APR Lazard Fixed Income Viewpoints 2021 6% and 7% as of April. A brighter outlook has indeed become TheViewpoints series gives investors Lazard’s perspectives “the base case,” as Powell noted. on the latest macroeconomic and fixed income news and trends. It reflects the views of the firm’s dedicated Our experts agreed that the biggest downside risk remains the specialists, who independently manage portfolios across the course of the COVID-19 pandemic as outbreaks continue around entire range of asset classes and sectors. the world. At their meeting this month, therefore, they focused on the right-tail, or upside, risk, which is hotly debated in the financial markets: Will the US economy grow so much and so Will the Economy Overheat? quickly in 2021 that it overheats, resulting in significantly higher After rising abruptly in February and March, US Treasury bond inflation and interest rates? yields had stabilized when Lazard’s fixed income professionals US: Money-Based Fear gathered in April for their monthly meeting. The pause was At the root of the concern over the US economy is the massive welcome and afforded our bond experts time to reexamine their amount of fiscal and monetary stimulus in the United States in expectations for 2021, especially for the United States. response to the pandemic over the past year. According to a US As Federal Reserve Chairman Jerome Powell noted in an interview bond portfolio manager, the result has been an “astronomical” in mid-April, the outlook has “brightened substantially.” With the rise in the money supply—specifically M2, which includes cash in passage of $1.9 trillion in fiscal stimulus in early March, another circulation as well as savings accounts under $100,000 and money $2.25 trillion in infrastructure and jobs spending proposed by market mutual funds. Indeed, M2 is at its highest level ever. Yet the Biden administration, and faster-than-expected progress bond yields are not offering investors much compensation for the on COVID-19 vaccinations in the United States, bond market risk of higher inflation. participants are trying to figure out just how high growth could Although the issue is widely debated in the United States, Lazard’s go. Forecasts for US GDP growth in 2021 have been continuously US fixed income specialists saw reasons why the economy may revised upward, from 4.5% in early January to anywhere between not overshoot this year despite the abundant money supply. First, HB30294 2 the velocity of M2 money has accelerated its downtrend, meaning 25%, which generated many multiple-notch credit downgrades. money simply does not have the same power to generate growth as Instead, awash in fiscal stimulus, state revenues were down only in the past. Previously, putting $1 into the system could eventually 1% last year, and some states will now run surpluses in the near create $8–$12 through lending, but when growth lingered at stall term, propelling the muni sector into a stable-to-upgrade credit speed for many years after the Global Financial Crisis, money lost environment. “From a fundamental perspective, things look great,” that power. Also, the pandemic has dealt such a blow to GDP and our muni specialist concluded. employment that economic overheating seems unlikely to Lazard’s All Eyes on Corporate Earnings US analysts; companies’ excess capacity remains very high, and anecdotal evidence from store closings and empty cruise ships to Corporate bond markets have also seen the glass as half-full lately. lack of business travel and waning demand for office space suggests Yield spreads in corporate bonds have returned to pre-pandemic to them that the recovery will take time. “We do not believe we are levels almost across the board. The lack of a comfortable spread just going back to 2019,” as one US specialist put it. “cushion” has increased the importance of underlying Treasury yield movements for corporate investors, however, and Lazard’s Still, the signals from the economy are confusing, our bond experts were awaiting clues on prospective growth through first- professionals conceded. The recession has been singular: “When quarter corporate earnings reports, which were set to begin shortly have you seen a recession in which incomes went up, house prices after this month’s fixed income meeting. went up, and people had $1,400 checks in their pockets?” an analyst asked. In addition, it will be difficult to get a true reading With spreads so tight, opportunities for above-market returns lie on US inflation over the next two-to-three months due to base in fundamental analysis, our analysts agreed—picking winners and effects—price increases will be high compared with the same losers and anticipating credit rating upgrades and downgrades. period last year when the economy essentially shut down due to After a record number of downgrades and outlook changes to the pandemic. Gauging how much costs are truly rising due to “negative” by the rating agencies in 2020, the corporate market, higher demand will be challenging until base effects diminish in too, has made an about-face this year, with the most upgrades the second half of this year, our bond teams pointed out. and changes to positive outlooks since 2013, our experts noted. Corporate defaults, which peaked at just over 8% last year, are now Lazard’s US experts anticipate that the US 10-year Treasury yield forecast to drop below 4%. “No one thought the market would will climb again this year, from its current range around 1.60% to come back this quickly,” an analyst added. 2%–2.25% as the recovery progresses. The “fear bids” lingering in the 10-year Treasury bond market should decline, they added, A few sectors have been left behind in the rally, however, including when investors gain more clarity on big unknowns like the aerospace and defense, leisure and travel, and real estate investment implications of Brexit, geopolitical tensions between the United trusts (REITs). The European high yield sector is also lagging due States and several countries, and the course of COVID-19 in to the recent lockdowns and slower-than-expected vaccine rollouts Europe, where lockdowns have been reinstated. there. In contrast to the Treasury bond market, the US municipal market US high yield bonds have returned about 1.5% year to date, in showed no real divergence in views: All systems were go. With line with the Lazard team’s forecast for a mid-single digit return federal support for state and local governments abundant, demand in 2021. Of note, the lower quality, CCC sector outperformed for munis up, and supply down, valuations were high—even significantly, with a 5.4% return. Several energy companies are “stretched,” as one muni bond professional noted. in this category, and the 23% rise in the price of West Texas Intermediate (WTI) crude oil so far this year was a big factor; Including the $1.9 trillion fiscal rescue package enacted last higher quality sectors also tend to be more sensitive to rising month, unprecedented total fiscal stimulus in excess of $5 trillion Treasury yields, which has damped their returns in 2021, our high should help keep muni bond issuers resilient over the next yield analyst added. two years, according to Lazard estimates, and the proposed $2 trillion-plus infrastructure and jobs plan would add even more Although high yield bond issuance set a record in March at $65 fiscal benefit to state coffers. There is also interest in reinstating billion, many bonds have been called over the past 12 months as Build America Bonds (BABs)—a federally subsidized taxable companies have refinanced, and demand has outpaced supply. bond program for muni issuers successfully used in 2009–2010. Many new deals have been three-to-five times oversubscribed, and Although the flexibility for issuers would be welcomed, BABs coupons that might have previously ranged from 5%–6% have may not even be needed with tax-exempt rates so low, our muni sunk below 3% in a few cases. “I never thought I’d see a coupon in specialist pointed out. the 2s,” a Lazard high yield expert commented. Since issuers have the upper hand, covenants on new issues have also become lighter The sunny outlook for munis is an about-face from a year ago and lighter. when, to assess the potential impact of the global pandemic, our municipal team stress-tested state revenues by dropping them 3 The strong demand could drive spreads somewhat tighter, but with The fate of emerging markets bonds denominated in domestic the current average high yield option-adjusted spread on the ICE currencies this year will depend mostly on currency valuations BofA US High Yield Index around 325 basis points (bps) and the against the US dollar. Despite US exceptionalism this year—in long-term average at 536 bps, there is also room for weakening if growth, vaccinations, and stimulus—the dollar has lagged its vaccine rollouts or stimulus programs hit any bumps. strong fundamentals somewhat, strengthening only about 2%. Emerging Markets: Currencies Leading the Way “The dollar is missing one piece: exceptional monetary policy response,” a Lazard currency analyst explained. Indeed, Fed Lazard’s emerging markets debt experts brought a different officials have said several times that the central bank will not raise perspective to the growth debate: When Treasury yields are interest rates until it sees actual evidence of sustainable, higher marching toward 2%, it is not the best time to dive into an inflation and continued improvement in unemployment numbers interest-rate sensitive asset class like emerging markets bonds. to pre-pandemic levels. In contrast, some emerging markets central They believe defense is the best course of action now because any banks are ready to fight inflation now; Brazil and Russia, for upside growth “surprises” in the US are most likely to happen over example, have already lifted rates.