sectors of the economy should provide a significant boost to demand.
For example, healthcare, one of the most sizable service sectors accounted for about 17% of the US gross domestic product (GDP) pre-COVID, was set back substantially due to COVID-19. A return to a normal level of healthcare spending will add jobs and boost the US economy quickly and meaningfully. In addition, we expect stronger consumption in certain sectors like travel, given that consumer savings have stayed elevated through the crisis. That said it is not only service that will experience strength from consumption – we also see good consumption retaining its strength as many of the structural shift in consumption as a result of COVID-19 remain in place.
A range of recent data indicate that corporations are spending as well with recent data reflecting upside surprises for example in US producer prices, Japan’s fourth-quarter GDP, machinery orders and Tankan manufacturing sentiment, and South Korea’s exports.
Strong fiscal stimulus: In the US, President Biden has recently signed the $1.9 trillion American Rescue Plan Act which includes relief measures ranging from stimulus checks to child tax credits, jobless benefits to vaccine-distribution funds, healthcare subsidies to restaurant aid. Similarly, governments around the world have been introducing strong stimulus to boost economies. COVID-19 has brought about a change in fiscal attitudes and we are potentially entering a new era where governments are more willing and able to take greater responsibility for growth through fiscal programmes.
Accommodative monetary policies: On the monetary policy front, actions by the Federal Reserve, European Central Bank, Bank of Japan and others helped avoid worst-case scenarios by maintaining liquidity and financial stability in a time of crisis. We expect monetary policies to remain accommodative.
OPPORTUNITIES IN CORPORATE BONDS
With the early-cycle mix of low interest rates and ongoing support from both monetary and fiscal policy, combined with the release of pent-up demand from consumers and manufacturers, we believe the economic backdrop is supporting higher corporate earnings, stronger balance sheets and lower credit risks. Therefore, we see pockets of opportunity in different sectors of corporate bonds.
Firstly, we believe corporations that were beneficiaries of the trends that emerged during COVID-19 will continue to be supported by strong tailwind. Examples of these include media, technology, and financial issuers that have fortified their operations in response to COVID-19. Many of them have experienced growth through COVID-19 with very solid fundamentals.
We also believe there are opportunities in some of the sectors that faced short term headwinds from COVID-19 but continue to show signs of strong secular growth.
An example of this is the leisure sector, in particular airlines and cruise ships. The pandemic has had a temporary impact on this sector’s clientele and as the global economy opens back up, we anticipate these industries and sectors returning closer to normality. In these sectors we are focused on market leaders operating sizeable and large scale businesses that have already survived the initial lockdowns last year, have demonstrated an ability to raise capital in periods of stress and maintain a viable business models that will have little maturity walls to refinancing in the future. Furthermore, many of these companies maintain liquidity on balance sheet (~12-24 months).
For investors looking for yield, it’s important to separate the short-term pain from COVID-19 from the bigger question of where industries and companies have been permanently or temporarily disrupted. In our view, the market tendency to ignore or misprice individual issuer prospects should allow active managers to find opportunities and enhance potential for portfolio income.
POTENTIAL RISKS
One of the identifiable tail risks is the vaccination rollout which will enable a gradual return to more service sector consumption trends of the past. While there is risk, we believe it’s relatively small and don’t assign a high probability to this scenario but it bears monitoring. It will also be important to monitor consumption patterns – what is the consumption balance between goods and services in the post COVID-19 economy and what are the implication this has for growth and inflation?
Another risk is a premature tightening of financial conditions from monetary policy authorities. We would also ascribe this as a tail probability given the new average inflation targeting regime that the Fed is operating under and their expressed desire to facilitate a rebuilding of inflationary expectations and a stronger labour market.
Lastly, inflation bears monitoring given the backdrop of unprecedently strong stimulus and extraordinary monetary easing coupled with strong growth.
So be cautious on owning longer maturity, longer duration, in particular government bonds, but also spread sectors like high grade corporate bonds that trade tight to government bond markets where any back up in nominal yields can create a negative total return experience given starting credit margin, or credit spread over those risk-free curves.
We believe there are attractive opportunities today in selective segments of the corporate bond markets that offer durable income with minimal duration risks. Investors should be playing relative value within credit to take advantage of some of the opportunities within the markets and keep to a shorter overall duration profile in their portfolios.
Adam Grotzinger is senior portfolio manager at Neuberger Berman.
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