Does the economic outlook call for more optimism?

Since the onset of the financial crisis, we have been steadfast optimists that the global and US recoveries would be ongoing.

Our feeling is and has been that despite the enormous headwinds facing global growth, the natural economic healing process, the persistence and ingenuity of the human spirit, and continued policy support would underpin the global and US recoveries.
A year ago such economic optimism looked horribly misplaced. Fears of a potential global recession were accelerating as oil prices dropped to $25 a barrel, and fears of an impending economic collapse in China helped send global equity and other risk markets into a tailspin. For those looking at the consensus growth forecast of the US in isolation, and following the Federal Reserve’s (Fed’s) guidance of four rate hikes last year, overweighting spread products and positioning for higher rates seemed straightforward. When viewing the US as a meaningful, but component part of the broader global ecosystem, the need to protect against these potential downside events was crucial for controlling risk, and ultimately proved very beneficial. Our belief was that the enormous policy accommodation globally was actually accelerating, particularly in China. We thought the case for growth turning up there, rather than down, was becoming stronger. We also believed that commodity prices had overshot to the downside. In this environment, we felt adding to our highest conviction positions was warranted, particularly as we had mitigated portfolio drawdown with diversifying strategies. Fortunately, this optimism was rewarded (see Exhibit 1). The excess returns for various spread sectors are shown for both the calendar year 2016 and the more enormous bounces from the market bottom of February 11, 2016 to the present.
As we think about where we stand now and how to position going forward, we need to revisit our discussion of the credit cycle. As we have stressed in these notes, great care should be taken in distinguishing between the credit and business cycles. Usually, they are very highly correlated. When investors talk about “late cycle” behavior, they often mean late credit cycle behavior—typically characterized by chasing yield while reducing credit caution. In retrospect, the end of the credit cycle can be found when yield spreads hit their narrowest point. The current credit cycle has had an interesting variant for the same aforementioned global reasons. The global undertow led to a bear market in US corporate credit in both 2014 and 2015 despite the ongoing US recovery. This means that, while the enormity of the credit rally over the last 12 months has brought spreads down, they have still not reached the levels seen in June of 2014, the current cycle tights.

We feel valuations are fair, even if no longer overwhelmingly compelling. By itself, this suggests spread overweights must be reduced. If valuations have become less generous, however, it is because the underlying fundamental story for credit keeps improving. The US economy’s growth rate has improved since the first half of last year. The prospect of substantial credit-positive policy proposals is on the immediate horizon. We are most specifically focused on the prospects of deregulation for business as well as corporate tax reform/reduction. Despite our expectation that progress would be slower than the original optimism set forth by the new White House Administration, we still believe we will see substantial implementation this year. On infrastructure spending, the jury is still out; our expectation is that it may become next year’s business.
There is also room for optimism on the global recovery front. Global inflation looks to have finally stopped declining (see Exhibit 2). The extraordinary monetary effort seen in developed nations to arrest this decline finally appears to be bearing fruit. We must remain cognizant that this rate is still near zero. Global policymakers therefore must continue to support recoveries meaningfully. Japan and Europe most particularly are nowhere near their inflation targets, and we expect years of continued monetary support. This combination of increased global growth and inflation—buttressed by continuing monetary accommodation—provides continued interest in the US credit sectors, which are both higher-yielding and in a better cyclical environment than their international counterparts.

Last year was one of an exceptionally broad-based yield spread compression. We feel that, this year, the crucial need will be for subsector and issue-specific outperformance. This is the part of the business cycle when management is typically focused on equity friendly policies. As a bond investor, we need to be exceptionally vigilant. Our preference, particularly in the investment-grade space, is to focus on industries that are not in any position to re-lever. We like the energy and the metal and mining industries, which need ongoing balance sheet repair due to the commodity recession. We also continue to like financials. Indeed, they may have been the true lottery winners from the election. Dodd-Frank and the Basel accords will continue to provide an overarching framework, keeping banks from re-levering. The application of regulations should take on a meaningfully lighter touch, however. The ongoing stupendous fines should recede. The prospects for higher short-term rates would provide cash flow for which many have been waiting.
With respect to high-yield corporates, our emphasis on the opportunity in the energy space needs to be revisited given the impressive returns over the past year. Our relative value discipline has led us to take select gains in this sector and redeploy cash into areas or credits with more favorable return profiles. Examples of such opportunities include rental service companies, which should benefit from an increase in infrastructure spending, and certain specialty retailers that have unduly suffered with the broader decline in more traditional retail.
On the global spread sector front, we continue to like selected emerging markets, both USD-denominated and local currency. This appeared to be very much a counter-consensus opinion earlier this year, as fears of protectionism and extensive Fed rate hikes could be adverse. Our thinking is that the valuation case is compelling. These markets have been pummeled over the last four to five years. Yields spreads versus developed markets are near 2008 levels, and currencies have been in a severe bear market. If fears of global growth shortfalls and commodity price weakness helped drive the downturn in emerging markets, our rather strong suspicion is that better growth and stabilizing commodity prices will underpin a meaningful recovery.

The Continuing Need for Diversifying Strategies
Overweighting spread products in portfolio construction generally provides a yield advantage. This benefit comes with concomitant risks. Over the last seven years, the depressed global backdrop has resulted in many periods of substantial spread product underperformance—early last year was merely the most recent. We have been able to post positive results in both risk-on and risk-off periods during this entire recovery by focusing on balancing spread sector overweights, which benefit from our central thesis of optimism in the sturdiness of the recovery, with thoughtful macro-strategies that would prove critical when downdrafts occurred. Today, the growth outlook appears sunnier, but valuations provide less cushion for error. More importantly, we think that while early optimism on the global recovery may be borne out given policy helpfulness, there are many downside risks that have to be considered.
The secular headwinds of debt burdens, demographics and productivity remain. Indeed, only six months ago the narrative of secular stagnation (no growth ever) was a major market and policy focus. More currently, the immediate political populism trends raise the prospect of a deceleration of globalization, a return to nationalism and increasing uncertainty in policymaking globally. In addition to these secular factors, we think that political risks in Europe and Great Britain present cyclical downside possibilities. And as our last note mentioned—while perhaps not of immediate cyclical concern—over time, our expectation for growth in China is a meaningful slowing.
The cyclical upswing in the US has to be viewed against a fledgling global recovery and a secular growth environment with ongoing challenges. Protective portfolio strategies are particularly helpful when market optimism prices in rosy economic forecasts. The extent of the growth optimism implicit in the forward prices for the federal funds rate is a sharp departure from previous years. For each of the last five years the Fed has missed both its growth and inflation forecasts. Each year the Fed publishes a forecast of its expected path for the fed funds rate, but the market expectations have looked for much lower rates. Exhibit 3 displays the market expectations before the 2016 election, current pricing and the Fed’s official forecasts. Rate expectations have shifted up dramatically. Most notably, the terminal fed funds rate projected by the Fed is 3%. This is only 20 basis points from the current market value of 2.8%. The tightening cycle envisioned by the Fed is for an extended period of above-trend growth leading to a lengthy hiking campaign. This path and the end result are largely priced in. Any disappointment could lead to a sharp repricing toward lower rates. From our portfolio perspective, it is just this sort of unanticipated disappointment that might prove difficult for overweights to higher-yielding fixed-income securities.

We therefore continue to balance our overweight to spread product with strategies to protect against adverse environments. We are cautious about shorting Treasury securities against our high-yield and emerging market positions. We continue to have some longer maturity global duration and we have modest currency positions that will benefit should Chinese growth stumble.
Last year, the overwhelming sentiment was pessimistic, yet optimism proved to be the unexceptional winner. This year, growth optimism abounds. We are optimists also, although the degree of consensus gives us pause. Perhaps our relentless focus on diversifying strategies will not prove necessary this year. If so, we will, like last year, have sacrificed some of our upside return. But if this extraordinary historical period produces some more of the surprises seen over the last seven years, our more robust portfolio construction should serve us well.

Ken Leech – CIO – Western Asset (Legg Mason Group)