Inflation Expectations Deserve Consideration From Investors

LONDON, July 16, 2015 /PRNewswire/ -- At a recent conference in London to discuss prospects for unpredictable global financial markets, portfolio managers from Legg Mason's affiliates were asked, "What risks do you think are not fully appreciated by investors now?"

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For three based in the UK, the biggest issue on the horizon was potential inflation. With Europe in the early stages of recovery, it may not be an immediate risk, but the combination of aggressive central bank policies with economies on the mend may give rise to fears of inflation.

"Central banks around the world have been engaging in extraordinary monetary policy," said Mike Zelouf, Director of London Operations for Western Asset. "The latest central bank to join that was the European Central Bank (ECB), with its decision to expand monetary asset purchases earlier this year. The key risk clearly is that central banks are successful in reflating economies."

"We don't believe inflation is likely to pick up very sharply, but what can happen is that inflationary expectations can increase much, much quicker than actual inflation."

That view was echoed by Michael Browne, a portfolio manager at Martin Currie. He observed that, "We are in a very benign economic phase at this moment in time – the early stage of recovery from a European perspective – but there are always going to be certain risks."

"The first risk out there, one that people will talk about as this recovery starts to take hold, will be inflation," Mr. Browne said. "We'll start to have to see a rise in interest rates across Europe and indeed globally over the next two to three years. In Europe there is no risk of interest rate rise until 2017, when the QE from the ECB will finish, but after that, will we start to see tighter labour markets? Will we start to see the necessity to raise rates? I am not sure we will. I think the European recovery is going to be based around labour and the increase in utilisation of labour at lower wages, rather than seeing big increases in wages – which could be inflationary."

To Gordon Brown, co-head of the Global Portfolios team at Western Asset Management, the financial market risk foremost in his mind was "the potential threat of global inflation."

"The market's pricing in a very subdued global growth outlook," he said. "Actual inflation and inflation expectations remain very well anchored but perhaps we are missing something. Perhaps we are not being as optimistic as we should about the global outlook, given the huge amount of policy accommodation we've seen, particularly from developed market central banks."

"It is quite possible we are not being optimistic enough on global growth," Mr. Brown advised. "With perhaps not factoring in central banks' abilities to generate inflation and get the broad level of prices back, closer to their targets, that is certainly an eventuality that the current level of global government bond yields is not discounting. That is something as investors at Western Asset that we are thinking about and looking to develop to protect us should that scenario play out."

Mr. Zelouf sees this as a potential opportunity for investors in the fixed income markets.

"Government bond yields in that kind of environment could rise quite sharply over a short period of time," he observed. "Although initially spread product credit markets could also follow suit, as they did in 2013, we believe the stronger growth environment underlying this scenario will help spread product credit markets. Unconstrained strategies, which allow managers to flexibly manage their duration and interest rate sensitivity, would do particularly well."

Yet Mr. Zelouf also foresees a second and what he considers more concerning scenario.

"If central banks are unsuccessful in reflating economies, expectations (could) drift towards a more recessionary or deflationary environment," he warned. "That is a concern because of the high levels of public sector and private sector debt that have accumulated, not just in the developed world but also in the developing economies around the world. If we slip into an environment where inflation slips lower, the more critically inflation expectations go down, central banks have very few tools they have not already used to address that."

What will happen under such a scenario? Mr. Zelouf believes some sectors will perform well.

"Government bond markets will do very well. There will be a very sharp flight to safety. Corporate bonds and other risk assets will be negatively impacted as a result of deflationary expectations. There will be a shift to fixed income and, once again, unconstrained flexible fixed income strategies will do well, as they will have the best exposure to hedge deflationary risk."

How likely any of these forecasts are to come to fruition will continue to be debated. The Legg Mason managers believe the greatest risk lies in ignoring these potential pitfalls.

"The risk from a European perspective is in fact undershooting some of the demand estimates that people see in 2017 and 2018," Mr. Browne of Martin Currie observed. "The risk is a slower recovery based around non-inflationary impulses and non-inflationary growth. If that does not occur, then of course there is no European recovery and there will be none going forward."

"As investors, we will see a risk from 2016 onwards of having to say: When is the right time to retreat from real assets? Looking at the corporate balance sheets; looking at the opportunity set; looking at return on equity; and looking at the cash flows – I think that is unlikely."

"What we really have to do is think about the risk as not being any inflation in 2017 and 2018."

About Gordon S. Brown

A Portfolio Manager with Western Asset since 2011, based in London, Gordon Brown co-heads the Global Portfolios team and provides specialist input on Eastern European debt. Previously Mr. Brown was a senior investment manager, emerging market rates and currencies, with Baillie Gifford & Co., from 2001 to 2011; head of global fixed income with State Street Global Advisors, from 1999 to 2001; senior portfolio manager with Commerz International Management, from 1996 to 1999; and a fixed income analyst with Dunedin Fund Managers, from 1994 to 1996. An associate member of the UK Society of Investment Professionals, Mr. Brown earned a M.Sc. in investment analysis from University of Stirling, a M.Sc. in business economics from University of Strathclyde and a M.A. in economic science from University of Aberdeen.

About Michael Browne

An Investment Director and co-manager of European long/short strategies based in London, Michael Browne joined Martin Currie in 2010. Previously he co-managed the European hedge fund of Sofaer Capital, from 2001; was head of international equities at Chase Asset Management, where he had overall responsibility for all non-U.S. equity portfolios; and began his career in 1986 at BZW Investment Management, where he was responsible for a variety of European unit trusts and segregated funds. Mr. Browne received a degree in economic history from Brighton College, Durham University in 1981.

About Michael Barukh Zelouf, CFA

 Mr. Zelouf is Western Asset's Head of Operations in London with overall responsibility for business and product development in Europe and the Middle East. He joined Western Asset in 1996 as the Director of International Investments with responsibility for managing global and global multi-sector portfolios, with a research focus on local-currency emerging markets.

Mr. Zelouf began his investment career in 1987 as a Research Analyst for Fuji Bank and later for Lehman Brothers Global Asset Management. Prior to this, he worked for British Petroleum as a Design Engineer focusing on artificial intelligence systems for BP's commodity trading arm.

Mr. Zelouf graduated from Imperial College, University of London in 1984 with a BSc (hons) in Chemical Engineering and is a CFA charterholder.

About Martin Currie

International in outlook and activities, with offices in Edinburgh, London, Melbourne, New York and Singapore, Martin Currie is an independently managed investment affiliate of Legg Mason Inc. Self-directed, innovative in approach and able to take a long-term view, the company actively encourages employee engagement across all areas of its business. This commitment closely aligns the firm's aspirations with those of its clients, enabling a culture of individual responsibility and shared success. Martin Currie builds global, stock-driven portfolios based on fundamental research, focused on core areas of investment expertise.

About Western Asset Management

Western Asset Management is one of the world's leading fixed-income managers with $455 billion in assets under management as of March 31, 2015. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, Sao 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, please visit www.westernasset.com.

About Legg Mason

Legg Mason is a global asset management firm with $707 billion in assets under management as of May 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).

Duration
Duration is a measurement that signals how much the price of a bond is likely to fluctuate when there is a change in interest rates. The higher the duration number, the more sensitive a bond will be to interest rate changes.

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The views expressed are as of the date indicated, are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation or recommendation or be used as the sole basis for any investment decision.

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