Where In The World Should Fixed Income Investors Search For Opportunity?

PHILADELPHIA, Nov. 12, 2014 /PRNewswire/ -- With global economic recovery sluggish outside the U.S., and some European and Asian economies tottering, investors must be careful. Deflationary trouble spots dot the world, including Japan, but Europe may be the most serious. Opportunities exist across geographies and sectors, but Legg Mason affiliate Brandywine Global believes the outlook for further quantitative easing by European Central Bank (ECB) and Bank of Japan (BoJ) may be an important driver in bond and currency markets throughout 2015.

"These are perilous times for European fixed income markets," said Brandywine Global's Francis A. Scotland, Director of Global Macro Research. "Ten-year German Bunds traded below one percent during the most recent quarter. Many of Europe's sovereign bond markets are expressing yields at multi-century lows. These yields are indicative of Europe's deflationary pressure and an extremely pessimistic outlook for the future of the European economy."

Fortunately policymakers have come to understand the scope and significance of the problems. Although it may take longer than decisions made by the Federal Reserve, Mr. Scotland believes the ECB is unlikely to make significant policy mistakes as has occurred in the past.

"The good news is that ECB President Mario Draghi has the playbook," Mr. Scotland commented. "He now has a valid reason to implement unorthodox monetary policy. His mandate for price stability is symmetric. The ECB is required to fight deflation as much as inflation. Draghi stressed that he has the unanimous consent of the council to pursue all unorthodox means required, if necessary. Policy actions or inaction in Europe – and China – over the coming six months likely will drive investment trends."

The recent ECB promise to increase its balance sheet by about 1 trillion euro shows that policy is in motion, but the lack of details illustrates the fragile consensus around the implementation details of ECB policy. The bank may push additional money into the system by purchasing corporate debt or sovereign debt, an important consideration given the ECB's charter forbids direct funding of sovereign debt.

The current situation leaves room for optimism about the world finally reaching synchronized and sustainable global growth.

"Our assumption that Chinese authorities are practical, above all else, implies they will undertake countermeasures to ensure enough growth for employment creation," Mr. Scotland observed. "If this and our ECB assumptions are met, the odds are that Europe's multi-century low sovereign bond yields are bottoming. Correspondingly, U.S. real yields would slowly resume their mean reversion back to pre-crisis levels."

Beyond the developed world, many emerging market countries were dealt severe negative monetary impulses in the wake of last year's "taper tantrum." Bond yields rose and central banks tightened in many instances, causing money growth to weaken significantly. Falling currencies kept pressure on central banks because of the headline inflation effect.

According to the Brandywine Global team, this caused growth in many of these emerging market countries to slow, although the steep decline in oil prices presents a broad consumption stimulus.

"On a net basis, the emerging world has yet to provide any kind of counterweight to the global tendency of disinflation," Mr. Scotland said. "This is best seen in global trade. Nominal growth in trade is expanding slightly, but real levels are virtually stagnant. Among the major EM countries Brazil, Russia, and India are all facing serious monetary challenges."

There is value to be had in emerging market fixed income, with enough research.

"In this environment, higher yielding EMs look attractive despite weak recent growth data," Mr. Scotland advised. "These include Indonesia, Brazil, and South Africa. Yields are high, global inflation pressures are manageable, if not benign, and monetary policy may have room for easing. As long as rate cuts spur growth and don't have negative impacts on currency valuation, rate cuts can be a net positive for emerging countries. EM rate cuts are much more likely should Europe, Japan, and even the U.S. need to introduce additional easing in 2015."

Mr. Scotland continued, "From a G3 perspective, however, stay away from currencies supported by central banks that will need to implement fresh stimulus. The mechanics of reflating Europe and Japan will likely necessitate less expensive currencies, even from the seemingly battered levels existent today. Our strategy continues to remain overweight the dollar with no exposure to the yen or the euro, where possible, and short positions in strategies that allow for nominal shorts."

Brandywine Global looks for the macroeconomic surprise in the investment outlook. This creates opportunities to benefit from embedded misvaluations in bonds and currencies.

The outlook for the U.S. economy is positive, if not wildly so. Brandywine Global expected it to hit the expansion phase of its economic cycle in 2014.

"The year started off a little rough with Russia's undeclared war on the Ukraine and cold weather in the U.S. that figuratively froze U.S. economic demand," Mr. Scotland observed. "But if you ignore the newspapers and the media and just look out the window, economic trends in the U.S. look pretty good."

Despite this robust economic performance, U.S. 30-year Treasurys are priced to yield a little above 3 percent, well below nominal GDP growth rates. Five-year Treasury Inflation Protected Securities (TIPS) offered a negative 50-basis-point (bps) yield as recently as August, while 10-year TIPS yields at 50 bps are still over 150 bps below the levels that existed before the 2008 crisis. These prices give the impression of a pessimistic economic outlook.

"We think two main reasons are driving the conundrum of low bond yield levels and good U.S. growth," Mr. Hoffman said. "First, household confidence is low. Progress remains slow despite recent gains. House prices have rebounded but are still below levels of 9-10 years ago. Nominal median family incomes remain well off pre-crisis trends. Roughly 80 percent of the increase in U.S. consumption since the crisis has been driven by the income distribution's top 20 percent.  Most people in the U.S. are not feeling the gains visible in the top-line economic data."

"Second, and more importantly, the U.S. economy is not an island. It operates within a global economy that is not growing as fast, is disinflationary, and is littered with anxiety-creating geopolitical hotspots. As a result, the dollar is rallying for the first time in 40 years before the Fed has raised interest rates. Excessive dollar strength risks sapping the U.S. of its growing momentum and undermining the inflation outlook. The euro is breaking hard, corporate credit spreads are moving higher, and U.S. breakeven inflation rates are falling to levels usually associated with earnings-multiple compression in the U.S. equity market."

About Francis A. Scotland

Since joining Brandywine Global in 2006, as Director of Global Macro Research Francis Scotland has developed a proprietary global macroeconomic research structure to support the fixed-income group's investment process. In addition to his extensive contribution to the global macro strategy, he provides investment ideas and strategic asset allocation recommendations for the firm's global fixed-income and hedge fund products.  Prior to joining Brandywine Global, from 1984 until 2005 Mr. Scotland was a principal of the BCA Research Group and head of global investment strategy.  He also spent several years in the policy departments of the Bank of Canada in the early 1980s, working in monetary, economic and financial analysis.  Mr. Scotland has a Master's degree in Economics from the University of Western Ontario in London, Canada, and an Honors B.A. in Economics from Queen's University in Kingston, Canada.

About David F. Hoffman, CFA

David Hoffman is a Managing Director and co-lead portfolio manager for the firm's global fixed income and related strategies.  He joined Brandywine Global in 1995.  He is a member of the firm's Executive Board, currently serving as the Board's chair.  Previously, Mr. Hoffman was president of Hoffman Capital, a global financial futures investment firm (1991-1995); head of fixed income investments at Columbus Circle Investors (1983-1990); senior vice president and portfolio manager at INA Capital Management (1979-1982); and fixed income portfolio manager at Provident National Bank (1975-1979).  A CFA charterholder, Mr. Hoffman earned a B.A. in Art History from Williams College.

About Brandywine Global

Founded in 1986, Brandywine Global Investment Management offers a broad array of fixed income, equity, and balanced strategies that invest across global markets.  Brandywine Global manages $61 billion in assets as of September 30, 2014. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. (NYSE: LM), and is headquartered in Philadelphia with office locations in San Francisco, Montreal, Toronto, Singapore, and London.

All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities.

U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity.

A basis point is one one-hundredth of one percent (1/100% or 0.01%).

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About Legg Mason
Legg Mason is a global asset management firm, with $708 billion in AUM as of September 30, 2014.  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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SOURCE Legg Mason, Inc.; Brandywine Global

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