Fixed Income Boutique
The already sweet climate for developed-market corporate bonds just got even sweeter. Indeed, Pfizer has announced that they, together with BIoNTech, are the first drugs-makers to achieve credible positive readings on the effectiveness of their Covid-19 vaccine trials. It appears that their new product can prevent 90% of infections, which is high for drugs in development. This is a watershed moment for science, humankind, and the economic recovery we projected in our previous article. In this piece, we re-iterate our positive stance for the corporate credit asset class as, in our view, the 2021 recovery is now cemented by the upcoming Pfizer BIoNTech Covid-19 vaccine.
Currently, companies are shoring up their balance sheets with cash, following much better than expected results during the second and third quarters. The better results also coincide with more positive revisions in one-year forward earnings expectations. We see this as continued evidence that we are transitioning through the cycle faster than anticipated with the recovery stage likely to be reached from the beginning of next year. The recovery stage should mature sometime later in 2021 with EBITDA and cash flow generation recovering more rapidly than anticipated. We can look through the macro weakness that Covid-19 has caused, thanks to adaptation by businesses, individuals and governments that have set the stage to keep businesses running. The fiscal packages that are on the way to be augmented in both the US and euro area should also ensure that our “swoosh-like” recovery gets completed with a return to pre-Covid levels by the fourth quarter of 2021 at the latest, in our view. We note that capital expenditure plans have continued to increase since this summer and this is another good indication that we should soon reach recovery from the repair stage.
The developed-market economies should also benefit from continued monetary support, even as they recover with good coordination amongst policymakers. What happened at Jackson Hole last August is of immense importance for the low rate environment and should ensure that the recovery takes hold now that a Covid-19 vaccine is on the immediate horizon. The recovery stage is generally the sweet spot for corporate bonds and credit spreads as corporates further increase cash flows, act for the benefit of bondholders and, in the end, reduce leverage. During such a stage, spreads typically tighten and we anticipate mid-yield spreads to continue to narrow further as they are not yet back to pre-crisis levels. The shifting drivers of market cycles from the repair stage are generally supportive for developed market corporates making the recovery sweet indeed, for those investors who choose to take part in it.
On to the US Federal Reserve and the dovish message from the Jackson Hole. The symposium also confirmed that the Fed is worried about the lack of inflation.
You may remember that last year Mr. Powell introduced the “three eras” of Monetary Policy in his speech, but lacked a label for the third era, which began in 2010. We suggested the term “Missingflation”, which is all the more appropriate today.
Indeed, at this years’ symposium, the Fed announced that it is pivoting its inflation strategy from a 2% forward-looking symmetric inflation target to targeting 2% inflation “on average over time”. The Fed believes that this will better articulate their inflation goal and will support better economic growth and job creation.
Their pursuit of average inflation at 2% means that the Fed plans to keep interest rates at zero until inflation reaches on average 2% and is sustained at that level for quite some years. Looking back at the past, their projections for “personal consumption expenditures inflation” had been below 2% since 2012, and one can imagine that the Fed will refrain from raising interest rates for quite some time, even if inflation overshoots above 2% for some years. By our count, there may not be any interest rate hikes forthcoming, thus keeping rates at the effective lower bound or zero in the US until 2024. This assumes that the recovery plateaus from 2022 with the Fed allowing inflation to overshoot above 2% for a couple of years to ensure that it is sustainable. Their notion of average inflation would allow for that now, especially as their inflation projections experienced periods of persistent undershoot since 2012.
These Fed developments are extremely positive for sentiment in developed corporate bond markets as they should support the recovery as it unfolds, in our view. It will also encourage investors to increase their credit allocations, as their mindset should move from perhaps doubting the recovery, to embracing it. The release of the successful trial readings for a Covid-19 vaccine now provides an additional dimension to the recovery, thus boosting demand for corporate bonds. As uncertainty diminishes, the hunt for yield should resume in a context of “lower forever” rates and an environment where fundamental credit risks have peaked.
The recovery is about credit improvements. Lower credit risk has started manifesting itself with credit rating changes stabilizing on the back of mitigating measures such as lower dividend payments, paused share buybacks, reduced M&A, as well as renewed cash flow generation. Therefore, we believe investors can use the sweet spot in developed market mid-yield bonds to produce returns.