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February 25, 2021 | GSAM Connect

Pause for an Inflation and Policy Real-ity Check

Real yields have recently trended higher, albeit from low levels. For investors, the driver behind the rise is important. If higher real yields reflect an improved growth outlook (due to additional US fiscal stimulus and encouraging vaccine progress), the impact on risk assets such as corporate credit and emerging market debt will likely be limited. If, however, the shift in real yields is driven by expectations for less accommodative monetary policy, the environment could turn less supportive for risk assets. Do we think global rates will trend higher this year? Yes; given prospects for further sizeable US fiscal stimulus and vaccine-driven growth improvements1. Do we think central banks will take their foot off the ‘accommodative policy’ pedal? No; we think central banks will remain on easy policy auto-pilot through 2021 and beyond because the underlying inflation reality is set to remain subdued (due to labor market slack) and given a more tolerant approach to higher inflation outcomes (informed by prior inflation shortfalls and an increased focus on economic inequalities by policymakers)2. As a result, our compass for navigating the ‘status low’, as discussed here, is unchanged. If anything, recent rate market volatility strengthens our resolve in the need for balanced exposure to risk assets, and we remain focused on seeking to ensure our clients' fixed income portfolios are resilient to tail risks such as rate market volatility and policy speculation3.

 

  • Near-term Inflation Turbulence. We expect volatility in near-term inflation readings for several reasons. First, annual inflation rates are poised to rebound following weakness in activity and oil prices in 2020. Second, certain policy measures—such as VAT rate cuts—will be reversed. Third, we will likely observe price pressures in virus-sensitive sectors including restaurants and entertainment venues as economies
    re-open, though we expect these pressures to prove temporary given limits to pent-up demand for certain services. For example, an initial surge in demand for haircuts will swiftly subside as we are unlikely to visit a salon several times consecutively to compensate for visits forgone last year. In addition, some shifts in consumer behavior during the pandemic may prove permanent; the ability to order meals from a broader array of venues to our front doors—akin to an at-home ‘room service’—may curb cravings for regular restaurant visits.

  • Weak Underlying Reality. Once the impact of the factors outlined above subsides, we think the underlying inflation reality will remain subdued given slack in the economy, and in particular the labor market. Relative to a year earlier, the US unemployment rate is 2.8% higher and the labor force participation rate is 2% lower4. US Federal Reserve (Fed) Chair Jerome Powell recently highlighted that US employment in January 2021 was almost 10 million below its February 2020 level. He also noted that correcting for a reduction in those looking for work due to the pandemic (for reasons such as health concerns and virtual schooling responsibilities) would lift the unemployment rate from 6.3% reported in January to close to 10%5. In Europe, there was considerable labor market slack pre-covid and youth unemployment rates have moved even higher into double-digit territory, while 13% of UK employments are still furloughed2.

  • This is Not a Textbook Economy. Inflation is challenging to predict at the best of times, let alone as we emerge from a global pandemic. During the last expansion, inflation remained puzzlingly low even as the economy and labor market recovered6. This led to a belief that the slope of the Phillips curve—a measure of the responsiveness of inflation to a decline in labor market slack—had flattened. One explanation for this may be that the national unemployment rate is not an effective measure of slack. This is one factor behind the Fed’s new focus on a “broad-based and inclusive” set of measures when taking the temperature of the labor market. Although the deflationary impact of technology has been modest in recent years7, as discussed previously, disinflationary trends such as e-commerce penetration and automation have been reinforced and accelerated by the pandemic. On the opposing side of the inflation debate is a view that post-pandemic fiscal policy will remain loose given policymaker focus on building a greener and fairer economy. In the US, we think discussion around structural, largely infrastructural-related spending will gain traction once pandemic-related spending has been delivered, though the reflationary impulse will depend on the extent to which additional stimulus is accompanied by higher taxes. Somewhat paradoxically, the build-out of green infrastructure will initially support commodity prices, including carbon-intensive energy sources, though central banks tend to focus on core prices and look beyond commodity price volatility. All of this is to say, the medium- to long-term destination for inflation remains highly uncertain and is subject to several structural shifts with little precedent in traditional economic theories1.

  • The Five Point Answer to the $1.9 trillion Question. A key question concerning US President Biden’s $1.9 trillion covid relief proposal—and expansionary macro policies in general—is whether the magnitude is excessive and therefore risks overheating the economy as pent-up consumer spending is unleashed, similar to the “roaring 20s” following World War I and the 1918 flu pandemic. Whilst we recognize the formidable size of the proposed US Phase 5 fiscal stimulus, we think there are five things to consider when assessing the impact on growth and inflation:
  1. We expect a slightly smaller Phase 5 package to be delivered, amounting to $1.7 trillion.
  2. The growth impact of support for state and local governments will likely be spread over several years.
  3. Some large components of the package such as support for businesses are likely to have a fiscal multiplier less than one.
  4. Certain measures such as unemployment benefits will decline over time as the labor market recovers.
  5. A proposed $1,400 stimulus check may not be spent in full by every household. In the fourth quarter, 7% of US households and 41% of those with student loans were skipping or making delayed repayments. Some of the stimulus check may therefore be saved in anticipation of future debt repayments as forbearance programs draw to a close.

  • A Strengthening Social Agenda. Even as economy-wide data improves, widening income and societal inequalities have raised the bar for policy normalization, especially if annual inflation is below or close to central bank targets (typically 2%). Fed Governor Lael Brainard—who may succeed Chair Powell when his four-year term ends in February 2022—recently said “lifting the lives of working people is at the heart of economic policymaking,” underscoring the rising prominence of social considerations in the central banker community. The phenomenon of inequality extends beyond discrete data which may explain why central banks have expanded their datasets in recent years to include qualitative insights from open-ended dialogues with the public8. Findings from the “Fed Listens” initiative are often quoted in Fed official speeches9, with policymakers highlighting ‘easy policy for longer’ can deliver faster wage growth for low income earners and narrow the gap between the unemployment rate for Black and white workers. Similarly, the “European Central Bank Listens Portal” indicates a significant number of respondents believe the central bank should take a more active role in objectives such as fighting poverty and inequality10.

  • Balance Equals Resilience. Our base case expectation is for central banks to remain on easy policy auto-pilot through 2021 (and likely beyond) due to a weak underlying inflation reality (informed by labor market slack) and given a more tolerant approach to higher inflation outcomes (which is a function of prior inflation shortfalls and increased focus on economic inequalities). Whilst we expect policy rates to remain low, we do anticipate discussion around reduced asset purchases to gain momentum toward the end of the year, providing financial conditions have stabilized and the growth recovery is underway. As a result, we expect a moderate rise in government bond yields in the coming months, with potential for further steepening of the US yield curve between 5- and 10-year maturities. Recent real rate volatility demonstrates that there will always be tail risks to navigate in financial markets, as we have observed in recent years with trade tensions and the global pandemic. We expect more volatility ahead as markets adjust to economy re-openings, incoming inflation data and central banker commentary, among other things. That said, our compass for navigating the ‘status low’ environment, as discussed here, is unchanged. Importantly, this past year has strengthened our resolve in the importance of balanced fixed income portfolios that are resilient to tail risks. We achieve this by combining risk asset exposures with suitable hedges including rates and currencies, or some combination of both.

 

 

The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved.  Please see additional disclosures at the end of this presentation.

See the Federal Reserve Bank of New York Economic Inequality Research Series.

3 The portfolio risk management process includes an effort to monitor and manage risk, but does not imply low risk.

Source: Macrobond. Data releases as of January 2021. US Labor Force Participation Rate for Women & Men aged 16 Years & Over.

5 See “Getting Back to a Strong Labor Market” (Chair Jerome H. Powell, February 10, 2021).

6 See remarks by current US Treasury Secretary, then Fed Chair Janet Yellen: What’s (not) up with inflation?.

7 In 2017, the presence of online retailers subtracted an estimated 0.25% from US core goods inflation and 0.1% from core personal consumption expenditures (PCE) inflation, the Fed’s preferred measure. Source: Goldman Sachs Global Investment Research, The Amazon Effect in Perspective (September 30, 2017).

8 See the Fed Review of Monetary Policy Strategy, Tools, and Communications – Fed Listens

9 For example, see “Full Employment in the New Monetary Policy Framework” (Governor Lael Brainard, January 13, 2021) and “Getting Back to a Strong Labor Market” (Chair Jerome H. Powell, February 10, 2021).

10 See ECB Listens – Summary report. Many respondents also believe the ECB could contribute to a shift towards a greener economy through a variety of measures including facilitating green investment, supporting the fiscal policies needed for the transition through reducing investment in polluting activities, taking climate criteria into account in the ECB’s refinancing operations, integrating climate-related risks in models and steering banks’ behavior to fund environmentally friendly companies.

 

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