Investment Highlights 2021
2Q Western Asset Fixed-Income Market
Key Takeaways US economic data was mixed over the second quarter as the employment data came in surprisingly weak while the inflation data came in surprising strong. The FOMC meeting in June resulted in projected rate hikes being pulled forward while the taper timeline remained unchanged. Yields were lower over the quarter as some of the exuberance around persistently strong growth and inflation has waned. Risk assets generally performed well.
Market Review US economic data surprised in both directions over the quarter with the rate hikes all the more striking was that forecasts for inflation in 2023 did employment data coming in surprisingly weak. Only 266,000 jobs were not change. The implication is that the current period of high inflation, added in April compared to expectations of approximately 1,000,000. rather than an expectation of higher inflation in the future, motivated the This was followed by a slightly better but still disappointing 550,000 jobs movement toward a tighter forecast policy. added in May. There were a number of reasons put forth to explain the disappointing jobs reports due to labor supply shortages. However, it could While forecasted rate hikes were pulled forward, the taper timeline was also be the case that matching one million plus workers with employers is not moved up. Instead, Federal Reserve (Fed) Chair Jerome Powell cau- quite difficult, especially if workers are changing industries or relocating. tioned that any decision on the Fed’s balance sheet was “still a ways off.” Restarting an economy takes time. The lack of movement on the balance sheet may be somewhat puzzling, especially given the hawkish shifts in the FOMC’s forecast for rate hikes. Inflation data, on the other hand, has been surprisingly strong. Two suc- The most likely reason for the disconnect is that if the labor market re- cessive months of above-consensus prints have taken core Consumer covery is going to take longer, then the timeline to taper asset purchases Price Index (CPI) inflation to 3.8% year-over-year (YoY), its highest level will also take longer. in nearly 30 years. However, the vast majority of recent monthly inflation increases have come from reopening activity, specifically hotel and airfare What to make of a meeting in which the FOMC appeared to have placed prices, as well as surging used car prices. Furthermore, a key reason for more emphasis on the upside surprises in inflation rather than on the the large YoY increases in inflation readings is due to base effects as the downside surprises in employment? One thought is that forecasts can 12-month growth rates began with severely depressed inflation a year shift meaningfully from quarter to quarter, especially in the current envi- ago. To adjust for this base effect, if we compare the May 2021 price level ronment of heightened uncertainty. One frequently discussed risk is that with the pre-Covid February 2020 level, the average annualized core CPI inflation could prove more persistent than expected. While the FOMC likely inflation over this 15-month period declines to 2.6%. If we further adjust discussed this risk, and that discussion perhaps influenced the forecasts, for surging used car prices, the core CPI excluding used cars over this it seems almost certain that other risks were discussed as well. Another 15-month period declines to approximately 1.9%, which is actually lower risk that may have been discussed is that the recent disappointments in on average over the Covid era than it was prior to Covid. Granted, other hiring could be the start of a jobless recovery (or, more specifically, the prices have seen increases lately, but for the most part, these represent risk that not as many jobs are recovered as were lost). Yet another risk may one-time rebounds back toward pre-Covid norms, not outbreaks above be that growth slows more than expected next year, following a truly pre-Covid inflation trends. unprecedented period of fiscal stimulus and reopening this year. Inves- tors are best served by focusing on these risks, rather than on the FOMC’s The discussion at the Federal Open Market Committee (FOMC) meeting forecasts, because ultimately the FOMC will be responsive to whatever in June likely centered on whether disappointing jobs or higher inflation happens. That is perhaps the most important takeaway from a day in was the more consequential development. The FOMC appeared to have which the forecasts shifted but the FOMC’s actual policies did not shift. decided that the inflation surprises were more important, at least for the moment, and the changes in the FOMC communications generally took Spreads for corporate credit and structured products over the quarter gen- on a more hawkish tone. The FOMC forecast for core Personal Consump- erally tightened, with high-yield credit outperforming. USD-denominated tion Expenditures (PCE) inflation in 2021 increased to 3.0% (up from 2.2% emerging market (EM) bond spreads tightened and EM local rates were in March). The median FOMC member also pulled forward their forecast little changed. The S&P 500 rose 8.2% and the 10-year US Treasury yield for the first rate hike, so that now the median participant expects two ended at 1.45% (from 1.74% in March). WTI oil rose $14/barrel (+24%) to hikes in 2023 (in March the median FOMC member forecast that the first $73.47 and the US dollar was mixed versus developed market (DM) cur- rate hike wouldn’t come until 2024). Making this movement in forecast rencies and generally weakened versus most EM currencies. Western Asset Fixed-Income Market
Outlook We expect that the second half of the year should see very strong global After the reopening bounce and as we look into next year, the uncertainty GDP growth as well as higher inflation as the world economy reopens on of what lies ahead will necessitate policy caution. Slowly rising long-term continued progress with the Covid vaccination rollout. Spread products core inflation rates, with a broadening economic recovery, is the objective. should be the main beneficiaries of this constructive fundamental outlook We believe that such a path is attainable. As the global economy reopens and should outperform sovereign bonds. Overweights in investment- supply chains will come back. The balance of supply and demand will no grade and “plain vanilla” high-yield have been reduced while increasing longer be one-sided. The secular challenges that have kept US growth and positions in reopening high-yield sectors, residential and commercial inflation to a moderate pace at best over the last several decades—the structured products, bank loans and EM bonds. stagnation of middle-class wages, aging demographics and rising global debt burdens—still remain in place. Fiscal policy globally will throttle back. Our assumption that all the lost ground can be made up, and the pre- Given this backdrop, we expect central banks will remain extraordinarily pandemic trend can be re-established in just a few years’ time, is inherently accommodative for the foreseeable future and that strategic portfolio optimistic—but by no means a foregone conclusion. Market expectations diversification will remain paramount. have jubilantly leapt ahead to a full recovery and a new permanently higher structural growth and inflation rate that would require precipitous Fed tightening. But that is a stretch given the current enormous economic slack, labor market scarring and the still-pervasive headwinds of debt and demographics.
Western Asset 2 Second Quarter 2021 Western Asset Fixed-Income Market
Risk Disclosures
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges. COVID-19 is the World Health Organization’s official designation of the current coronavirus disease. The Federal Reserve Board (“Fed”) is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices and a sustainable pattern of international trade and payments. Gross domestic product (GDP) is an economic statistic that measures the market value of all final goods and services produced within a country in a given period of time. Spread refers to the difference between Treasury securities and non-Treasury securities of similar maturity but different credit quality. U.S. Treasuries are direct debt obligations issued by the U.S. government and backed by its “full faith and credit.” The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Franklin Resources, Inc., its specialized investment managers, and its employees are not in the business of providing tax or legal advice to taxpayers. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penal- ties or complying with any applicable tax laws or regulations. Tax-related statements, if any, may have been written in connection with the promotion or marketing of the transaction(s) or matter(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor. Any information, statement or opinion set forth herein is general in nature, is not directed to or based on the financial situation or needs of any particular investor, and does not constitute, and should not be construed as, investment advice, forecast of future events, a guarantee of future results, or a recommendation with respect to any particular security or investment strategy or type of retirement account. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional. ©2021 Franklin Distributors, LLC. Member FINRA/SIPC. Western Asset Management Company, LLC and Franklin Distributors, LLC are Franklin Templeton affiliated companies.
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Western Asset 3 Second Quarter 2021