More of the Same Expected for Rates, Inflation in 2021

Interest rates were already stuck at stubbornly low levels even before the outbreak of the coronavirus pandemic, and the federal government has since signaled a commitment to accommodative monetary policy.

During a recent webcast sponsored by Natixis Investment Managers, two fixed-income experts shared their hopes and concerns for what might be coming in 2021.

The speakers were Elaine Stokes, executive vice president and portfolio manager at Loomis, Sayles & Company; and Adam Abbas, portfolio manager and co-head of fixed income, Harris Associates. The pair noted that fixed income market watchers should now have little doubt that a “new normal” for interest rates is firmly in place. This is to say that rates were already stuck at stubbornly and historically low levels even before the outbreak of the coronavirus pandemic, and the federal government has since signaled a commitment to supporting the markets and the economy through accommodative monetary policy.

“Central bank support is now basically the rule, wherever you look around the globe,” Stokes said. “Interest rates are low or even negative wherever you look. It’s much more than just a United States challenge.”

Stokes and Abbas said this dynamic will clearly present lasting performance challenges for investors who traditionally seek to rely on “safe assets” to drive the bulk of their portfolio returns. They suggested such conditions should give active managers a chance to shine, particularly when it comes to fixed income. At the same time, these conditions underscore the fact that government bonds and investment-grade corporate debt may now be more important as risk-ballasts in a diversified institutional portfolio, rather than return drivers, as they might have been in the past. 

When it comes to overall market volatility, Stokes and Abbas said they expect less in 2021.

“One thing that created a lot of volatility in 2020, beyond the pandemic, was political division and disagreement,” Stokes observed. “I think and hope that 2021 will bring back more conventional political tactics and strategies. This would help to bring back a longer-term view about the global economy’s potential, and that could help to give the markets more comfort. That said, depending on the outcome of the Senate runoff elections in Georgia, we will still have a divided government, and most likely at least some tensions will continue to play out.”

Stokes and Abbas said the rollout of the various coronavirus vaccines in 2021 should slowly start to reveal exactly what parts of the economy could be irrevocably changed moving forward. The pair said it remains to be seen, for example, what long-term impacts there could be on future levels of business and leisure travel. Another unknown is how commercial real estate will be impacted once the acute challenges of the pandemic have been overcome.

When it comes to the inflation outlook, Stokes and Abbas voiced very little concern. They said some areas of the U.S. and global economy could see modest inflation in 2021, but, on the other hand, other areas could face deflationary pressure. Cases in point, they noted that employee productivity has meaningfully increased this year, while serious slack has developed in the labor market. Both factors should help keep inflation in check, they said.

Consensus Views From Vanguard

The same day that Natixis presented Stokes’ and Abbas’ commentary, Vanguard published its 2021 market outlook report, “Vanguard Economic and Market Outlook 2021: Approaching the Dawn.”

At a high level, the report concludes the next phase of recovery depends on greater immunity to COVID-19 and a return to consumers engaging in normal economic activities.

“Should a vaccine become distributed, administered broadly and be effective, much of the economic losses from COVID-19 could be recovered in the next year,” Vanguard suggests. “That said, there is risk that if immunity does not rise, economies may only see marginal progress from current levels.”

According to the report, Vanguard economists expect interest rates globally to remain low, despite a constructive outlook for firming global economic growth and inflation as 2021 progresses.

“While yield curves may steepen, short-term rates are unlikely to rise in any major developed market, as monetary policy remains highly accommodative,” the report says. “Vanguard expects bond portfolios, of all types and maturities, to earn returns close to their current yield levels. As 2021 unfolds, the greatest risk factor would appear to be higher-than-expected inflation.”

The Vanguard report projects that inflation should cyclically bounce higher in the middle of 2021 from current lows, before plateauing near 2%, “but such a move could introduce market volatility.”

“In 2020, disciplined investors were yet again rewarded for remaining invested in the financial markets despite troubling headlines and a challenging environment,” the report explains. “For 2021, the wisdom will be to maintain that same level of discipline and long-term focus, while acknowledging returns may moderate from the past.”

The report concludes that economic growth and inflation will likely “stay even lower for longer” after the first phase of the economic recovery, and with the markets expecting loose monetary policy to persist.

“We find it hard to see any material uptick in fixed-income returns in the foreseeable future,” the report says. “Instead of viewing this asset class as a primary return-generating investment, investors are encouraged to view bonds from a risk-mitigating perspective. Our analysis in last year’s outlook suggested that bonds maintain their diversification benefits despite low-to-negative global yields; the events of 2020 only confirmed that.”