Health Uncertainty vs. Economic Uncertainty: The Need To Safely Restart Growth

Policymakers face difficult tradeoffs. Fixed Income Views explores macro and sector outlooks.

Franklin Templeton Fixed Income

In this issue

As many now find themselves reading this paper from the confines of their home, under a government-mandated “quarantine” intended to slow the spread of a novel coronavirus, there is no question that the world has fundamentally changed since last year—even from just two months ago. This paper therefore provides a substantial update to our macroeconomic outlook and sector views compared to our previous deep dive.

To halt or at least slow the spread of the virus, a number of governments across the world have suddenly shut down large parts of their economies, causing an enormous degree of disruption in just a small amount of time. With more than a third of the planet’s population under some form of restriction, the shutdowns have impacted people in a much more tangible and palpable fashion than past crises—for the first time in living history, entire economies came to a halt—and routine, daily activities were no longer allowed. Substantial restrictions on global travel have compounded the impact, inflicting substantial damage on global supply chains.

Governments and central banks have immediately stepped in with powerful fiscal and monetary policy expansions; these will be very helpful in cushioning the short-term damage, but the recovery prospects hinge crucially on how quickly economic activity can resume.

We are now entering this crucial phase: some US states and European countries are beginning to cautiously relax their restrictions on economic activity. Uncertainty remains high, but we have some encouraging signs: various countries such as South Korea, Taiwan, Australia and New Zealand have demonstrated the ability to contain and even eliminate the spread of this novel coronavirus, despite their relative proximity to the original epicenter. Other countries and US states seem to have been able to slow contagion with more moderate restrictions to economic activity. Scientists and researchers around the world have shown progress on the development of a vaccine, antiviral and antibody therapeutics, and treatment regimens.

The fear that reopening the economy will cause contagion to accelerate anew lingers, however; some policymakers are therefore proceeding with great caution. Finding the right path to safely reopen the economy—restarting economic activity while preventing a new wave of contagion strong enough to overwhelm health care systems—is now the crucial priority for policymakers. It is inconceivable to believe that the world can stay in stasis until a vaccine is developed and mass produced at scale in order to inoculate the entire global population. The priority must be to identify a strategy to restart global economic activity while maintaining appropriate precautions to safeguard public health, which will likely require widespread testing capacity, contact tracing, serology testing and some form of continued social distancing measures.

Policymakers face a difficult tradeoff between health uncertainty and economic uncertainty. If policymakers succeed in safely restarting the economy over the coming couple of months, the massive policy stimulus in the pipeline can still fuel a robust recovery. If instead the current shutdown is prolonged, or if initial steps to reopen the economy are reversed, the structural damage to the economy would be much more serious, and the recovery prospects correspond¬ingly dimmer. And the adverse economic (and health) consequences will continue to fall disproportionately on the most vulnerable sections of society.

In an environment with such a high degree of uncertainty, active management has become even more critical as dislocations and extreme panic can create opportunities but also cause indiscriminate market movements. Deep fundamental analysis and security selection will be required to find the most attractive opportunities going forward, in our view. Fixed income investors should prepare for further periodic bouts of volatility in the quarters ahead, but we think investors will be well served by not panicking and by continuing to invest for the long term.

In this paper we discuss:

  1. US and euro area macroeconomic overview and outlook
  2. Scenario analysis for growth going forward
  3. Sector outlook

Sector Settings

What Are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. AMBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.