Continued central bank support, optimism for a trade deal, and a potential rebound in emerging markets

Q&A with Ken Leech, Chief Investment Officer at Western Asset

What should we expect to see from the U.S. Federal Reserve this year?

In the U.S., the window of opportunity to raise rates looked wide open in the middle two quarters of 2018, with the economy accelerating to over 3.5% growth at an annualized rate. Inching the fed funds rate up three times seemed non-controversial. But by December 2018, the U.S. economy was downshifting quickly and the global picture was also weakening. Having guided the markets so clearly to expect a December hike, the Fed followed through, but then executed a pause. It is not absolutely clear cut, though, that today’s rate is at the bottom end of the Fed’s “normal range.” However, we believe that the economy will have to pick up speed for an extended period, bringing inflation with it, before the Fed will tighten again.


And how about central banks in the rest of the world?

Globally, as growth and inflation remain below target levels, monetary policymakers have been in a more accommodative mode than those in the U.S. In fact, we believe the most underappreciated theme continues to be the extraordinarily subdued inflation rates around the world.

In today’s debt-laden, sub-par expansion, we believe monetary policy will stay accommodative until growth resurges and presents an opportunity to restart normalization. Then very modest incremental changes can be enacted, assuming they remain constantly vigilant in case growth should stall.


How are you viewing China today?

The need to shore up growth as the challenge of competition with the U.S. became more pronounced led to extensive policy stimulus. China has cut interest rates and reserve requirements. It has cut individual tax rates and moved to increased fiscal stimulus. Most tellingly, China has very publicly trumpeted the need to reinvigorate the private sector, virtually reversing last year’s program.

These policy measures will take hold with a lag, and therefore economic indicators may not turn decisively up for some time. But a long rounding bottom is our base case for China, with growth in the second half of 2019 being better than in the first.


Can we set aside worries about the U.S.-China trade war?

With the downshifting of growth, both the U.S. and China have strong incentives to reach a bargain, and have been signaling the likelihood of such an outcome. We do not expect such a deal to come remotely close to resolving all the issues, and expect the economic competition to be a central theme going forward. But we do expect the attenuation of investment projects as uncertainty mounted late last year will subside.


What’s happening in the rest of the world?

European growth is off to a very slow start after last year’s downshift to trend from above-trend growth in 2017. We expect modest, close-to-trend growth of 1.25%-1.5% in Europe.

Chinese growth continues to slow. Japanese growth downshifted, and non-China emerging markets are trying to shake off the negative effects of last year’s brutal combination of both downwardly revised global growth and higher U.S. interest rates.


What opportunities do you see in fixed income today?

We continue to see a meaningful opportunity in emerging markets, especially after its severe underperformance last year. The challenges that hit emerging markets in 2018—including higher U.S. interest rates, an ever-stronger U.S. dollar, and fears of slower growth in China and Europe—have led to emerging market local debt being priced at an 18-year low.


Where do we go from here?

Global weakness, in conjunction with fears of sustained U.S. monetary policy tightening and a potential trade war, caused risk assets to perform badly last year. The question now is this: Can growth remain sturdy?

Many of these headwinds are not only abating, they are reversing. Fed tightening is no longer in prospect. An ever-stronger dollar seems unlikely. Chinese growth could move from a headwind to a tailwind. And a much more sober approach to global trade resolution may be in the offing.


Ken Leech is Chief Investment Officer at Western Asset, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.

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