Capital Markets Spotlight: A Trip Around the Globe

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  • 33 mins 55 secs
John Hubbard, Ward Brown and Robert Spector, all of MFS, discuss the year so far as it pertains to fixed income. (Q3, 2020)

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Jon Hubbard:

Hello and welcome to the MFS Capital Markets webcasts for the third quarter of 2020. I'm Jon Hubbard from the Investment Solutions Group here at MFS. Welcome to our listeners and thank you for tuning in today. I'm really excited to be joined by two members of our fixed income team, Ward Brown, emerging market debt portfolio manager, and Robert Spector, global fixed income portfolio manager. Thank you both for joining me.

Jon Hubbard:

What an incredible six months it's been. While the market and the global economy are dynamic and they're really always in flux, there are certain periods in history where are major disruptions that happen in an extremely short period of time. I think it's safe to say that we're in the midst of one of those periods, because what started as an isolated healthcare scare quickly turned into a global pandemic upending societal norms, global economy, and many aspects of our everyday lives.

Jon Hubbard:

Now, there are clearly many dimensions to this issue, but in our time here today with the expertise that I have here, we're going to focus on the global macro-environment, what an economic recovery might look like, and then spend some time thinking about both near term as well as the longterm impacts of this on asset prices. Clearly, the timing and magnitude of the healthcare and economic crisis varied widely by country to country, as did each country's government response, but some countries such as China already appear to be on the path to recovery. They're opening up their economy as GDP is once growing again, and while in contrast in the US, in many emerging economies across the world, they're still temping down on hotspots and facing rolling shutdowns.

Jon Hubbard:

Ward, I'd like to start with you. How do you think this will all play out globally and how will different parts of economies and different countries across the globe be impacted?

Ward Brown:

Thanks, Jon. I think we're in the beginning of the recovery phase from the extreme downturn in GDP that occurred in the second quarter due to the shutdowns, which happened everywhere and as we go through this recovery phase, it's probably going to be more gradual once we have an initial rebound.

Jon Hubbard:

Perhaps one of the lessons that was learned by the global financial crisis from policymakers is that, yeah, you really want to go big and you want to go early when faced with a crisis of this magnitude and in response to this crisis, central banks and fiscal policymakers, really around the world, they reacted in an overwhelming and unprecedented way, larger than I think most market participants thought probable or even possible.

Jon Hubbard:

Robert, I'd like to come back to you. Was this policy response appropriate?

Robert Spector:

I think that without question, the policy response was appropriate. Whether it's been interest rate cuts, yield caps, or other measures to support financial markets, I think that the creativity that central bankers have shown has been quite refreshing compared to the financial crisis.

Robert Spector:

I think I would be remiss if I didn't mention fiscal policy because I think one of the key debates among macroeconomists prior to the pandemic, and really prior to the recession, would be, "We're running out of room on the monetary side, rates are negative, yields are low. It's going to have to be about fiscal policy," and that was tested after another round of easier monetary policy and creativity on that front.

Jon Hubbard:

Thanks, Robert. Ward, can we have that same conversation on the emerging market side of the equation?

Ward Brown:

Yeah, sure. I think Robert made... Before I go there, I want to reiterate what Robert said, it's so true. For those viewers of can remember the financial crisis, the global one, right, I mean, there was a lot learned from that. I mean, think about when Congress rejected the first fiscal package called TARP.

Jon Hubbard:

Yeah, that's right.

Ward Brown:

They actually didn't pass it right away and they had to go a second time, so markets were concerned that they would not get the right amount of support, they would not get timely support, and in this crisis, you haven't heard a single thing about that. They came out super fast, both on the fiscal and the monetary, and they came up with such enormous size the markets have never questioned those as going to be enough, so it's, I think, very high marks for developed market governments and their response to this.

Ward Brown:

Emerging markets has been really quite interesting. It's new territory because they have tried to replicate the same response, which is large monetary and large fiscal combined to counteract the economic effect of the shutdowns and that's dangerous territory for EM. These countries have risk and a lot of the risk is around the sustainability of their public debt levels. When you talk about using monetary policy to finance deficits, that has a history in EM and it's a bad history. It's a history of deficits that are not sustainable and last choice financing options being to use money supply.

Robert Spector:

Let me just add one more point about the lesson from the financial, as it relates to fiscal and some of the fiscal measures. In the financial crisis, sure, their fiscal policy was used and there was a lot of concern at the time that perhaps it wasn't big enough, but generally speaking, the support was about banks and markets and it was the first volley, for example, into QE. Of course, this wasn't a banking crisis, it's a medical event, a health event, but I would certainly call both fiscal and the monetary side much more of a main street response, much more about supporting workers across sectors, across skillsets, whether it's providing an additional unemployment benefits, whether it's providing, relief for renters, clearly whether it's forbearance.

Robert Spector:

Each country has done it in its own way across DM, whether it's the UK, Europe, United States, Canada, but the flavor, the texture around everything that's been done has much more of this main street support of work as opposed to being geared around the financial sector, banks, and markets. Not saying there wasn't support for the markets, there was, but you think about how the policy response might've been split between those two, it was clearly a lesson learned from the financial crisis.

Jon Hubbard:

Right, so while policymakers, they really did what they needed to do in terms of the speed, the magnitude, and as you mentioned, Robert, even the creativity of some of these programs that were developed and rolled out, but none of this is without economic consequence and I'd like to talk a little bit about the economic implications around debt levels, fiscal deficits, and even the ability to respond to future crises.

Jon Hubbard:

Ward, how do you think about the longer-term economic implications?

Ward Brown:

I think public sector debt is going to be one of the critical pieces of that longer term. It's going up everywhere and the question is: Are these new levels of debt going to be sustainable, and secondly, if we don't reduce these debt levels, will governments have the fiscal space to respond to the next downturn? I think what Robert commented on, on developed markets, largely, they have higher levels of sustainable debt. Japan's debt level's around 260% of GDP. That's much higher than all of the other developed markets.

Ward Brown:

Emerging markets, less so, but the good thing about emerging markets is that most of them have come into this with fairly low levels of public sector debt, so they have had scope in this crisis to expand those debt levels in response, but as I said earlier, they don't have a long way to go in terms of the runway to bring their debt levels back to a sustainable point, or rather, bring their fiscal deficits back down. There isn't as much institutional credibility in emerging markets and so the markets are going to want to see that steps are being taken to start to control the fiscal deficits if they're going to continue to finance them at these prices.

Jon Hubbard:

Right, and Robert, how about on the developed market side?

Robert Spector:

I'll let go some of the comments that Ward just made. I think that to get through to the next business cycle, I don't have a lot of concerns over the sustainability more broadly within developed markets, but how many times can you run this experiment? I mean, we're going to have another recession at some point down the road and that's going to be met with another fiscal response. Maybe not as big as this one, hopefully not as big as this one, but more broadly, it's going to lead to another leap up in public debts, so this can't be run forever.

Robert Spector:

But if you ask me about this particular cycle, are we at critical levels across developed markets, I wouldn't make that my base case as it being a major concern, but that said, as we go through a maturing business cycle, as choppy as it feels at the beginning, as we get into the maturing part of the business cycle, we're going to have to see at the very least a stabilization in these debt levels, even though it's going to be at a higher level. They can't continue to rise even in the recovery phase because that would potentially lead to certainly some concern over sustainability, and as Ward just mentioned, the price that governments can finance these.

Ward Brown:

One interesting thing, Robert, is that in a funny way, emerging markets almost benefit from the market discipline. That's going to come into play sooner for emerging markets and it's going to help them respond. If markets are not concerned about the sustainability of developed-market debt, that same market discipline may not pressure governments to take the fiscal adjustment measures they need to, and strangely enough, may cause them to delay necessary measures.

Robert Spector:

Safety in numbers.

Jon Hubbard:

So, Ward, what you're really saying there is that you're saying that the market is not going to let the emerging market economies get away with sustained increases in their debt levels?

Ward Brown:

No. I mean, it's going to want to see steps of fiscal adjustment to restore fiscal deficits down to levels at which debt to GDP can start to decline. Of course, there a wide variability in emerging markets. Countries like Brazil, it's essential, South Africa, essential. Other countries like Russia, debt levels are really low there, they probably have more runway, but for the ones where it needs to be done, they're not going to be able to take a lot of time in the recovery formulating those plans. They're going to have to do it fairly quickly, I think.

Jon Hubbard:

Mm-hmm (affirmative). If we think about the amount of stimulus, really globally that has been put into the system, both monetary and fiscal, one of the topics that's been talked about quite a bit is the impact on inflation. Now, near term with such a simultaneous demand-and-supply chalk, it's pretty clear that this is a disinflationary environment that we're in, at least if we think about it broadly, but as we think about the longer-term implications for inflation, Ward, are there going to be differences between developed and non-developed markets here as we think about inflation and the potential for us to see increased inflation, something that we haven't seen really globally for the past several years?

Ward Brown:

I think broadly speaking, no. If you think about the arguments for an inflationary impact, they tend to be right now around the huge growth in money supply and the view that money naturally translates into inflation, but we've seen that that's not as straightforward a result of increased money supply as the basic theories would lead you to believe. In fact, what happens typically is that money demand responds to absorb that increase supply, so the critical thing, and this does happen in emerging markets, is when that money demand doesn't respond to the increased supply and people holding local currency in emerging markets become concerned about it. The main concern is inflation and what would drive that concern about would be concerns that the fiscal deficits are unsustainable and that the government's not going to correct the problem.

Ward Brown:

That's an EM story that we have seen play out before. It's not farfetched to have a country fall into that potential scenario. Right now, I don't think it's likely that any EM country will. I think that they're going to make the adjustments they need, but that's where an inflationary outcome could result in that type of scenario, but it takes years to get there, and so I wouldn't expect that type of scenario anytime soon.

Ward Brown:

On the developed market side, I'll pass it over to Robert, but I think it's even more difficult, a higher hurdle for developed markets to get to that type of inflationary outcome.

Jon Hubbard:

Robert, how about your views on the developed markets when it comes to inflation?

Robert Spector:

I think that the structure that Ward just talked about could easily be applied to DM as well. I'll just add in this general point about the secular deflationary or disinflationary pressures that have been in place, particularly around technology demographics, these tend to be disinflationary/deflationary trends. There's no doubt that globalization, which had been a disinflationary or deflationary factor for some time, is certainly shifting, but that actually started before the pandemic.

Robert Spector:

We've talked before about the sustainability of public sector deficits and debt in developed markets and how it doesn't seem to be an immediate concern as far as making that shift towards money-printing and destabilizing inflation expectations, and then there's question about in the short term, I think that it's pretty clear to me that we're going to be seeing relative price movements with various sectors showing potential for shortages of either inputs and those inputs including labor as the economy is trying to adjust to whatever short term new equilibrium this world looks like.

Robert Spector:

We talked earlier about substitutions across different sectors and some sectors' impairment being more longer-lasting, some coming back quicker. That is going to lead to relative price movements, but whether that actually leads to a sustained change in the disinflationary or deflationary trend that has been in place for decades, I'm not convinced that that's a near-term event.

Jon Hubbard:

Great. Thanks for those comments. Given some of the comments that you both have made, has this been a transformational event here in global economies over the past several months, or is this really just sort of a temporary economic step back, a hiccup, albeit a large and abrupt one, but do we just get through to the other side of this and continue on-trend? Curious to hear your thoughts, Ward.

Ward Brown:

Well, from the macro, I don't think it's a transformational event. I think that once the dust is settled here and we return more fully into the recovery phase, the same structural factors that were driving trends prior to the crisis are going to be still in the driver's seat, so that is a secular stagnation, low growth, low inflation type of environment, and this is... If anything, I think the crisis has given some renewed impetus to that type of macro-environment.

Jon Hubbard:

Robert, Ward mentioned "secular stagnation." What are your thoughts on that? Is that a force that's in place and that will continue?

Robert Spector:

Yeah, I broadly agree with Ward. These longer-term trends that were in place around secular stagnation are likely to remain in my view. There's been some work done, some academic studies about the post, longer periods after larger health events like pandemics, and those results show an ongoing period of low real interest rates, which, again, is a prominent feature of secular stagnation, and because of the health event, because there's that shock to the economy and to society, there tends to be a higher amount of precautionary savings, so that increase in domestic savings is also not only related to low real interest rates, but is a feature, a prominent feature of secular stagnation.

Jon Hubbard:

Right, right, and I want to go back to one other topic we talked about previously, which was the coordinated response by fiscal policymakers. Now, I think given the nature of the crisis, everyone was in agreement in terms of what needed to be done and how quickly it needed to be done, but things don't always work that way, particularly when it comes to the fiscal picture, so you have to bring politics into this at some point, as you think about the future. Ward, what are your views on the political atmosphere right now?

Ward Brown:

Well, in emerging markets, I think that the politics will turn around to support fiscal adjustment. Of course, they're not there now. You can't be addressing that in the middle of a health crisis, but I think that generally speaking, emerging market electorates recognize that they have to stabilize that fiscal after this huge response, so I think we'll see it, but in each country, there are details and there are challenges, so we'll have to see country by country. It's going to be not a straightforward thing to do.

Ward Brown:

The one thing as a wild card also for emerging markets is the potential for taking some structural reforms. It's not an uncommon storyline in EM that once you come out of a crisis, you go through a crisis. Part of a way to get out of it is to reform parts of the economy and that opens up potential for stronger growth rates. For example, Brazil is discussing major tax reforms and privatizations. I think they've already passed a pension reform, but additional liberalizing measures in their economy. South Africa, that may be another place that could happen. It's these crisis situations which often help catalyze political support for changes that wouldn't be easy to get through in more normal situations and so we're watching very closely at potential for EM to not only do fiscal adjustment, but take additional steps to improve the efficiency of their economy and incentivize private sector investment and economic growth.

Ward Brown:

When you think about developed markets, they've shown historically that they have been able to deliver fiscal adjustment when they've had to do it, but the political circumstances in a number of countries in developed markets are different this time. There's less unity or more difference of opinion and deep differences of opinion. There's larger sense of disenfranchisement. These were trends that we had talked about prior to this crisis.

Jon Hubbard:

Yeah, and that's something that certainly bares watching for sure across both DM as well as EM markets. We've covered quite a lot of macro ground here and I'd like to think about now, what are some of the implications for this macro-environment that we've spent the last bit of time talking about? What are some of the implications for asset prices? Robert, any thoughts there?

Robert Spector:

I'll take a first crack at some of the key markets that Ward and I monitor closely and I'll start with the outlook for interest rates, particularly in developed markets. Okay, so you put this together. What have we really covered? We've covered this unprecedented recession with supply-demand both reacting in a way that was unlike any of the downturns that we've seen, certainly since the depression, and then a recovery phase, which has been quick, but likely to be uneven going forward. You put those together with this unprecedented policy response and the outlook for debt levels and the potential for inflation volatility down the road, but not imminent. What we see is this ongoing period of lower for longer that was a trend that was in place before and likely to remain in place. It's really that feature of secular stagnation that we discussed earlier not being disrupted in any significant way, in fact, potentially accentuated.

Robert Spector:

As you roll that through for developed market interest rates, they're negative and unlikely to go further negative for the countries that are in negative territory. For the countries that are at, their effective lower bound on rates are still positive, those central banks are banging the table that they don't want to go into negative territory, so I think if there is the need for additional accommodation, it'll either be in the form of yield curve control or yield caps, which is already in Japan, and more recently in Australia. It's not imminent, at least the Fed is not saying it's imminent, and haven't heard much from other central banks in terms of it being a tool that's going to be used in the next several months, but it's out there. It's out there as a possibility to keep medium and longer-term interest rates low.

Robert Spector:

I think one more point I want to make on the outlook for interest rates at the longer end of the curve, that isn't likely to be any part of any yield curve control or yield cap, I'm talking about interest rates beyond 10 years, and there's concern, I hear it all the time about the increase in supply from all of these deficits and these auctions that are global every day, another country's coming to market with another, another bond, another tenor of supply.

Robert Spector:

But again, as we mentioned, one of the features of secular stagnation, of a post-pandemic environment is a rise in precautionary savings. In other words, the domestic savings is there to absorb that supply and it either is because of this imbalance between savings and investment, which is likely to persist in this recovery period, but also, you have support from the central banks who continue to use QE to buy bonds.

Robert Spector:

Now, that isn't going to be forever, but at the same time, these QE programs are unlikely to go away in the next couple of years, so we think that the longer end of the curve across many of these markets are not only going to be attractive in terms of being able to absorb the supply and unlikely to rise dramatically given the uneven recovery and lack of inflation, but also have the potential to rally if we do get any volatility in risky assets. In other words, the long end of the curve is still one pocket that might provide some hedge to volatility and risky assets.

Jon Hubbard:

Right, and some of that comes back to that selectivity element, right, where you're going to have this unevenness and you're going to have different sectors impacted differently, you're going to have different idiosyncratic issues with companies and how they deal with the debt that they've accumulated during this time.

Robert Spector:

Yeah, Jon, that's right. I think that we will continue to see security and sector dislocations that will require a clear understanding of the bottom-up and picking winners from losers, but the broad macro trend, I think, is going to be central bank support to how far spreads can widen in the short term and then pressure to delever as the recovery matures.

Jon Hubbard:

Ward and Robert, thank you for joining us here today. I'd just like to ask you, any concluding remarks that you'd like to make?

Ward Brown:

Well, I guess I would just recap our views that we're in the recovery phase here, but it's going to be bumpy and there's going to be a lot of differences in how sectors perform and how countries perform. The policy response that we've seen I think has put a floor and help support this recovery. It's going to stay there. That raises longer-term risks. No question. The tail risks of inflation, tail risks of deflation are probably higher now given balance sheets, but that's going to be a longer-term issue.

Ward Brown:

In the near term, there's large output gaps, there's deflationary forces here matched with reflationary forces, so in the near term, I don't think those tail risks will come to floor, and I think that as you plan your portfolios for near-term outcomes, there is some value still in countries with positive yields to serve as a balance for portfolios, credit spreads probably in good shape here given the deleveraging we're going to see, and certainly EM credit still has attractive valuations and the global backdrop will help those countries move into a T-leveraging phase as well.

Robert Spector:

I'll just echo those comments by saying that just to avoid the temptation of really gravitating to either of those extremes, the inflation scenario, the imminent huge rise in inflation scenario is extremely seductive given the huge rise in government deficits and rising in money growth, but I think Ward put together a very strong argument why that is not an imminent risk, and by the same token, these big output gaps and big drops in GDP that we're going to see for the second quarter when they're released, and frankly, for the year as a whole, but at the same time, the policy response, the creativity, both monetary and fiscal, in our view, suggests that that extreme deflationary, no recovery phase. I wouldn't jump into that territory either.

Robert Spector:

This is a recovery it's choppy, it's uneven. It's going to be creating these winners or losers at the micro level that is going to be extremely critical to try to navigate those as the economy reaches these shorter term and longer-term equilibria, but I think as a base case, we should be expecting the low interest rate secular stagnation environment that persisted before the crisis to continue. I think that means low interest rates and supportive for credit and we will add in the additional wrinkle that within this recovery phase, we should see the US dollar continue to decline, to lose that status as the go-to only game in town in terms of G10 currencies.

Jon Hubbard:

Well, great. Well, with that, I would like to thank all the listeners who tuned in here today and remind everyone that you can access additional MFS thought leadership on mfs.com, Twitter, and through LinkedIn. If you have any follow-up questions at all, please feel free to reach out to your MFS relationship manager. Hope everyone stays safe and enjoys the rest of the summer. Thanks again for joining us.