Global Economic Growth, Like Fed Rate Increases, Expected to be Long and Slow
Western Asset CIO Believes Economic Recovery on Right Track but Continued Policy Accommodation Necessary
PASADENA, Calif., Sept. 24, 2015 /PRNewswire/ -- In a quarterly webcast to provide market updates and strategy insights, and to reflect on volatility and the outcome of last week's Federal Open Market Committee meeting, Western Asset Management Chief Investment Officer Ken Leech said that, while not surprised at the U.S. Federal Reserve's inaction, "Global growth uncertainty is now very high."
"Our thought on interest rates is this normalization process will proceed," Mr. Leech declared. "Accommodative monetary policy not only remains crucial, but it can accelerate and we believe it will. Ultimately we will have higher rates, but this is going to be a long and slow process."
"If we're right about this, spread sectors continue to have opportunity and are well priced with good valuation to outperform government bonds."
These were the headlines from a market outlook affected by widespread and recent changes.
"Three months ago there was a lot of optimism about global growth," Mr. Leech said. "When you looked at spread and risk markets, they were pretty firm. That obviously has changed pretty dramatically with some extraordinary developments in the global economy."
"Growth downshifted along with global inflation. We thought downside risks were persisting and we needed to have some strategies to help offset them. The good news is we needed those strategies. Unfortunately, the bad news is that we really needed them. Those risks showed up."
"Broad-based weakness in commodity prices certainly has been very pronounced," Mr. Leech continued. "It suggests that the global economy has essentially approved the statement that demand has weakened. Certainly, it has put the emerging markets in a very difficult position."
Mr. Leech balanced this grim global picture by pointing out continuing growth in the U.S.
"From a U.S. perspective, things seem reasonable," he reported. "We think growth is going to be fine, but the global situation is much more challenged than what we have in the U.S."
Much of his presentation focused on the Fed's decision last week to not raise interest rates.
"At Western Asset, we have a lot of sympathy for the Fed's decision-making challenge," Mr. Leech said. "Should they raise rates? When should they raise rates? Certainly rates are extraordinarily low, and we expect the Fed to move them up. We think the Fed has been very sincere in their desire to get started in that process. I do believe they're going to move before year-end."
Noting that Western Asset Management changed its own call, which originally contemplated a June or September rate increase, Mr. Leech said global developments were influencing the Fed. He also cited the U.S. unemployment figures as justification for a potential rate raise.
"Not only has unemployment declined, it's declined all the way to where we're starting to get into the range the Fed considers close to full employment," Mr. Leech said. "That clearly suggests the Fed not only should be raising rates now, but could have been raising rates much sooner. A lot of reasonable people are getting in on the debate from a U.S. perspective straightforwardly."
"This is where other reasonable people can say delaying for three months, given some of the challenges and uncertainty in the global markets, is not an unwarranted position."
"Inflation is much more subdued than the Fed would have otherwise thought," Mr. Leech said. "That has to do with global growth and to some extent commodity challenges. Our perspective is that if U.S. growth stays at a 2 to 2.5 percent track, we envision the global economy – while having experienced a mild downshift – continues on its recovery course. Then we would see inflation rates stabilize and move up, but this may take longer than people think."
Mr. Leech emphasized that the timing of the Fed's moves is less important than the substance.
"Whether the Fed moved in September or December is not a major event for the bond market," he said. "The bigger picture is not when and whether the Fed moves that first funds rate – inches it off zero. It's really how aggressively and how far the Fed ultimately intends to move rates."
The Western Asset team believes the Fed's thought process has evolved: they think the fed funds rate indeed will be moving to a higher level, but it will be taking a longer period of time.
"That's the communication," Mr. Leech said. "The Fed is trying to change the communication focus from the first lift-off to the path and trajectory. How worried should market participants be given the pricing in the market of a very, very slow and gradual path of increase? The policy path is going to be one of normalizing rates in a very slow fashion. Inflation is going to be very slow to normalize and move up. The bond market therefore is going to have reasonably low rates for longer than market participants might've otherwise thought at the beginning of the year."
Mr. Leech also touched on the economic climate in Europe, starting with the impact of Greece.
"How do we feel about European growth?" he posed. "The headline challenges of Greece buffeted markets for most of this year. While Greece is still going to be a challenge, that issue has been resolved for the most part on a favorable basis. We still want to keep our eye on it, but we believe that has been handled pretty reasonably from a systemic risk point of view."
Accommodative monetary policy, including quantitative easement (QE) by the European Central Bank (ECB), led by President Mario Draghi, was met with optimism by Mr. Leech.
"Monetary policy is getting traction slowly, but surely," he reported. "When we look at European growth our forecast is just under 2 percent, which is not heroic by any stretch of the imagination, but neither is it the drag it's been the last few years. That change from Europe being a risk case to a positive contributor is important when we think about the global dynamic."
That set the stage for Mr. Leech to "talk about the elephant in the room, and what caused people to really rerate the global recovery prospects and the risks of the global economy: China."
"We've had tremendous anxiety over Chinese growth. Their stock market has come up very precipitously. The major change in policy with respect to China going off the dollar and allowing their currency to float created tremendous uncertainty as to what was motivating that change."
"We have felt that the diminution in Chinese growth is part of a long-term structural and secular change that needs to be monitored pretty closely, but the growth rate decline was going to be manageable. That's still our base case. But giving themselves flexibility with the currency means that, over time, if their economy were to weaken more substantially, the wherewithal to allow their currency to devalue is certainly now on the table. It's got market participants nervous."
Emerging markets are of concern to the Western Asset team, yet also exhibit opportunity.
"When we look at emerging markets, the challenges we're seeing with the slowdown in global growth, and slowdown in commodities, comes at the same time when a lot of emerging markets have really increased their debt load over the last five years," Mr. Leech cautioned. "This stands in remarkable contrast to the developed market. We've used the United States as an example, which shows that since the crisis there has been a meaningful amount of deleveraging, yet debt levels are still at very, very high levels. That's one of the reasons why when global growth shifts down, risk markets get very nervous. In the emerging space, this challenge is even more severe."
"We think valuations are pretty compelling, but we think the story line certainly is not only challenged, but continue to be challenged," Mr. Leech said. "We monitor this situation closely, but there are still pockets of opportunity given the deep valuation of emerging markets."
Moving past macroeconomics, Mr. Leech discussed prospects for particular bond markets.
"With the exception of the Taper Tantrum, long-term U.S. Treasuries have been a pretty good diversifier to risk," he said. "They help provide a portfolio balance and actually provided positive returns when other sectors have been negative. That's a strategy we're continuing to use. This works particularly well in a disinflationary environment, which we feel very strongly we're in. I think people can get nervous about this strategy, and where reasonable people can differ is in a very robust economy where the Fed accelerates tightening beyond people's expectations."
"You can get movement negatively in spreads and rates at the same time, so this strategy is not without some risk, but by and large … when risk to growth has been declining, risk to inflation has been declining, and spread products come under pressure, the beneficiary has been long-term U.S. Treasuries."
Mr. Leech noted that spread products have been under pressure for more than a year.
"So while equity markets especially in the U.S. are waking up to this challenge, fixed income markets have been under pressure for 15 months. That's important because it sets up the point we have been trying to make: that it's not what's your view, but what's the market price."
This creates opportunity in certain sectors of the bond markets.
"Investment-grade always trades wide to the actual default rates, but fundamentals are ultimately the key to our process," Mr. Leech said. "Investment grade credit is pretty reasonably priced."
"High yield has a similar backdrop. The fundamentals matter and high yield has been winding pretty sharply. There is fear defaults may be increasing. We think that's going to be happening in the energy and commodity space, without doubt, but this minor move up, let's say towards 3 percent, is not going to be enough to invalidate the movement we've seen in spreads. We still think they're pretty attractive and think this is a sector that needs to be in our plus portfolios."
"We have underweighted agency mortgages because we think the Fed starting their interest rate process will eventually lead to their curtailment of purchase of mortgages. With a more volatile interest rate backdrop it probably will be a little bit negative, so we've been underweight this sector."
"To talk about non-agency mortgage securities, where we've been holding our positions, we continue to believe in the fundamentals backdrop for housing – we're not huge fans of housing bubbles. We do think housing prices have put in their bottom and they're increasing. The affordability of housing, especially given that rates have stayed so low, continues to be positive."
In Q&A, Mr. Leech was asked what influence the Fed's inaction might have on Europe or Japan.
"I think (ECB President Mario) Draghi's position is that given the weakness in inflation, which is coming largely from weakness in commodity prices, it may give him the ability to extend the QE program for a longer period of time," he answered. "We would not be surprised to see that at all … That is why we think the backdrop for monetary accommodation is pretty positive."
"Similarly, our Tokyo team feels that we were going to get more monetary stimulus out of the Bank of Japan. That may not come for another quarter or two, but they have been missing their inflation targets and have the latitude to expand QE even further."
Asked about reported recent sales of U.S. Treasuries by the Chinese, Mr. Leech said, "From a macro perspective, we are not concerned by the Chinese selling of U.S. Treasuries. What they're trying to do is basically defend their currency and keep its volatility within certain bounds … but we do not think their selling of U.S. Treasuries is going to derail U.S. growth."
Asked about opportunities in investment-grade bonds, Mr. Leech pointed to the financial sector.
"When it comes to sectors, the total returns are not really the key. It's really the subsector and issue selection … and investment-grade financials have been the best performing sector. Banks and finance – bank paper – will continue to improve relative to the corporate average."
About Ken Leech
Ken Leech is Chief Investment Officer of Western Asset Management Company. He joined the firm in 1990. From 1991–2014, assets under management grew from just over $5 billion to $466 billion. Mr. Leech leads the Global Portfolio, US Broad Portfolio, and Macro Opportunity teams. From 2002–2004, he served as a member of the Treasury Borrowing Advisory Committee. In 2014, Mr. Leech and the Western Asset team were named Morningstar's US Fixed-Income Fund Manager of the Year for the Western Asset Core and Western Asset Core Plus Funds. He was inducted into the Fixed-Income Analyst Society Hall of Fame in 2007. Mr. Leech is a graduate of the University of Pennsylvania's Wharton School, where in four years he received three degrees, graduating summa cum laude.
About Western Asset Management
Western Asset Management is one of the world's leading fixed-income managers with $453 billion in assets under management as of June 30, 2015. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, São Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more about Western Asset Management, please visit www.westernasset.com.
About Legg Mason
Legg Mason is a global asset management firm with $682 billion in assets under management as of August 31, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).
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