Inflection Points and Avoiding a Lost Decade – 2021 Outlook

2021 is likely to prove an inflection point for Australia with a strong and broad-based recovery being key to avoiding a lost decade.

    Alastair Hunter

    Andrew CanobiDirector, Fixed Income

    Alastair Hunter

    Chris SiniakovManaging Director, Fixed Income

    Our near-term macro outlook for 2021 is relatively positive. The economic and personal havoc wrought by the COVID-19 pandemic in 2020 will gradually give way to recovery. As we end 2020, the major economies of the Northern Hemisphere find themselves still battling the raging fires of the virus, Brexit uncertainty, and suppressed economic activity.

    All these headwinds will abate in 2021 and give way to broad growth as the constraints on consumer and business behaviour are alleviated. The assumption underpinning this forecast is, of course, the successful rollout of vaccines that act to bring about substantial immunity across most populations. We make this assumption based on the near conclusive evidence that this remarkable healthcare breakthrough has been achieved, and in record time. In Australia, we expect that the arrival of vaccines in line with Government timelines of March, coupled with already low and manageable levels of virus, will create a robust platform for activity levels to return to normal.

    Against this backdrop, central banks and governments will maintain unprecedented stimulatory stances well into any recovery phases, which will be a multi-year process. The RBA now works with an official cash rate at the perceived lower bound of 0.10%. In addition to this extraordinary policy level, the RBA now has an explicit yield curve control framework which targets three-year government bond yields at 0.10%. The RBA has also implemented a quantitative easing program in the form of committed asset purchases; potentially to the tune of hundreds of billions of dollars. This dramatic expansion of monetary intervention is a significant change for Australia and presents risks of unintended consequences.

    The legacy of the pandemic will be a coming decade of fiscal and monetary activism that sees governments more willing to borrow to spend than anytime this century. In practice, this means pressures for rising bond yields will be tempered by the power of the central bank printing press. As is always the case, however, investors find a way of pricing outcomes into markets and we expect rising inflationary pressures to have important implications for real yields and currency markets.

    The Australian Economy Ahead

    A strong and broad-based economic recovery in 2021 is critical to Australia avoiding a lost decade. As alarming as this may sound, consider the poor track record of the world’s major developed economies recovering from economic crises. Japan’s lost decade of the 1990s never really ended. And in the United States a strong case can be made that the period since the Global Financial Crisis has been a lost decade for all but the top wealth decile. What we conclude from these and other case studies is economic imbalances are born out of crises. The key to a proper and sustainable recovery is reversing the imbalances rather than building upon them.

    Across our leading Australian economic indicators, the shining light going into 2021 is the strong pipeline of construction work. Government stimulus targeting residential building has been highly effective – housing credit approved for construction purposes is approximately 70% higher vs. one year ago - and recent program extensions will likely see this rise further. It is also worth noting that this credit expansion is happening alongside increased infrastructure spending by state governments which was included in recent FY21 budget announcements.

    The fiscal impulse beyond construction-related spending is more uncertain but likely to remain very supportive. Current estimates show a decline in government spending over the coming years, albeit from extraordinary levels.

    Rather refreshingly, there appears to be agreement across the major political parties on the importance of working alongside the RBA to lower the unemployment rate. We expect broad programs like JobKeeper to morph into targeted support for specific industries and groups of workers to address any unevenness in the labour market recovery. As Milton Friedman famously said, “nothing is so permanent as a temporary government program”.

    Australia’s COVID-19 Hangover – A Lack of Population Growth

    While growth momentum and effective policymaking are likely to make good progress in reversing the imbalances which emerged in 2020, we expected one disruption to remain for some time; namely, the slowdown in population growth. Over the past several years, net overseas migration accounted for approximately 60% of total population growth, or said differently, Australia’s 2.25% p.a. population growth becomes 0.75% p.a without it.

    In the long-run, a slower rate of population growth lowers potential GDP growth. This is because potential GDP growth is broadly equal to working-age population growth + productivity growth. Fortunately, we expect the Australian decline in population growth will likely be a shorter-term dynamic, i.e. <5 years, and over this horizon, the economic impact can be quite different.

    Strong population growth combined with an expanding economy often (somewhat counterintuitively) results in slower wages growth and lower broader inflation pressures. This is what we observed in New Zealand in the mid-2010s and is largely due to the very strong rates of labour force participation among overseas migrants. Government programs which aim to attract migrants with skills in industries where the local labour supply is low reinforces this dynamic.

    We see the period of slower Australian population growth as likely to reverse the dynamic in house prices, wages growth, and broader inflation experienced over the past several years. House price growth is likely to remain lower, i.e. neutral in real terms, while wages growth and broader inflation will likely recover faster than the RBA and the market currently expects. In Western Australia, we are already seeing evidence of acute skills shortages and this is likely to feature as a national headline next year.

    Portfolio Positioning Into 2021

    With expectations for 2021 to bring higher growth and inflation, we are positioning portfolios quite differently to the past several years. We own inflation protection and we generally have less exposure to Australian and United States duration.

    This positioning is predicated on our assessment that return profile of government bonds is likely to be poor in this environment. In fact, our expectation is that the entire government bond yield curve is likely to produce negative inflation-adjusted returns, and in addition, a high probability of periods of negative nominal returns too; something we have already started to see as 2020 draws to a close.

    Across portfolios, we remain exposed to high-quality investment-grade bonds which performed very well in 2020, and we expect will continue to do so in the year ahead. Recovering profits and activity, along with paltry yields on government bonds, will keep demand strong for corporate bonds from issuers likely to benefit as day-to-day life normalises, e.g. shopping centres. However, given the uncertainty in the outlook, we favour issuers with strong balance sheets and diversified portfolios.

    Our outlook is that the Australian dollar likely outperforms the US dollar in 2021, but we remain largely neutral due to tail-risks related to the Australia / China geopolitical dispute. The inclusion of iron ore in the list of goods China is imposing tariffs on (whilst highly unlikely) would likely see the Australian dollar depreciate sharply. We prefer small currency exposures in economies in Asia with positive real yields.

    Generating Return Without Yield

    We are often asked, how do we generate return in a low yield environment? The answer is roughly the same we would provide in an environment of higher yields; do not rely solely on yield as a source of return but actively seek out opportunities where securities are mispriced relative to our analysis of fair value. This has again proven the right approach in 2020, and we expect it to continue into 2021.

    Learn more about the Franklin Absolute Return Bond Fund: HEREHERE

    Important Information

    Issued by Franklin Templeton Investments Australia Limited (ABN 87 006 972 247) (Australian Financial Services Licence Holder No. 225328), Level 19, 101 Collins Street, Melbourne, Victoria, 3000.

    The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal.