Fixed Income Investors Should Seek Opportunity in Emerging Market

Dovish Central Bank Accommodation Will Continue, and U.S. Federal Reserve is Unlikely to Raise funds Rates Until Conditions Improve

We expect steady, unspectacular U.S. and global growth. That’s been our basic message: slow but sustainable growth globally. The fear the market had in the first quarter, that the slow growth rate might actually fall, is what got the markets in pretty dire straits.
During that first quarter, Western Asset did not believe the global growth situation was going to develop into a global recession, but it has warranted exceptional monetary accommodation.

Policymakers have to be attentive to downside risks, especially in an environment where U.S. and global inflation remain exceptionally subdued. Fortunately, central bank accommodation is aggressive, and increasing. That means U.S. Treasury bonds and sovereign bonds will be underpinned by these low policy rates, which will continue around the world.

Strong opportunity ahead in investment grade (IG) corporate bonds
Where we’ve concentrated our efforts – and the majority of our risk budget – is in spread sectors.

Regarding Europe, the recent Brexit vote injected a high level of uncertainty into the outlook.

We expect that the European Central Bank (ECB) will expand its QE program, both in length of the program and the size. We have been very impressed and continue to believe that the ECB will be very aggressive in its buy of corporate bonds as part of its asset purchase program.

Europe’s negative interest rates obviously present quite a challenge from a net margin perspective. That’s got to be watched pretty carefully.

Emerging markets (EMs)
There’s a real case to be made for emerging markets, both in local currency and dollar-denominated bonds. That’s an area we are focusing on even more meaningfully than coming into the year. The yield spread between EMs and developed has reached crisis wide. When you think about valuations and people needing yield, this is where yield is abundant.

The two positions we’ve liked structurally have been Mexico and India. Over the course of the year we have been opportunistically investing in a number of others. One I’d highlight is Brazil.

To buy EM bonds, and take advantage of those yields, investors must buy their currencies.
The EM widening against developed market yields really provides an opportunity, but that opportunity exists due to weak global growth, challenging commodity prices and a lot of volatility. You have to be real thoughtful about your proportionality and do your homework.

While we’ve had a terrific bounce, there’s no reason to rush to the exits, given both the growth and the policy backdrop. We continue to think the valuations are pretty reasonable.

Another reason to be optimistic is the enormity of the yield advantage, especially in the U.S. credit space, for global investors.

The U.S. credit market has the greatest yield value, and also has the greatest market value. The U.S. also has the highest yield among all IG sectors. So we see an awful lot of global demand, particularly from Asia, and recently increasing from Europe, into the U.S. credit markets.

When you look at the high-yield market, you see a similar picture. The U.S. high-yield market is much larger, having more attractive yields than either Europe or Asia. Valuations are attractive, the backdrop is pretty positive, and compare and contrast how pessimistic default estimates are to reality.

Future plans of the U.S. Federal Reserve
Our position on the Fed has been that they have moved from a desire to routinely think about ways to move the funds rate up, to one that’s much more opportunistic. While they would like to inch up, they need a lot of stars to align. We do not think they’re going to be there for them.

Basically the Fed is on hold unless they get three conditions. Obviously economic growth has to be in line with the Fed’s forecast. They’ve expressed optimism that a 2 to 2.5 percent growth rate going forward is in the cards. That’s what they’re looking for as a backdrop. Financial conditions also have to improve significantly; reasonable people can differ on where we stand there. And the last one: inflation expectations need to rise. That’s where we are hanging our hat, since we think the Fed is really going to need to be cautious. It hasn’t gotten as much attention, and we might be a little bit of an outlier in our focus on this point.

With inflation continuing to come in at lower-than-forecast levels in the U.S. and worldwide, the company observed that market participants are slowly but surely starting to ratchet down their expectations to a lower rate of inflation over time. That has significant meaning to the Fed.

When you look at equity markets you go, oh my gosh, they really are strong. Why would the Fed have any concerns whatsoever? Contrast that with inflation expectations: over the course of the year, they are down in the U.S., Europe, Japan and Germany. After Brexit, they fell further in all four places. This is not supportive of the need to tighten policy.

While many of these macroeconomic factors are not new or surprising, one certainly is.

The most immediate risk that’s different than we would have talked about six months ago is Brexit. That’s fair reason for caution.

Another point highlighted by the World Bank is the bumpy adjustment in China. China’s growth is going to be slow. We need to be very thoughtful about it, but the policy adjustment in China was so aggressive that they could avoid a hard landing.

As slack comes out of the U.S. economy and we reach full employment, you would expect the inflation rate to stabilize before it might move up. That would also have to be true for the global recovery, but we have the opposite picture. Developed market inflation is not only not stabilized, it’s broken down. That’s also a reason why policymakers need to be very, very accommodative.

Global headwinds are straightforward. When you look at world GDP, we have been in the camp that a 3 percent growth rate, very slow by historical standards, can be maintained. A low bar, and it’s going to take a lot of policy help. Fortunately, we’ve had that, which truncated some of the downside risk. But the major headwind of growth over time is the enormity of the debt burden around the world. It’s going to take time, low interest rates and a continuation of policy support.

Kenneth Leech – Chief Investment Officer – Western Asset Management Company