2021 - System Health Check...Source: CBO, IMF Given the fragile structure of capital markets coming...

Fixed Income Macro View

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2021 - System Health Check

Rubrics Fixed Income Macro View January 2021

Underlying Illness

2020 began with an abundance of monetary

support. The Fed’s U-turn on rates in late

2018, coupled with the resumption of QE in

the wake of the Q4 ‘19 repo market problem,

created a backdrop of loose financial

conditions. Such extreme action, however, was

not suggestive of a stable financial system. The

situation on the ground was also challenging as

a large proportion of workers had barely enough

savings to last more than a few weeks and had

to rely heavily on government support when

Covid hit. Despite one of the longest economic

expansions in history, the US fiscal deficit

topped $1 trillion at the end of 2019. Not exactly

a healthy starting position for 2020. In hindsight

therefore, it was not surprising to see century-

long norms smashed in response to the

pandemic as fiscal and monetary authorities

worked side by side. Unlike 2008 however, it

was the power of the fiscal rather than monetary

that stimulus shielded the real economy from the

worst of the Covid shutdowns.

Capital markets also required emergency

treatment. Highly leveraged corporations

couldn’t survive even a few weeks of revenue

outages, while larger businesses were kept alive

by government grants, loans and salary

protection programmes combined with easy

access to capital markets. Corporate issuers

aggressively sought cheap money to ride out the

pandemic and keep creditors at bay – the recent

spate of covenant-lite bond issues no doubt

helped in this regard. While the swift and

decisive action of central banks (in particular the

Fed) did much to prevent the collapse of the

credit markets, many businesses might have

been expected to cope with what at the time

was predicted to be a short hit to business

activity. The fact that they weren’t, we believe,

is in part due to the moral hazard that resulted

from a decade-long period of cheap credit.

15

17

19

21

23

25

27

29

31

33

35

Fed Balance Sheet as % GDP

38

43

48

53

58

63

ECB Balance Sheet as % GDP

95

100

105

110

115

120

125

130

135

140

BOJ Balance Sheet as % GDP

20

22

24

26

28

30

32

34

BOE Balance Sheet as % GDP

Central Bank Balance Sheets as % GDP

US Revenue and Spending

Source: Bloomberg as at 31/12/20

Source: CBO as at 30/09/2020

2

0%

5%

10%

15%

20%

25%

30%

35%US Revenue and Spending (% GDP)

Spending Revenue

Rubrics Fixed Income Macro View

Origins of the Disease

With central banks desperate to kick start an

inflation cycle in the post 2008 period, capital

markets became dangerously reliant on low

interest rates and Quantitative Easing.

Corporates swapped debt for equity (buybacks)

and market liquidity became ‘transaction light.’

Against this central banks promised under their

new ‘macro prudential’ regimes we couldn’t

experience another 2008. With the banking

sector de-risked, the low interest rates that led to

the subprime crisis would not have the same

systemic impact this time around. In reality what

transpired was a transferal of risk from the

banking sector to the shadow banking/asset

management industry. Money flowed

precipitously into mutual funds, ETFs and private

equity vehicles, while secondary market liquidity

declined equally as sharply. In essence, a

financial system considerably more unstable

than that of 2008.

Throughout this period stock prices soared by over

400%, in stark contrast to the 56% growth in sales

revenues, as an ever growing supply of money

searched for a home - no matter how risky. The

inexorable rise in equity valuations and the

associated build up of low paid gig workers only

served to reinforce the view of the authorities of

the great work they were doing.

Once highly rated businesses like Boeing,

AT&T and McDonalds went from being low risk

operations in 2010 to highly leveraged entities

by 2020, issuing $ billions in debt to buy back

stock and pay dividends. Monetary policy had

created the ideal environment for corporates to

engineer a wealth transfer to management and

shareholders at the expense of underlying

business investment. It was no surprise when the

crisis came that so many companies were heavily

exposed to the negative news flow.

January 2021

Equity Market vs Corporate Profits

Share Buybacks vs Change in Corporate Debt



3

-

10

20

30

40

50

60

70

80

90

100

20%

22%

24%

26%

28%

30%

32%

34%

36%

38%

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

Jan

-11

Jan

-12

Jan

-13

Jan

-14

Jan

-15

Jan

-16

Jan

-17

Jan

-18

Jan

-19

Jan

-20

Share buybacks funded by corporate debt

Corp Debt as % GDP

S&P 500 Buybacks per share RH

0

100

200

300

400

500

600

700

800

900

1000S&P 500 vs US Corporate Profits

S&P 500 US Corporate Profits Revenue Per Share

see it as the ideal ‘goldilocks’ environment for

asset prices.

In respect of the global rehabilitation however,

the easy part is behind us. The nuanced nature

of the so called K-shape recovery will be far

more difficult to manage than the initial

phase of direct emergency money provision.

Ensuring temporary measures don’t become

permanent (as QE and negative real interest

rates have become) will be a Herculean task. As

with the pre-Covid economy, the post-Covid

edition will have many more challenges, not

least the added political dimension that fiscal

policy entails not to mention deteriorating

demographic and climate outlook.

Government spending will be of critical

importance, even more so than monetary policy

in stabilising future crises. In this regard,

markets will become as concerned with fiscal

developments as they have been with monetary

policy over the last decade.


Source: CBO, IMF

Given the fragile structure of capital markets

coming into the pandemic, the nature of the

response from central banks and governments

needed to be seismic. The Fed’s foray into direct

corporate bond and ETF purchases along with

the many corporate bailouts that followed,

assuredly fit the description. But yet again we

find ourselves asking at what cost? Central

bankers have once more been hailed as heroes,

with few questioning the role that monetary

policy played in destabilising the capital markets

in the first place. With each crisis comes an

exponential increase in the scale of required

stimulus and a sequential decline in subsequent

trend growth.

Can we really believe that a return to the old

playbook of bailouts, stimulus and rate cuts

is somehow the lasting solution and not the

root of the problem itself?

Post-Op Recovery

2021 is expected to bring an exit from the

pandemic and with it an economic recovery.

With a ‘wall of money’ set to be unleashed on

the global economy and central banks

continuing to keep the foot on the peddle, many

January 2021

US Fiscal Deficit – Historical & Projected

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

19

29

19

32

19

35

19

38

19

41

19

44

19

47

19

50

19

53

19

56

19

59

19

62

19

65

19

68

19

71

19

74

19

77

19

80

19

83

19

86

19

89

19

92

19

95

19

98

20

01

20

04

20

07

20

10

20

13

20

16

20

19

20

22

20

25

US Fiscal Deficit % GDP

IMF Projection

-5.9%

(1983)

-29.6%

(1943)

-3.4%

(2004)

-9.8%

(2009)

-17.9%

(2020)

4


The evolution of the market mindset from bullish

to euphoric is complete, with mania now setting

in. The questions of liquidity verses solvency,

low rates or higher inflation, a weak or strong

dollar will determine what happens throughout

2021. The reality is that fiscal support has

made any difficult questions irrelevant to

most market participants - analytical rigour is

no longer required. At stages throughout 2021,

the consensus will get challenged as the health

crisis begins to subside and policy makers have

far more difficult questions to answer.

Over the following pages we list some of the

biggest risks we feel are facing the global

economy and financial markets in 2021. In doing

so, we wish to highlight the contrast between the

current levels of bullish market sentiment and

the fundamental backdrop supposedly

underpinning it. This is not to say each and

every one represents an imminent systemic

threat, but rather should provide cause for

consideration in the context of current market

valuations.

Risk Factors

Banking Troubles – Much of the support given

to the economy has once again favoured big

companies over small ones. Businesses reliant

on bank funding have seen a significant

tightening of lending standards and government

loan programmes have frequently been

unsuccessful. In spite of the scale of current

monetary support, concerns remain over banks’

ability to provide sufficient liquidity to the real

economy – including China, Europe and the US.

Economic Transformation – The pandemic

has, in a matter of months, heralded a level of

digital transformation that would have otherwise

taken years. The cost of this has been clear in

the level of worker displacement that has

occurred. Retail is an obvious example of this,

where in the UK over 25,000 jobs were lost in

December from the bankruptcy of two major

brands. Many who have lost jobs may not easily

find new employment and it is only when the

furlough programmes end that we will begin to

understand the true extent of the damage.

-

2

4

6

8

10

12

14

16

-40

-20

0

20

40

60

80

100 Tightening Lending Standards

Bank Loan Officer Survey - Net % Tightening Lending Standards for C&I Loans to Large/MediumBusiness

US HY Spreads

Looser

Tighter


Bank Lending Standards vs Credit Spreads

5

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

Jan

-17

Mar

-17

May

-17

Jul-

17

Sep

-17

No

v-1

7

Jan

-18

Mar

-18

May

-18

Jul-

18

Sep

-18

No

v-1

8

Jan

-19

Mar

-19

May

-19

Jul-

19

Sep

-19

No

v-1

9

Jan

-20

Mar

-20

May

-20

Jul-

20

Sep

-20

No

v-2

0

Jan

-21

Bitcoin



Lasting Pandemic – The welcome arrival of

vaccines has created a market wide expectation

that Covid will soon disappear from our lives.

Most of the medical profession would disagree.

Plenty of challenges remain around the virus

itself and the vaccine rollout that mean it will

likely take longer than expected to arrive at the

‘new normal’. Covid will continue to have a

major input into how 2021 plays out.

Valuations – On any valuation metric, most

asset classes look beyond stretched. As with

previous boom periods, revenues are rarely the

main driver, but rather low rates at which to

discount future cashflows. The slightest rise in

interest rates would therefore quickly undermine

elevated valuations. If you are concerned about

bonds then you really ought to be very worried

about interest rate sensitive tech stocks. The

analysts understand revenues might not explode

higher, just like the last cycle, and are betting

heavily that costs stay rock bottom. This means

limited space for wage hikes or workforce

expansion.

At such extremes, anything that changes the

bullish sentiment about valuations could have

grave consequences.

Zombification – A number of businesses today

who could (and perhaps should) have folded

before the pandemic have been given a new

lease of life with yet more bailout money. None

of which will make these operations any more

profitable. 20% of US companies are currently

considered “zombies”, ironically the same

number which significantly dampened Japanese

output potential since the 1990s. The upshot is

that any initial jump in economic activity post

pandemic might well be short lived with trend

growth declining to a structurally lower sub 2%

level. The constant provision of cheap money

that undermined the previous cycle, will likely

perpetuate for the next number of years absent

some form of ‘creative destruction’ that can help

cleanse the system.

$7,000bn

$9,000bn

$11,000bn

$13,000bn

$15,000bn

$17,000bn

$19,000bn

$21,000bn

$23,000bn

$25,000bn

$1,000bn

$2,000bn

$3,000bn

$4,000bn

$5,000bn

$6,000bn

$7,000bn

$8,000bn

Central Bank Balance Sheets vs Top 5 Tech Stocks

Big 5 Tech Stocks (LHS) G3 CB Balance Sheets (RHS)

Central Bank Balance Sheets vs Big Tech

Corporate Debt vs Credit Spreads


6


2

4

6

8

10

12

14

16

18

38%

40%

42%

44%

46%

48%

50%

52%

54%

56%

58% HY OAS vs Corp. Debt to GDP

Corp. Debt to GDP (LHS)

HY OAS (RHS)

Lack of Investment – Throughout the last cycle,

the amount of corporate investment barely

covered the level of depreciation, and when it

did, it was as a direct result of specific fiscal

incentives like those of 2005 or 2017. Supported

by accommodative monetary policy,

management teams favoured share buybacks

over investing in the riskier real economy –

ultimately impairing long term growth and

increasing corporate leverage. Absent a

realignment of incentives away from financial

engineering and towards real domestic

investment, any above trend growth will remain

short-lived.

Government Spending – There has been

much talk in economic circles of a ‘great reset’ –

principally involving a significant increase in

government spending. As is already evident,

government spending will be needed to plug the

hole that the private sector has left behind.

However what many fail to acknowledge is that

public sector activity is no longer insignificant.

The UK for example is predicted to borrow in

excess of £400billion over the period of the

pandemic – just for context in 2006 the UK

national debt was less then £500billion. 2021/22

spending is expected to stay at an unsustainable

8.5% of GDP. Many countries are already on a

similar path. Without new forms of revenue

governments will struggle to continue to provide

the level of support that is anticipated by many.

The fiscal belt will most likely need to tighten in

2021, something the market has yet to factor in.

US State Bankruptcy – The chief headwind

faced by the Obama administration was the lack

of support given to individual states. States

which are mass employers of teachers, firemen,

policeman, construction workers etc have a

major impact on national growth figures. The

scale of the unemployment benefits throughout

the pandemic has brought many close to

bankruptcy. While the Federal Reserve has

facilitated low cost borrowing, additional cheap

debt might not be enough as the crisis rolls.


7

US State Budget Shortfalls ($bln)

-$60

-$105 -$110

-$60

-300

-250

-200

-150

-100

-50

0

2002 2003 2004 2005

2001 Recession

-$130

-$230

-$150-$120

-$60

2009 2010 2011 2012 2013

2008/09

-$105

-$290

-$105

2020 2021 2022

COVID-19

Source: CBPP

US Federal Government Expenditures

Source: FRED


Source: Federal Reserve Bank of St Louis 30/11/20

January 2021

Inequality – The uneven nature of the post

pandemic recovery is causing even greater

levels of inequality. Despite what aggregate cash

holdings/savings may suggest, millions will be

left unemployed in the coming year, many of

whom do not have the crutch of the S&P 500 to

rely on. As critical a role as asset bubbles have

played in aiding consumption for the asset

owners, trend growth and personal incomes

have not kept up. 25% of Americans are now

considered food insecure while 50% don’t have

3 month’s rent in savings. The recent pandemic

pay-outs have helped but they are not a long

term solution. Inequality will have a big impact

on the durability of the recovery we will see in

2021.

Wealth Redistribution – Governments will need

to find new ways to continue to support their

spending and infrastructure plans. In the UK a

5% wealth tax has been discussed, while in the

US a host of other programmes including

changes to Trumps’ inheritances and corporate

.

tax breaks have been touted. Might 2021 be the

year when we take our first steps towards a re-

distribution? Top earners may be expected to

pay a greater contribution either directly through

income or indirectly through the stocks that they

own. The latter in particular would not be

welcomed by Wall St.

Wall of Cash – Much of the optimism around the

recovery is currently derived from the ‘wall of

cash’ that is supposedly waiting to go into the

real economy. Two critical questions come to

mind. 1) where has this cash come from and 2)

how likely is it to find its way into the real

economy. In response to the first, a combination

of fiscal transfers, drawn down credit lines and

the proceeds of large scale debt issuance make

up the bulk of the cash. In addition, there has

been a large movement of capital away from

long term savings accounts into checking

facilities – perhaps a pre-emptive move due to

concerns over Biden’s wealth and inheritance

tax plans.

Inequality of Income growth

% Household Wealth by generation

8

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

Increase in Wealth by Income Percentile

Top1% 40-60% 20-40% 0-20%

-

10

20

30

40

50

60Generational Wealth Distribution

Millennial

BabyBoom

GenX

Source: Federal Reserve as at 30/09/2020

Source: Federal Reserve as at 30/09/2020

As with the bank lending activity, much of the

above is derived from concern over the future

and is very much at odds with the prevailing

market bullishness. This brings us to the second

question. In our view it is likely that a lot of this

cash will need to be set aside for mortgage and

rent repayments in Q2. Certain corporates

meanwhile will probably use some of this cash to

repay emergency debt raised over the

pandemic, some will double down on share

buybacks, and yet others may be somewhat

more conservative given the challenging outlook.

The bottom line is that a vast majority of this

cash ultimately belongs to a select number of

corporations and individuals – much of it having

accumulated since the pandemic. These

entities/individuals will not have a high marginal

propensity to consume. While aggregate cash

balances may look impressive on the surface,

the extent to which they can fuel a consumption

boom in excess of a few quarters is highly

questionable in our view.



January 2021

.Final Prognosis

In stark contrast to the health outlook, the

financial markets have never felt better. The

rapid response of the authorities has left little in

the way of visible scarring on market sentiment.

The flip side of this is that there has so far been

little in the way of ‘creative destruction’ that

would typically result from recessionary periods.

Any talk of a system rebirth is therefore wide of

the mark. Post the 2008 crisis, central banks

looked to clean up the banking system with

robust regulation. Will they look to do the same

with the asset management industry this time

around? Or will their focus remain on existing

concerns (e.g fee levels, ESG), assuredly

important, but not addressing the more

fundamental financial stability issue. Indeed

what is required now is an incredibly

delicate balancing act – any overheating

would clearly spell trouble while a

deflationary re-lapse would be even more

damaging.

-500

0

500

1000

1500

2000

2500

3000

-2000

-1000

0

1000

2000

3000

4000

5000

6000

Dec

-10

May

-11

Oct

-11

Mar

-12

Au

g-1

2

Jan

-13

Jun

-13

No

v-1

3

Ap

r-1

4

Sep

-14

Feb

-15

Jul-

15

Dec

-15

May

-16

Oct

-16

Mar

-17

Au

g-1

7

Jan

-18

Jun

-18

No

v-1

8

Ap

r-1

9

Sep

-19

Feb

-20

Jul-

20

Personal Income vs Savings Rate

US Personal Savings ($bln) US Personal Income ($bln) RH

Savings Rates and Personal Income

Declining Real Yields and Bond Fund Flows

-1.5

-1

-0.5

0

0.5

1

1.5-300,000

-200,000

-100,000

0

100,000

200,000

300,000

400,000US Real Yields vs Bond Fund Flows

ICI Total Bond Flows (3m Rolling Changes LH)

US 10Yr Real Yields (RH Inverted)

Decline in real yields has

encouraged increase in

asset flows – and kept

spreads contained


9


Source: Federal Reserve Bank of St Louis 30/11/20

January 2021

.

The two factors most relevant for the markets

today is the much publicised dollar demise and

the return of inflation. Both of which are joined at

the hip. Many believe it is higher inflation that will

drag the USD lower. History however disagrees.

It won’t be asset purchases in themselves that

will cause the great inflationary turn, but rather

the fate of underlying currencies. Inflation is no

friend to these over-leveraged markets, no

matter what the strategists say. Higher rates will

thwart many aspects of the current recovery

from government deficits, to house prices and

equity valuations.

The world can no longer grow out of its debt

problems or simply inflate them away. The fallout

in terms of economic and political chaos would

be too great. The likes of Fed Chair Powell and

the centrist president-elect Biden must surely

recognise the precarious position of both the

economy and financial markets. For this reason

they will pull back from the brink sooner than the

markets may be expecting.

2021 might not end up been the quite the year

the markets are expecting. A slow Covid

restricted start, strong middle and a return to the

mean at the end is our best guess. However

there are sharks at every turn. Strategists are

already preparing headlines of the ‘greatest

asset market of all time’ – just like they all did in

2018. When will the markets pay the piper for

the decade of largesse? Will it be because of the

rise in inflation, bond vigilantes, or the dollar’s

demise? Or will it be something unforeseen?

The global economy is rooted between a rock

and a hard place with no easy exits. A great

deal of optimism now surrounds the Democratic

Senate victory, as confirmation of recent

reflationary moves. This increases the likelihood

that fiscal will take over from monetary policy in

respect of driving the recovery. However the

potential pullback in monetary support will likely

trump what fiscal can do in our view. Prioritising

a bottom up approach might well result in a

different outcome for the markets this time

around.


Price to Sales Ratio at all time highs

0

5

10

15

20

25

30

Jan

-01

Sep

-01

May-…

Jan

-03

Sep

-03

May-…

Jan

-05

Sep

-05

May-…

Jan

-07

Sep

-07

May-…

Jan

-09

Sep

-09

May-…

Jan

-11

Sep

-11

May-…

Jan

-13

Sep

-13

May-…

Jan

-15

Sep

-15

May-…

Jan

-17

Sep

-17

May-…

Jan

-19

Sep

-19

May-…

US M2 Money Supply (YoY % Growth)

US M2 Money Supply Explosion


10

-

0.5

1.0

1.5

2.0

2.5

3.0

Jan

-00

Jan

-01

Jan

-02

Jan

-03

Jan

-04

Jan

-05

Jan

-06

Jan

-07

Jan

-08

Jan

-09

Jan

-10

Jan

-11

Jan

-12

Jan

-13

Jan

-14

Jan

-15

Jan

-16

Jan

-17

Jan

-18

Jan

-19

Jan

-20

S&P 500 Price to Sales Ratio

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January 2021

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Date post:	08-Mar-2021
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