Fixed income 2021
Unfix your thinking.
The onset of the coronavirus pandemic was a brutal stress test for society, financial markets, and employment. Throughout last year and to the current day, all attention has been on the pandemic, as it both overshadowed and accelerated a structural change.
For several years now, we have highlighted that 5G and connectivity would change the world, bringing with it a prolonged period of lower rates. The pandemic gave a turbo boost to this connectivity trend.
At the beginning of last year, we believed 5G would change the industrial world, because there would be more connectivity between devices and machines. But what we saw in 2020 was a different kind of connectivity, not device-to-machine, but device-to-device. Indeed, it was a brutal stress test as, from one day to the next, we were cut off from friends, loved ones, and our colleagues – we were told to stay home and work from home.
As humans, we are quite resilient and we bounce back – and we did bounce back by overcoming these new challenges. The fact that we were physically cut off from people pushed us to reconnect, and we did this through the use of connecting apps, which became the big thing. Today, we use these connecting apps to talk to each other; now it’s Zoom, Dreams, WebEx, Skype, etc. This is device-to-device connectivity, and 5G makes it possible.
On one side, this connectivity bounce back of ours was beneficial – we still got to connect with other people. However, on the other side, many started working from home but sadly, many went home without a job. For example, jobs in the hospitality sector were decimated. So, we believe, these apps are not just convenient toys, they represent a business process that actually replaces routine jobs. For example, the jobs numbers in the US paint a grim picture of this ongoing job destruction – right now there is a 10-million-job deficit in the US and it will not be clawed back easily. Certainly, the old jobs will not be replaced with the same jobs.
The chart below shows the US employment market going all the way back to the 1980s. As is evident on the right of the chart, the corona crisis caused jobs across the board to collapse. But if we look back in history at how jobs recovered after a recession, we can glean an important lesson.
After the 2008 financial crisis, we see that service-sector jobs declined, but then, they never really recovered. Now, with the corona crisis and our transition to using apps rather than face-to-face services, we do not expect there will be a significant recovery in the service sector. Why go to the shop to get advice and buy new headphones, when you can just press the smartphone screen a few times to find expert advice, search for the best price and then have the product delivered to our door? Each step in this now-typical sales process is deflationary. As technology continues to advance and replace routine jobs, it would not be surprising for such jobs, and particularly the human element in these service functions, to cease to exist post the pandemic. And unfortunately, although the coder behind the shopping app and the blogger behind the expert headphone review site may be highly paid, their skills can scale across millions of transactions, meaning that the market’s spending power reduces.
This trend of job polarization puts consumer-spending power under pressure as slack labor markets plus reduced consumption mean that inflation drivers remain scarce, requiring continued low rates (potentially even forever) to keep economies working. In other words, central banks will need to continue their bond buying programs for a very long time.
The Fed is acutely aware of this 10-million-job deficit in the US and therefore, has made the commitment to keep rates low until at least the end of 2023 / beginning of 2024. However, this is not a one-to-two year thing. The digital revolution is structural and, therefore, the employment-deficit problem is going to take a very long time to solve.
The Fed is not alone: central banks across the world face the same challenges. They have a big task on their hands and they will try to keep yields low to keep the economy ticking and inflation will be kept in check due to the disinflationary nature of digitalization and 5G connectivity.
So, how can bond investors profit from this, if yields remain so low? We think it’s not all bad news as this environment provides an excellent opportunity to earn carry, making corporate credit a viable choice for bond investors.
In fact, multiple factors support corporate credit spreads. We are on the recovery path with monetary and fiscal policy supporting the economy, and central banks and governments remain keen to sustain the growth path.
The changes we have discussed here are structural and they will keep rates low for a very long time. We have to think in eras, and an era is 25-to-30 years because this is the fourth stage of the industrial revolution (digitalisation). Investors require returns and they are in need of steady coupon income. As long as we believe that corporates are sustainable, which we do, we are comfortable with the risk and the attractiveness of our asset class. There are indeed pockets of value in the markets for many credits, which active investors can and should take advantage of. There are still good credit spreads to enjoy in this low rate environment, and corporate bonds, we believe, should continue to offer positive carry returns for many years to come.