Sonal Desai: Navigating Historically Low Yields and Stretched Valuations
The CIO of Franklin Templeton’s fixed-income team assesses the risks and rewards of bonds, the economic recovery’s durability, and the future of monetary and fiscal policies.
Our guest this week is Sonal Desai. Sonal is executive vice president and chief investment officer of the Franklin Templeton Fixed Income Group. In addition to her responsibilities overseeing many of Franklin’s fixed-income teams, Sonal also co-chairs the group’s fixed-income policy committee and is a member of Franklin Resources executive committee as well as the firm’s management and investment committees. Sonal is a listed portfolio manager at a number of strategies, including Core Plus, Strategic Income, and Global Fixed Income. Sonal joined Franklin in 2009 from Thames River Capital in London. Prior to that, Sonal worked at the International Monetary Fund and as director and senior economist at Dresdner Kleinwort Wasserstein. She earned her bachelor’s in economics from the University of Delhi and her doctorate in economics from Northwestern University.
Fiscal and Monetary Policy
“On My Mind: Adrift--Has Monetary Policy Become Unanchored?” by Sonal Desai, franklintempleton.com.
“On My Mind: Modern Magical Thinking,” by Sonal Desai, franklintempleton.com, March 12, 2019.
“On My Mind: Bringing the Economy Back From Life Support,” by Sonal Desai, franklintempleton.
“On My Mind: Now Let’s Get Those Jobs Back,” by Sonal Desai, franklintempleton.
“If You Open It, They Will Come,” by Sonal Desai, advisorperspectives.com, June 5, 2020.
“Quick Thoughts: Why Our Managers Disagree on Inflation, Rates, and Growth,” by Stephen Dover, John Bellows, Sonal Desai, and Francis Scotland, franklintempleton.com, April 23, 2021.
“U.S. Macro Outlook: Let’s Bend the Economic Growth Curve,” by Sonal Desai and Nikhil Mohan, franklintempleton.com, April 22, 2020.
“On My Mind--Inflation: The Devil We Knew,” by Sonal Desai, franklintempleton.com, Feb. 26, 2021.
“Sonal Desai: ‘In Fixed Income, Active Investment Historically Has Been the Winning Strategy,’” by Sonal Desai, advisoranalyst.com, Nov. 8, 2019.
“On My Mind: A Tale of Two Recoveries,” by Sonal Desai, franklintempleton.com, April 22, 2021.
“Too Much of a Good Thing?” by Sonal Desai, David Yuen, John Beck, and David Zahn, franklintempleton.com, April 8, 2021.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.
Ptak: Our guest this week is Sonal Desai. Sonal is executive vice president and chief investment officer of the Franklin Templeton Fixed Income Group. In addition to her responsibilities overseeing many of Franklin’s fixed-income teams, Sonal also co-chairs the group’s Fixed- Income Policy Committee and is a member of Franklin Resources executive committee as well as the firm’s management and investment committees. Sonal is a listed portfolio manager at a number of strategies, including Core Plus, Strategic Income, and Global Fixed Income. Sonal joined Franklin in 2009 from Thames River Capital in London. Prior to that, Sonal worked at the International Monetary Fund and as director and senior economist at Dresdner Kleinwort Wasserstein. She earned her bachelor’s in economics from the University of Delhi and her doctorate in economics from Northwestern University.
Ptak: Sonal, welcome to The Long View.
Sonal Desai: Thank you, Jeff. Thanks for having me.
Ptak: It's our pleasure. So, you oversee many of Franklin's fixed-income teams as CIO of the Franklin Templeton Fixed Income Group. That gives you a good perspective on key issues rippling across the bond market. In your view, what's the key risk/reward trade-off for investors to focus on at the moment? And how are your teams working through that issue?
Desai: So, I think, first of all, I'd say essentially, we are looking at fundamentals, valuations and in a combined way, in certain asset classes, policies or prices are going to be a big deal. I'd say that markets have been moving very far in advance of economic data points over the last year and a half. This happened on the way down, and it certainly has happened in this completely--I hate using the word--but unprecedented recovery. That word has been used so often. And I'd say that, in connection, many risk assets have rebounded really sharply. And so, a lot of them are now trading tighter than pre-COVID.
And now, the remaining pockets of value, for us, in particular, if I look at emerging markets and high-yield markets, it involves finding exposures, which were most directly affected by COVID, issuers that have had to extend themselves to get through the crisis. And I'd say that what our teams are really doing is trying to navigate through these issues by really focusing on fundamental research. Now, I would say this, but there's never been a more important time to be active. For example, as Congress negotiates the whole infrastructure stimulus, we are looking at how the proposed funds would be spread out, what are the potential effects on pricing materials of labor? And if you see the enormous amount of capital that has been raised over this period of incredibly low interest rates, that's something which we're monitoring very closely as well. If I think about policy surprises, for example, in emerging markets, anything which comes as a surprise from the Fed, or from even the ECB, this is going to be important for this asset class in particular. So, looking at how fast markets recovered, and in particular, how fast valuations have come back.
Christine Benz: We have many advisors who listen to this podcast, who are trying to help their clients navigate retirement amid a vexing set of issues. What advice do you have for them, particularly when it comes to the role that low-yielding bonds might play in a portfolio?
Desai: I think that something which is true is that there's general consensus that people need to be holding more equity in their portfolios. And I'd say that, certainly, this is something which we're very cognizant of. Certainly, rising life expectancies have changed how retirement works in an ongoing, forward-looking way. I'd say that definitely there is potential for need for more growth assets, such as equities, and there's a greater need to ensure that enough assets are also invested in fixed income to basically provide that ballast, I'd say, to the riskier assets. There is this consensus, and I actually don't disagree with it, that perhaps today you need to have more equities--that traditional 60/40 idea perhaps isn't the correct one to think about as you're looking forward into the future, which will include a longer life span.
I think income continues to be a core objective of retirement planning. These things have not changed. And a steady stream of distributions are going to be particularly valuable in a low-rate world. But I do think that it behooves retirees and potential retirees to broaden their investable universes beyond equities where appropriate, and to look into areas such as high yield where you can get outsize yields to supplement lower-yielding assets. And I think that historically high yield has always made people nervous in terms of riskiness and so on, but the asset class has grown, both in size and quality, over the past few decades. And I don't think we should be looking at high yield or even emerging markets anymore as a fringe or a non-retiree investment.
Ptak: We're going to burrow into high yield a little bit later in the conversation. But for now, I wanted to focus a little bit more on macro, one aspect of which is flows. Despite paltry yields, which we've already talked about, investors continue to pour money into bond funds over the trailing year through May 31, 2021. For instance, our data finds bond funds gathered nearly a trillion--with a T--in net new dollars, which is really stunning. What in your view--you're very close to the action there--what explains this? Is it demographics that continues to fuel the demand?
Desai: I think demographics certainly plays some role, but I think we also need to look at this truly remarkable period we're in where there is a lack of yield around the globe. So, you're not just looking at U.S. demographics here, you're looking at global demographics to some extent. And I think this does drive to some extent the continued flows into bond funds. The famous TINA--there is no alternative--comes into play. And if we look again at what central banks have been doing, even not just in this last year, in the post-COVID period, I would really take it back further and talk about in the post-global financial crisis period, the world has been flushed with liquidity. There is an enormous amount of liquidity and central banks, certainly developed central banks, have been suppressing yields around the world. This means that investors keep getting pushed out on the risk spectrum and they end up being forced into longer duration, one way or the other, and to some extent, lower quality in the search for yield.
And I think that something else in the more recent past, which would have contributed, would have been the policies which got put into place, combined with--I'm talking about fiscal policies here--combined with the fact that we had a significant increase in the savings rate over the course of the pandemic. It means that there's a lot more money available to invest. And so, I would say that on the demographic side, certainly, we would say that there continues to be a need for income, as I noted before, and as you have the enormous cohort of the baby boomers going into retirement, that does mean that you will have an increase in quantity of investors who are putting money into bond funds. And you also have the fact that bond funds will always give you, or should give you, less volatility, and that's a desirable characteristic as well. And I think all of these have contributed to the flows into bond funds.
Benz: Here in the U.S., we've seen somewhat mixed economic signals. Unemployment claims continue to fall. But the pickup in jobs hasn't been quite as robust as some might have hoped. Where are we in this recovery? And do you still expect the global economy to roar?
Desai: I do. I do. Because I would say that, you're right, the pickup in unemployment, I would actually… Let me take a step back. Christine, I would maybe take a little bit of issue in terms of how robust the recovery in jobs has been. I think it has been about as robust as could have been expected. And I do think that we had a collapse in jobs. But we definitely had a very V-shaped recovery, at least in wages, if not in the entire area of jobs.
If I look at the unemployment rate at 5.8%, yes, even adjusted for slightly lower participation, I'd say the actual data also captures the fact that we have a variety of different forces at play, one being, earlier this year, I would have said that continued concerns about COVID were playing some role in people being less keen on reentering the job market. I would say, given the recent developments on the COVID front, on the vaccine front, these concerns surely are much lower than they were even at the start of this year.
I think that there is a meaningful difference between what we are seeing right now relative to what we saw at this time last year. And I can certainly expand on that further. But definitely, amongst other factors, I'd say that the enhanced benefits, the $300 additional unemployment grants that has been given by the government, that is certainly playing some role. It's playing some role on the margins, in particular, in the sectors, which lost the most in terms of employment at the start of the pandemic, which was, of course, in sectors such as hospitality, for example, restaurants, hospitality, service sectors. Those are the areas, where we're having the greatest difficulty in refilling, so to speak, the spots. The employers are having an enormous amount of difficulty in filling those roles.
I don't think that should come as an enormous surprise, because these tend to also be lower-paid jobs, where the supplemental benefits would have the largest marginal effects. So, to me, I would say, I look at the JOLTS number, and we've got the highest number. It came out well over 9 million. This is the highest number in the history of that particular time series. So, over 20 years, we haven't seen job openings at these levels.
So, where do we go? I would say, I think historians--economic historians, at least--will look back at this period and will debate a lot on the impact of incentives. To me a very near-term result we will be able to see as we get closer to September when these benefits start expiring, and assuming that we don't have any renewal of these extended benefits, I would expect to see a fairly sharp pickup in hiring. Now, that's interesting to me just as an economist. It means I will know probably by September or October whether my speculation that these enhanced benefits have played some role, whether that's correct or not.
Ptak: We should mention that JOLTS stands for Job Openings and Labor Turnover Survey for those listeners that perhaps are unfamiliar with it.
Ptak: I wanted to do a quick turn and talk supply chains. And I think you've touched on some aspects of this, but they're snarled, and we've seen shortages across many different categories of goods and services. To what extent do you think this poses a threat to the recovery in the near-term?
Desai: So, I think, temporarily, I would say that supply chains could pose a headwind to the recovery, but perhaps equally, they could pose an additional tailwind to inflation. The snarl-ups we've seen in everything, certainly, I'd say the chip shortage is probably playing a role in some of the price increases we're seeing on vehicles, for example. First you have a situation where, of course, there are delays, but the next step would be that prices could go up.
Near-term, I do think the supply chain impact is going to be important. Over the longer-term, I would anticipate it gets somewhat sorted out. Because another way of imagining in a completely different context, a supply chain snarl-up--when there were tariffs put on various items coming out of China a few years ago, there was concern about supply chains in that event as well. And what we found was that a lot of manufacturing relocated in that case to different countries in Southeast Asia, including Vietnam, for example. And at some point, that hiccup passed. Now, that was much more temporary. This time around, there's a certain amount of lack of knowledge, because, of course, if there's a second wave of COVID, which one hopes there wouldn't be and certainly, we have vaccines now, but if that were to occur, a brand-new wave in Asia, for example, that could extend the supply bottlenecks further.
So, I think that temporarily, it would probably be a limiting factor perhaps once we've gotten the recovery behind us, because right now, we're probably going to see growth despite the supply chains coming in at close to 10% for this quarter after the 6.5% growth we had last quarter. After we've recovered, I think that the supply chains bottlenecks might act as a bit of a cap in the short run. Longer run--and even in the short run, it's going to have inflationary impact--but longer run, I think that supply chain impact will be worked out. We shouldn't overemphasize it.
Benz: We wanted to shift over to discuss fiscal and monetary policy. Pre-pandemic it seemed like monetary policy was looser than it might have been if fiscal policy hadn't been so tight. That's shifted amid COVID as governments have opened their coffers to give consumers and businesses relief. Do you think this marks a regime shift toward a more accommodative fiscal policy? And what are the implications for monetary policy?
Desai: So, first of all, let me just say, I certainly hope not. But is it a bit of a regime shift? I think that is quite clear actually that there has been some form of a regime shift in the sense that even prior to the COVID pandemic--which was almost 2.5 years ago now--that we started talking about the idea of Modern Monetary Theory, something which I call magical monetary theory, practically. The idea that there is essentially no budget constraint on how large government deficits can be, how large government debt can be, in particular, for the U.S., as it does have the reserve currency.
So, what I would say is to me this is a concern, it has longer-term implications, it actually acts to suppress growth over the longer term. However, talking to the more specific issue which you raised, does this mean that there would be a rebalancing of fiscal and monetary policy? I would just note, so far, we haven't seen it. So far, we've had extremely loose fiscal policy and we continue to see enormously loose monetary policy as well. These are both happening together. Further forward, do I think monetary policy will need to tighten? I think it will if central bankers are serious about inflation, because I actually really don't think that we can see the current state of looseness in fiscal and monetary policy continue indefinitely--that feels a lot like what policymakers are envisaging. I would note that this is almost equal opportunity since this is not a question of one party or the other being more fiscally conservative. Both parties actually seem to have a preference for enormously loose policy. It's just a question of where that policy is used, where that policy ease is used, on the fiscal front.
Ptak: The trajectory of reopening is clearly different depending where you are in the world. China let us in and out of the pandemic, I suppose you could argue. Other geographies, like Europe, have been slower to emerge and emerging markets are even farther behind by many measures. Could this make monetary and fiscal policy trickier to coordinate? And, if so, what are the implications?
Desai: I think it does make it a little bit more complicated because I'd take it one step further and say, even within emerging markets you have great differences in terms of how certain countries have come out, if you will, of the pandemic, how certain countries have reacted to the pandemic. That has been quite different across the different regions and areas.
To me what you might see--there are very many different possibilities. On the one hand, if we got to a stage where you had the U.S. continue on its current trajectory of growth, at some stage you would get certainly monetary policy further advanced in the U.S. than in the euro area. I would note one thing, though: the eurozone, for example, is typically more inclined to run tighter monetary policy than the U.S. I always think about it as the DNA of these two central banks. The DNA of the ECB really comes from the Bundesbank, which in turn had its defining moment via the hyperinflation around the trade wars. Whereas in the U.S., the defining moment--I'd say, the defining characteristic or DNA of the Fed--that defining moment was from the Great Depression. So, the Fed has always been more inclined to be easier.
Nonetheless, if we get a rebound in the U.S., which is substantially stronger, inflation which is substantially stronger than the eurozone, you are going to see that the euro area is probably at a different point in its cycle than the U.S. and you will get a mismatch of the central banks. One of the things this will result in will be currency consequences, because typically currencies do follow areas where we believe that you're going to have tightening of monetary policy sooner, typically that currency is going from a country where monetary policy is going to tighten sooner, so interest rates are going to be higher. That currency is likely to appreciate against another one. That would argue for a stronger dollar. On the other hand, stronger inflation in the U.S. would actually probably argue for a weaker dollar. So, the implications are less clear than they would normally be, because typically, you will have some inflation, some growth, just not quite as much inflation and quite as much growth, and at the same time, quite as easy policy.
Regarding emerging markets, I think we have seen pickups in inflation rates across EM. And in emerging markets, they don't have the luxury that the U.S. has of not tightening monetary policy. They need to tighten because you have an immediate feedback loop into current account deficits, into depreciation of exchanges rates and so that happens rather quicker. Fiscal policy in EM, again, was a lot less--emerging market was simply a lot less expansive to begin with, though it is still pretty loose by historical standards. I would say that in every case it is not going to be as easy to coordinate policies as we have seen historically.
Benz: To follow up on inflation, you have argued that the recent stimulus in the U.S. was larger than it needed to be and courts the risk of inflation that's difficult to contain. It seems like view wage growth is the key risk there. What are you looking at to gauge wage pressure and what can the Fed do to ease that pressure should it arise?
Desai: I don't think that the Fed can target wages in particular, but the Fed can target overall monetary conditions, in the sense that if I look at just anecdotal evidence even from the Fed's Beige Book for April, May, for a few months now. It does show that we're seeing that employers are pretty bullish, they are seeing that people are coming back from COVID but that hiring lower-wage or hourly workers is very challenging. And if we look at wage pressures, in particular, in low-skill jobs, those have been some of the strongest pickups that we have seen. The last set of data I think showed wage growth in month-over-month terms of over 1% in certain service sectors like leisure and hospitality. And I think that this mismatch, if you will, it really is accentuated when you look at the job-openings data that I made reference to earlier, we've seen unemployment rates, which are still hovering around that--let's call it round 6%--but we've seen very high wage growth.
Typically, when you have higher unemployment, you would anticipate lower wage growth, because employers have an abundance of choice to find workers to pull them in. You're not seeing that this time. So, it's a very different kind of unemployment. Today's 6% is not the 6% we saw during our recovery from the global financial crisis as unemployment came down slowly to 6%, and then 5% and 4%. This is very different, because back then, you didn't have job openings, which was so high and wage growth, which was as strong as it currently is.
So, yes, I'm looking at those individual sectors, and I just say that, in particular sectors that are seeing pretty high hourly wage growth, there they have vacancies--I just pulled this out, some of our analysts did this work. Those sectors have vacancies, which are two or three standard deviations higher than the average. So, almost 50% of the non-farm payrolls, we're seeing strong wage growth in areas where you have massive amounts of vacancies, but also relatively high levels of unemployment.
So, you've got this combination of factors, which does make me think that more than the Fed doing something in this particular area, I do think we actually have to bring it back. I don't think it's in the hands of the Fed. To some extent, it has to be in the hands of the fiscal policymakers. If that wage growth continues, and employers continue to have these difficulties and finding workers unless they offer bonuses. And, again, anecdotally, I think we're all aware there are bonuses being offered to bring people back on. I think these will be an indication that the Fed perhaps does need to do less for the economy rather than more. Again, we will have a test case, because I believe there are something like 25 Republican-led states right now who are planning to opt out of the expanded federal unemployment benefits early. And that could affect around 4 million workers. Now, it would be almost like a trial case to see when we see the state-by-state data, whether states which remove some of this additional assistance see a higher pickup in jobs growth, because that would be pretty conclusive. We might not, but we might.
Ptak: I wanted to switch over and talk bonds. Our first question for you is, what kind of return do you think investors can expect from investment-grade U.S. bonds over the next decade, over the next 30 years? Also, it'd be useful for those who are trying to form their own expectations if you can explain how it is you arrive at those estimates? How do you go about the process of estimating what kind of return one would earn on investment-grade U.S. bonds over the next decade or 30 years?
Desai: So, first of all, let me just say that, forecasting returns over that longer horizon, I would have to caveat anything I say with saying that that would really be a bit of a guess. There'd be some guesswork involved there because 10 to 30 years is really almost a lifetime. And from an investment perspective, there are many factors. Having said that, near term, or in the near to medium term, I'd say we're starting from a point of historically low yields and enormously stretched valuations. So, if I look at investment-grade corporates, and I look at over the last five to 10 years, investment-grade corporate bonds, on average, returned about 5% a year. Now, if I look at the next several years, I would expect that the return would be somewhat lower, given the lower starting point in terms of yields, or equivalently, the stretched valuations that I noted that we're going to see, that we're seeing right now. In particular, if I look at the next 12 to 18 months, since our view continues to be that the yield curve will steepen and Treasuries are actually going to move higher, I would say that the total returns for Treasuries could well be negative, and that in turn would imply a not-very-rosy outlook for investment-grade. Note that couponing for investment-grade--we think that's going to be the largest driver while we go in this uptrend, and that will, of course, help offset, mitigate to some extent, the headwind which comes from rising Treasury rates. I would say, if we're anticipating negative total returns for U.S. Treasuries, I'd say that investment-grade would likely marginally outperform as long as economic conditions remain relatively strong, which is what our outlook is, and we expect spreads to stay somewhat stable.
I would say that if I look at the next several years, and we say that we've had around 5% per year, on average, over the last five to 10 years, we would expect that if we look… Again, I don't want to go 30 years, because in that time period, I think that we will have come to the end of that 30-year secular downturn in yields, so yields going down and prices going up of Treasuries. And I think we might have come to a base, and the policies which are in place today are likely to see us at the bottom in yield terms, and then gradually shifting upwards. There will be several cycles over the next 10 to 30 years. However, I think that we will see yields going up. We need to get to a point where they start looking quite attractive. During this period, the returns on IG are likely to be negative, maybe not massively negative, not as negative as Treasuries, but they will be negative. But then, at that stage, they start looking attractive again, because of course, we don't think that there will be no more economic cycles. There will come a stage when the Fed has raised rates, we do eventually get to a stage where another recession is possible. And at that time, I think we might start seeing IG looking more attractive again.
I'm sorry, that wasn't a very clear answer. But I would say that I feel safe in saying that the next 10 to 30 years is going to be not as good as the last 10 to 30 years, if that is helpful.
Benz: That is helpful. You referenced rising yields in your last response. What does history tell us about how core bonds perform amid rising interest rates? And should that have investors thinking about fixed-income alternatives that might hold up better, perhaps categories like utilities or REITs?
Desai: So, that's an interesting point. I would say the reaction of core bonds of different kinds to rising rates, it really depends on what is driving the rates higher. So, the extent to which rates are going up because underlying economic growth has done, is doing, very much better, so it's improved, and we think that scenario is really quite likely, then to some extent, spreads have room to tighten to help offset a little bit those higher rates. So, the difference between the yield on your spread sector, such as high yield versus the underlying, such as U.S. Treasuries, there's some scope for some spread compression. It's getting more limited, admittedly, but there is some scope for that. And I think returns are also clearly going to depend on how quickly those yields rise and the duration of the assets. So, yield and roll down with steeper curves, it means that you don't have to go negative in every one of your core asset classes. In general, I'd say, when you have periods of rising rates, Treasuries can definitely underperform versus other sectors.
That's no surprise, but also sectors where you have lower duration alternatives, they're going to perform better. So, for example, it's not just high yield, I'd also look at bank loans. So, floating-rate loans, sectors. And I'd say, those are areas which would perform well and hold up well. And I'd say there are also subsectors, other subsectors, which could do well. Emerging markets have done well in rising-rate environments, high yield has done well, floating rate has typically done well. U.S. Treasuries and investment-grade don't do well. And I would also say that if we look at alternatives, such as REITs here, I think that that wouldn't be a bad place to look. Alternative asset classes have proven to be quite popular. And I think there is a reason for that. So, I would agree. We are trying to stay underweight, what I would consider the most rate-sensitive sectors, while being more favorable on sectors, which are just more leveraged to an improving economy.
Ptak: And I think that we may be a little later in the conversation will talk about one of those sectors, which is EM debt. But before we did that, I wanted to go back to inflation, which we've referenced at a few points during the conversation. My question is, do you think markets have done a good job of pricing in inflation in the past and does the current, it's around 2.32% 10-year inflation expectation that's baked into Treasury yields right now, seem about right to you?
Desai: So, if you look directly at inflation expectations as priced into TIPS, or Treasury Inflation-Protected Securities, over time, the Fed has always looked at these as a window, if you will, on the markets' inflation expectations. But the truth is that if you look at the inflation break-even, it also reflects, for example, the liquidity premium for TIPS versus nominal Treasuries, and as well as an inflation-risk premium, so the risk of that inflation overshoots. So, I'd say that if I look at 10-year break-evens, currently, the Fed should be quite pleased. They said that they wanted to overshoot 10-year break-evens indicate that markets believe the Fed, that in fact, inflation will overshoot.
I actually think that as we get reopening, or gaining more and more momentum, and keep in mind, we still are not fully reopened in this country. We are not. I think that markets, in fact, might start pricing in even more of an inflation-risk premium, i.e. a greater overshoot. So, I think that you could get those going even higher.
Benz: Emerging-markets debt is one of the few sectors where you have a more bullish outlook based on the stronger outlook for the global economy. Can you talk about the risks to that view and why you think current yield spread levels more than compensate for those risks?
Desai: I'd say that, if we're looking at emerging markets… First of all, let me be very clear, we have to be extremely careful as to what countries we're looking at, where in emerging markets we're looking. I think the basic factor is, I'd say, the risks to emerging markets would be triggered probably from significant outflows which come, in turn, these would be driven… There are different sets of risks, first of all.
Let me first talk about the external risk, which would come from Fed policy. For example, this could put pressure on emerging-markets debt. So, fears of sudden shock tapering, which is again, not our baseline, because the Fed has said that they are going to be extremely careful, studied, and they are going to allow policy to be easier for longer. All of this is rather supportive for emerging markets. So, I'd say that as long as we're not in a situation such as what – I think that the taper tantrum is the most recent example in 2013, where you had a sudden reversal, sudden change in market expectations on how the Fed would behave, and this caused a massive outflow from EM. And I'd say this would certainly be a negative if you had a sudden change in the COVID outlook. Again, not our baseline given that we do have vaccines which have been developed, and increasingly, it appears that the vaccines are going to be useful also in the variants which are emerging. But if you didn't have that, and you had another whole wave, again, you could look at what happened in March of last year. And that, again, was a big reversal. I'd say that these would be two scenarios, which clearly, I will view--neither of which are our baseline, which also are a part of the reason we continue to like emerging-markets debt, in part because spreads do remain elevated in the asset class. And if I look at other fixed-income markets, we're seeing most of them trading close or through historical types. So, emerging markets remain an area and it's relatively rare to find one right now, where we're seeing a certain amount of scope for spread tightening.
Ptak: Switching over to Europe, you've written that there could be a risk that rising Treasury yields drag eurozone yields higher, and that puts pressure on higher-debt peripheral sovereign-issuers like Italy. Can you explain the scenario and more broadly walk through how you're positioning for investing in European bonds?
Desai: So, I would say that this historically has been the case that when you have yields go up in the U.S., typically, there is a drag factor to other developed markets, and in particular, European bonds. In the case of Europe, what we're looking at is, there is a tension there within Europe between growth which by European standards is strong, so it's about half of what we're seeing in the U.S., and inflation, again, it's higher than we have seen in Europe. And there are a lot of the same questions which are coming out here, whether it's durable, transitory, all of these factors are in play in Europe as well.
Against this, we have central banks. The central bank in Europe, the ECB, which even in its discussion today appears to be looking through these traditional macro drivers, if you will. And so, they continue to play this role of being a relatively non-price-sensitive buyer. So, on the one hand, if U.S. yields go up markedly, that could have an impact in certainly peripheral Europe. But what has also happened is that the ECB is indicating that it's going to look through the change in growth, and they're going to continue their PEPP program that this program that they have--and I actually don't remember the full acronym myself--but by which they buy individual sovereign bonds. And the central bank response, I think, is one which is ignoring those traditional drivers, which should keep a cap on eurozone yields. If you've got growth in Europe, which was sufficient to allow the ECB to come back to looking at that tilt toward the growth-inflation trade-off, that could lead to higher yields. And, yes, we would be looking more carefully at the developments in that area and at that point to try and decide how to work with higher yields. This is going to be more pronounced, if you will, in the 10s to 30s part of the curve. But I would say that we are limiting it by keeping our maturity somewhat shorter.
Benz: The sunny economic outlook that you expect to see should benefit areas like high yield, which you favored in recent comments. But credit spreads have returned to pre-pandemic levels. Given this, does high yield afford investors a sufficient margin of safety for the risk that they are courting?
Desai: I think so, actually. We are in a situation where policy-driven there is so much liquidity that nobody can actually say that you are getting value, especially value in terms of your returns if you compare it to what historically we have received for taking that additional risk in the high-yield sector. But I would also note that the quality of the asset class, it has really improved quite materially since pre-pandemic right now because you've got BBs making up 54% of the Bank of America Merrill Lynch High-Yield Index. This is, I think, around 5 percentage points higher than at the start of 2020.
It seems that many of the weaker credits did get flushed out from the high-yield index during 2020 via defaults. And also, you've got an improved makeup of the high-yield index from the number of fallen angels. So, investment-grade credits, which migrated down from investment-grade. And so, you combine this relatively stronger asset class in terms of just quality, together with what we think is going to be a pretty favorable economic backdrop. And this huge quantity of liquidity, so capital markets are completely open. It's allowed issuers to build up quite a lot of liquidity themselves and they've pushed out maturities. So, all of this I think results in fewer defaults and slight… Credit selection obviously is going to remain very important. It always is in an area like high yield. But overall, I would still say that we remain comfortable with the asset class and it's one of the few areas where we continue to take risk here.
Ptak: You've touched on inflation in several spots during this conversation. So, I wanted to close with a question about Treasury Inflation-Protected Securities, which is a category that you've liked. How well have the real yields on TIPS predicted the actual real return investors in TIPS bonds have enjoyed over time?
Desai: So, just touching upon an earlier question that we were talking about, I had mentioned there that you have a negative inflation risk premium, which comes from essentially overshoots of inflation, that's around 5 to 10 basis points over the long term. And you get a positive liquidity risk premium that is a plus 30 to 35 basis points, which is because TIPS are somewhat less liquid, significantly less liquid than Treasuries. So, on net, you get a premium to Treasury of around 25 basis points between these two factors. So, that means over the longer periods of time, you're going to find TIPS tend to outperform nominal Treasuries, if you assume that inflation expectations, of course, are correct.
So, have they actually reflected actual inflation? Again, the point is that we have five years, 10 years and even more years of data and you see that if you just held on to TIPS, a lot happens because you have crisis periods where TIPS massively underperform because of a big increase in the liquidity risk premium. This is the enormous rush to Treasuries that happens, for example, during the global financial crisis or at other periods. I'd say but if you put aside these periods where TIPS, rather than reflecting inflation or deflation, those are the times when everyone says, oh, TIPS are reflecting deflation. They're not really. What they're reflecting is that they're not very liquid and that's what the true yield is reflecting at times like that.
If you set aside those periods, they've probably been a reasonable estimate, I'd say, of realized inflation. This, again, is in large part because the Fed has kept inflation over the last many years pretty stable. I'd say that rather than thinking about TIPS in a static environment, you have to really think the most interesting, I think, when they appear mispriced, let's put it this way. So, at a time like right now, where we actually think there is potential to have higher inflation, we are always looking for periods when we get market expectations for inflation come down a bit, so that we could add, because I do think it's probably worthwhile using TIPS as an inflation hedge in portfolios.
Benz: Well, Sonal, this has been such an illuminating and wide-ranging conversation. We so appreciate you taking time out of your schedule to join us today.
Desai: Christine, thanks so much for having me. This was great.
Benz: Thanks so much for being here.
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