The current fervour around rising rates and inflation in the US seems extraordinarily optimistic. 
Although we’re extremely hopeful we’ll overcome the medical and economic challenges ahead as Covid-19 infections and economic disruptions recede, we believe it will take more time than what markets are pricing in at the moment. What we have experienced is the most severe economic slowdown since the Great Depression and the rebound must be seen through that lens.
Consider the goal of how quickly the US economy may get back to pre-Covid levels; what did that former environment look like? In December 2019, the US was at 50-year lows in unemployment, equities were at all-time highs and the Fed was cutting interest rates because inflation was subpar.
Today, by contrast, considering the participation rate, unemployment is near 10 per cent — approximately 10 million Americans are out of work, with some of those jobs permanently lost due to Covid. The labour market has been severely wounded and will take a long time to heal. Sectoral and technological changes are likely to lengthen the process. Regarding the debt burden, we are in a considerably worse position than we were in December 2019. Furthermore, the $1.9trn coronavirus economic relief package combined with the new $3trn recovery plan, will be funded by even more debt.
Fiscal thrust will be a terrific short-term boost to the US economy, but will it be self-reinforcing enough to generate meaningful longer-term GDP growth? That remains to be seen.
It is worth remembering the 2018 passage of the largest personal and corporate tax cut in US history which at the time was marketed as a self-reinforcing kick-start, and of course with the exception of higher inflation. By December of that year, growth fizzled, and the Fed spent the rest of 2019 undoing a number of rate hikes previously implemented — again because inflation was anaemic.
Current pricing reflects spectacular optimism. For example, the current five-year, five-year forward suggests the Fed will have the funds rate past 2.0 per cent in five years. That implies the Fed will have been able to completely taper all its purchases and accommodation and raise rates at least 200 basis points without impeding growth.
Furthermore, the five-year, five-year forward also suggests that the tremendous debt burden will not have slowed growth and that the Fed will have achieved broad-based, full employment whose benefits are broadly shared. This begs the question whether anything can go wrong or take longer to achieve? To short the market at today’s pricing could be quite risky as those accomplishments are required simply to break even on the trade.
We expect that through base effects, pockets of inflation will rise this year. Both the chair and vice chair of the Fed openly acknowledge they are willing to look through “transitory inflation” in the great likelihood it may not persist. Their inflation goal is not only to achieve 2 per cent over the medium term, but to have a high degree of confidence it will remain there persistently.
Longer-term secular forces in operation since the global finance crisis have muted inflation. These include the debt burden and ageing populations throughout the developed world, which increase dependency ratios, and advancements in technology. While tech advances do increase productivity over time, they also displace human workers at an increasing pace. All three of these forces have worsened over time.
The cyclical outlook is good, and improving, but the secular growth and inflation headwinds remain firmly in place. We envisage for spread sectors to outperform against a backdrop of global economic recovery.
Our spread sector exposure is focused on investment grade and high yield corporates, as well as emerging market debt. Our Global Macro Opportunities strategy holds positions that should respond well to anticipated pockets of inflation, such as exposures to investment grade energy, high yield energy, Russia (energy), CAD and AUD. With many uncertainties and further long-term challenges ahead, the usefulness of strategic portfolio diversification remains paramount.
Joseph A. Filicetti is a product specialist at Western Asset Management. The views expressed above are his own and should not be taken as investment advice.