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Patrick O’Toole, vice-president, global fixed income, CIBC Asset Management.
When looking at the outlook for the fixed-income sector as the economy moves to a new normal, I think first we have to decide what’s the new normal? We don’t even know yet. We’ve had things like the pandemic has certainly fast forwarded some trends, like work from home, but that may mean a surge in productivity. We already know that business spending has been increasing and they have plans to keep it up. And higher productivity generally means lower inflation. That’d be supportive for lower bond yields going forward.
But really, long term, nothing has changed. Long-run secular forces haven’t gone away and some call them the three Ds. And they’re largely the reason why GDP and inflation stayed at or below 2% in the last cycle. And they’re what drive the medium to longer-term outlook that investors should stay focused on.
Regarding the 3 Ds. Number one: debt. There’s too much of it; it even got worse post-Covid. Number two: demographics. There’s no change there. We all know the demographic story. Maybe we’re even seeing a faster retirement phase than what we might’ve expected. And the third D is de- or disinflation from technological developments, and they’ve accelerated since Covid.
The outlook is really that we’re going through a sugar high of growth, almost solely based on all the government spending. And that is seeing some making more by staying at home than going into work. We all know that that government spending, it won’t be as large next year with some of the programs being wound down this year. So, the high fades away as we move into 2022. That sets the stage for bond yields to potentially be lower by year-end, even as investors price in this eventual outcome.
Those three Ds mean that the trend of 2% growth and inflation will return. That’s what we saw in the post–great financial crisis era until the Covid era. And that means government bond yields can be lower sooner than most think. Sure, they can rise in the interim, particularly if inflation doesn’t prove to be quite as transitory as quickly as central banks now expect. But the long-run secular forces of those three Ds should return and keep bond yields low.
Let’s not forget: when yields rise, the hit to consumers, businesses and governments is painful quicker, given the higher debt levels that we see now. So, higher yields, while they happen, haven’t generally lasted very long.
Now, with respect to real return bonds, that’s a different asset class in the bond market or in the fixed-income sector. There is a potential for them to do OK, because most people think that you buy real-return bonds when inflation is moving up, and it certainly has been moving up of late. But remember, real-return bond yields generally follow nominal bond yields. They diverge when inflation expectations shift, but generally that adjustment is usually fairly brief. So, I wouldn’t be surprising to see real yields move a bit lower, not quite as quickly as nominal yields do if nominal yields do decline. Some would argue that central banks actually want negative real yields to continue, thereby making it easier to service debt.
With respect to inflation. That is really the big question for this year. Will it prove to be transitory as the Fed, the Bank of Canada, and other central banks believe? And we think yes. Now, wages are usually the big determinant of whether businesses can keep raising prices. And average wages are up, but they’re distorted due to the loss of lower-paid workers. So, you could say that some of the wage measures that most are focused on are distorted by compositional changes. The more lower-paid workers falling out of the workforce, the average overall wages of those remaining looks higher.
There’s a measure called the Atlanta Fed Wage Tracker, and it monitors the wages of the same group of workers over 12 months, so it avoids the distortions. And it’s at the lowest levels we’ve seen since early 2018. On the inflation front, though, some believe that higher commodity prices are leaders in inflation, but we’ve already seen many commodity prices already rolling over. Some key ones like lumber, copper, corn have fallen materially off their highs.
Some also say because of Covid, countries all look to do more onshoring of goods, not wanting to be reliant on other countries, and that could be inflationary. And, sure, this is happening in some areas, where that onshoring is occurring, but globalization certainly isn’t dead, and it’s been a significant driver of dis- or deflation for the last 20 years. And despite Covid, we actually have global trade volumes are at fresh new highs.
While inflation appears to be a problem in the U.S. right now, outside of the U.S., inflation is near historical lows, globally. Canada’s inflation is lower than in the U.S., but is still a bit high. It’s actually above the Bank of Canada’s 2% target, but we think it will follow the path of U.S. inflation. We think inflation will be back at 2% in one year in the U.S., and Canada will stay close to 2% for the next year too.
So, what tips do we have for investors in this environment? Well, number one, don’t get caught up in short-term trends. What are the long-run forces? Those 3 Ds haven’t changed. Stay balanced. We always get curve balls, like last year, and bonds continue to do their job when that happens. Nothing has really changed for the longer term.