Manager Q&A: Global Fixed Income Market Commentary
Ken Leech, Chief Investment Officer at Western Asset Management
Q: What is your assessment of the global economy and worldwide financial markets?
A: In early 2018, financial reports of a “global synchronized recovery” were omnipresent, and global growth optimism was pronounced. Since then, global divergence has been extraordinary.
In the US, the economic picture has been even better than we thought. Above-trend growth, subdued inflation and a cautious Federal Reserve1 (Fed) remain our base case. In the first half of 2018, growth came in at over 3%, while inflation flirted with finally hitting the Fed’s target of 2% after eight years of expansion. Better growth with subdued inflation had provided a sturdy backdrop for the outperformance of most US spread assets.
Our outlook for a broad and sustained global recovery has been challenged on a wide variety of fronts. The growth downshift in Europe, Japan, China and non-China emerging markets (EM) came from very high and, in our view, unsustainable levels. This crucial question is whether this downshift is the beginning of a more precipitous decline, or whether a return to the more moderate (3.5%-4.0%) growth of the last few years is in the offing. We are strong proponents of the latter camp, but we have to acknowledge that risks have risen.
Q: Do you expect these conditions to continue in the second half of 2018?
A: Growth in the U.S. may come in between 2.5% and 3.0% as the fiscal stimulus continues to provide incremental help. Meanwhile, the inflation outlook remains muted, despite improvement in the labor market. We believe the sluggish trajectory in rising inflation rates in the U.S. and across the developed world will remain.
Q: What might cause a price rebound?
A: Global growth remains the key determinant. Despite major market fears that unfortunately have plausible roots, the actual growth performance has remained solid. Worst-case fears may not be realized. Trade tensions can abate – a NAFTA2 or EU3 deal would change the atmosphere. While Chinese trade tensions may persist, they have also galvanized Chinese policymakers to provide sharply increased fiscal and monetary stimulus to improve their economic growth.
Q: What is your outlook for fixed income spread sectors?
A: Spread sectors in the U.S. have held up reasonably well, while spread sectors outside the U.S. have performed poorly.
Investors in spread products rather than U.S. Treasury or sovereign bonds are trying to make their coupons. If you sell a Treasury bond to buy an investment grade corporate bond, can you make that coupon? We think the answer is yes, but the risk/reward is not very compelling. The better outcome for spread product investing is spread compression. In investment-grade corporate bonds, we think there is not much meaningful opportunity for that.
But what about the case for EM? The real yield spread of EM to developed market debt is now at a 12-year high. In a world where developed market yields are low, and spreads are tight, here is an asset with a substantial coupon. Can you make this coupon? If spreads merely hold, the answer is likely yes. Can you get spread compression? Can anything go right? Can any of these fears abate? We think the answer once again is yes. The key to our prognosis is a continuation of sustained moderate global growth.
Q: With this backdrop in place, how do you expect the Fed to proceed?
A: The Fed has acknowledged the need for a more pragmatic approach to thinking about interest rates. Typically, as interest rates rise, fixed-income values fall. While a September hike is fully anticipated, Fed Chair Jerome Powell’s recent speech at Jackson Hole suggested future hikes are far from assured.
Powell eschewed overreliance on economic models, distancing himself from those advocating additional hikes based on estimates of the neutral rate. In a telling reference to former Fed Chair Alan Greenspan’s restraint in the mid-1990s, Powell said that a “wait-and-see” approach may be more appropriate, as long as inflation expectations remain well anchored. Powell concluded his speech by noting, “We have seen no clear sign of an [inflation] acceleration above 2 percent.”
An attentive listener can easily put the pieces together: anchored inflation expectations, a “wait-and-see” approach and no sign of inflation acceleration suggest only limited rate rises from here.
Q: How did the current market situation come to be?
A: The deep malaise that gripped the global economy in the aftermath of the Global Financial Crisis (2010-2016) started to lift in 2017. The global recovery was broadening and becoming less fragile. Seemingly every one of those years started with Fed optimism about growth, inflation recovering to target, and potential rate hikes. None came to fruition, but by 2017, U.S. growth could move above trend, inflation would move slowly to the Fed’s target, and the Fed could finally accomplish the very gradual normalization of its interest rate program.
In such an environment, risk assets would be extremely preferential versus U.S. Treasury and sovereign bonds, not only in the U.S., but globally. The sector that struggled most severely post-crisis and whose assets were cheapest, EM, would be the prime beneficiary.
Q: Did these market conditions play out as expected?
A: Yes. In 2017, it went according to script. But as noted, in 2018 global divergence has been extraordinary, with mirrored results in the financial markets.
Q: As a proponent of “steady global growth,” what concerns you about today’s markets?
A: The spectacular divergence of U.S. asset prices, and many outside the U.S., leaves the ironic challenge of those of us who have held that narrative tormented from opposite perspectives at the same time. Will the developed markets overheat, suggesting we are too pessimistic on growth? Or will the EM markets face collapse, suggesting we were too optimistic on global growth?
We have always characterized this global recovery as a two steps forward, one step back process. The current EM setback presents yet another illustration of the one step back. But we remain optimistic: we very much like our chances of the two steps forward.
Ken Leech is the Chief Investment Officer at Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
1In the U.S., the answer lies in the role of the Federal Reserve, or simply, the Fed. The Fed is the gatekeeper of the U.S. economy.
2The 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.
3The European Union is a group of 28 countries that operates as a cohesive economic and political block.
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