Can Bond Markets And Economies Keep Diverging?
By Jack P. McIntyre, CFA, Portfolio Manager, Global Fixed Income, Brandywine Global
How would you summarize your outlook for global fixed income markets?
We are in one of those periods where markets and real economies are diverging. The global economy is still doing well, yet emerging markets are undergoing a mini-taper tantrum. Right now, Argentina and Turkey are taking the brunt of the selling pressure, but the developing world will continue to be a key driver of global growth. When the dust settles, which should be in the not too distant future, there will be attractive bargains in emerging markets. We believe the combination of emerging market valuations and a stable global economic backdrop will start the process of attracting investor capital. Remember, our time horizon is measured in years, not months or quarters. To break it down like a baseball game, I would say this developing market cycle is only in the third inning. Investors, who want less volatility than they might be willing to undergo with a long-only portfolio, should think about unconstrained bond strategies. We have a couple of risk hedges embedded in our portfolios, including one that serves as protection in the event global growth and trade slow down. We have portfolios that are skewed towards risk neutral, risk seeking-type environments. We want to counterbalance that a bit. Maybe we should be buying more U.S. Treasuries, nibbling a little. The spreads between Treasuries and other core government markets look compelling.
What do you consider the dominant theme in global fixed income today?
For now, the markets have seemingly forgotten that the global growth environment remains constructive. Last fall, I was at the International Monetary Fund1 conferences and a speaker pointed out that 192 countries were growing - and only six were contracting. Some of those six were in the Caribbean, which had a bad hurricane season, and some were in Africa. That's about as broad-based as you're going to get in terms of global growth. Maybe, global growth isn't quite as broad-based as late last year, but the global economy is still doing very well. We expect the markets to refocus on this positive theme.
What about the impact of non-economic risks, such as geopolitics and monetary policy?
They have not been quite as important in 2017, but coming into this year, we saw a transition where their influence on the markets has increased. Part of this rising influence happened because global growth slowed a bit. The markets shifted their focus to some of those non-economic risks, which has been a source of recent volatility. The dollar is undergoing a countertrend-type move. It's been incredibly weak for the last 18 months. The dollar strength we've seen in 2018 is not a trend change, which is incredibly important for our portfolios. The factors that have gotten the dollar to this point - its overvaluation, better growth outside of the U.S., President Trump's view on currencies - remain in intact despite the short-term resurgence of dollar strength.
Despite tax reform, there is going to be better growth outside the U.S. That should ultimately drive the dollar lower. The U.S. Federal Reserve2 is, so far, committed to tightening three times this year, which is discounted in the dollar. We don't see inflation running at a level that would compel the Federal Reserve to add an additional fourth rate hike this year. We believe the market volatility to date in 2018 is more of an aberration. We have not fundamentally changed our portfolios based on the price action over the last six weeks.
What major indicators are you focusing on as 2018 progresses?
Global growth will remain on solid footing. We are not tracking anything that suggests a big growth scare on the immediate horizon. Despite all the trade tension rhetoric - fortunately, it's more rhetoric than action - global trade is doing well. There is no global inventory overhang that can be an economic cycle killer. We think CapEx3 is going to start to ramp up. All that should help growth both in the U.S. and in other countries and regions.
Inflation is a key factor. Our portfolios are positioned on a cyclical basis, expecting inflation to move higher. However, we are well aware of the secular disinflationary forces out there that are probably going to keep a lid on how high cyclical inflation can go and ultimately, how high bond yields can go.
How important are the U.S. and China to global economic growth prospects?
Not surprisingly, what happens in the U.S. and China sets the tone for global markets and the global economy. We are viewing China through the lens of economic stability and expect trade tensions between the U.S. and China will not escalate into a full-blown economic cold war. Constructive things are going on in China. The consumer is becoming a bigger driver of economic growth. New industries are doing well and not saddled with a huge amount of debt, unlike the state-owned enterprises. China will continue to chug along at 6-6.5 percent-type growth, better quality growth, less reliant on investment and exports. Remember, given China's economic impact on the global economy, the country sets the price in commodities, which is a positive for commodity-based emerging market countries.
What is your view on the direction of the U.S. dollar?
Our view is that the dollar has embarked on a multi-year downtrend. One of the reasons we don't think this countertrend, dollar-strength move has a lot of legs is the Trump Administration. When President Trump was elected, we spent a lot of time asking, "What motivates him?" He has talked for decades about the risks associated with a large U.S. trade deficit. He views trade as zero sum and that perspective drives his protectionist leanings. I think President Trump will continue to embrace a weaker dollar to help U.S. corporations gain a competitive edge over their foreign counterparts.
The dilemma is that with tax reform, we may get a little better growth. Consumers are going to enjoy a bit more income and buy stuff - but we don't make a lot of stuff consumers can buy, so that could deteriorate the trade deficit, again. Keep an eye on the interesting relationship between Presidential approval ratings and the U.S. dollar: they tend to move in tandem. Trump's approval ratings are pretty low. If they keep running low, it could reinforce the weak dollar environment.
What are the key factors that led you to invest in emerging markets?
Valuations first. The emerging world has done well over the last year to 18 months, but valuations remain compelling. Emerging markets have lagged since 2011. These are not just one- or two-year cycles and then they end. We think this cycle has legs despite the mini-taper tantrum is currently unfolding. There has been underlying improvement in the economic fundamentals in a lot of these countries. Current account deficits have improved. Central banks, by and large, have shifted to more pro-growth policies. Inflation has been fairly contained. The supply/demand dynamic should keep commodity prices stable. That's going to flow through into the emerging world. Our portfolios are skewed towards oil producers.
It is not abnormal to see a volatility uptick in financial markets after the Fed has been tightening for two years. We need to focus on political and policy risks. I find myself being more of a political analyst these days than a market analyst. Geopolitical risk is interesting. The North Korea situation has calmed down; that was a big uncertain variable. If we shift back to the global growth scenario, emerging economies will do well, and their markets and currencies should do well.
How are you approaching Mexico and Brazil?
Our outlook on these two countries has remained constructive yet cautious. Both countries will hold crucial elections this year. In Mexico, we are, of course, watching the NAFTA4 renegotiations closely. We think the negotiations will get done, but the timing is an issue. We expect that markets have already priced in an Andrés Manuel López Obrador victory in Mexico. Therefore, we do not expect to see much more volatility around the presidential elections.
We have seen a backup in the Brazilian real, but we have always been more positive on the country's bonds. Inflation expectations are still running high. Volatility has ticked up, but if the global economy does well and trade tensions between the U.S. and China subside, Brazil has just emerged from recession and could start to recover. We will be watching the new president closely and whether the new administration will finally address pension reform.
Both countries will benefit from higher oil prices. That's not capturing sentiment in these markets at the moment, but we believe it will.
1The International Monetary Fund is an international organization that aims to promote global economic growth and financial stability, to encourage international trade, and to reduce poverty. Investopedia.
3Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. Investopedia
4The North American Free Trade Agreement, which eliminated most tariffs on trade between Mexico, Canada, and the United States, went into effect on Jan. 1, 1994. Investopedia
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All investments involve risk, including the loss of principal.
Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls.
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. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Foreign securities, where permitted, are subject to the additional risks of fluctuations in foreign exchange rates, changes in political and economic conditions, foreign taxation, and differences in auditing and financial standards. These risks are magnified in the case of investments in emerging markets.
Tapering of the Federal Reserve Board’s quantitative easing program and a general rise in interest rates may lead to increased portfolio volatility.
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