Market & Strategy Update: Quick Take

Third Quarter Outlook

Market & Strategy Update: Quick Take

Western Asset CIO Ken Leech surveys the state of global bond markets, sharing views on growth, inflation and the impact of trade and monetary policy.


We continue to be optimistic about both US and global growth increasing, though we note the recent divergence of US growth outpacing overall global growth.
Western Asset CIO Ken Leech

Summary

Ever since the global financial crisis erupted 10 years ago, we’ve asserted that the recovery of global markets would require a slow healing process over several years. This restoration of global markets is on-going and we expect it to progress as it has thus far: unevenly.

The bumpy road presented itself recently in the form of several Emerging Market (EM) challenges and pervasive uncertainty surrounding the escalating trade tensions. Yet we continue to be optimistic about both US and global growth increasing, though we note the recent divergence of US growth outpacing overall global growth. We are vigilant regarding the potential impact of the trade pressures, but don’t feel that tariffs will have a lasting impact on inflation either at home or abroad. Our base case continues to be that if we’re correct about the eventual success of the global recovery, spread sectors should offer the best fixed-income investment opportunities. Despite the recent challenges to our view, we continue to see EM as the most attractive asset class.

 

Market Review
  • Global growth has improved from low levels, but there was a notable divergence between US growth (stronger) and growth in other parts of the world (weaker) relative to expectations.
  • European growth disappointed as it downshifted recently to more reasonable levels after being well above trend. The European Central Bank (ECB) responded to slowing growth decisively with a very dovish reaction.
     
US Economic Outlook
  • US interest rates—raised in June by the Federal Reserve (Fed) in response to better US growth and positive fiscal policy (tax cuts)—will remain very attractive relative to all other interest rates in the developed world.
  • Better global growth suggests a decline in the US dollar over the longer term.
  • US inflation is picking up from very low levels as core Personal Consumption Expenditures (PCE) finally reached the Fed’s target (not ceiling) of 2%, which is positive but the uptrend is still mild.
  • We think the Fed will be very circumspect in moving rates higher given the current outlook.
     
Global Economic Outlook
  • Despite improving economic momentum globally, inflation rates are moving up very slowly even in the face of improving employment conditions.
  • Our view is that global growth is stabilizing in the sub 4% range, which we believe can be a sustainable pace.
  • Global inflation finally increased from about zero two years ago, and continues to move up slowly and should stabilize.
  • The global debt loads and changing demographics globally continue to be a secular headwind impeding believe they also serve to temper any meaningful upshift in global inflation.
     
Market Update
  • The uncertainty regarding trade tensions persists; fears about how the trade path will develop have a significant impact on the outlook for capital spending and real investment all over the world.
  • Europe: Growth slowed from a very high level, as it was above trend; core inflation continues to be extremely slow to rise.
  • Japan: Despite a disappointing first quarter, second quarter growth improved. Core inflation continues to be extraordinarily subdued, with no discernible uptrend visible.
  • China: We recognize the risks associated with the ongoing trade tensions that may present further challenges.
     
Investment Themes
  • Sector performance so far this year has been poor, but spread products should be the primary beneficiary of the current global growth scenario moving forward.
  • High-yield: Spread sectors have narrowed; we currently favor long BBs over BBBs.
  • Investment-grade: Spreads have widened; valuations are now more attractive yet we see no reason to alter our overall stance. We continue to favor energy-related issuance.
  • Non-agency mortgages: Agency credit risk transfers (CRTs) have performed well and we continue to favor CRTs based on the improvements in the fundamentals of the US housing market.
  • Emerging Market: While EM investments were challenged so far this year—facing headwinds from higher US rates, a higher US dollar, downshifting European, Chinese and Japanese growth, higher oil prices and trade war escalations—we still believe this area benefits from very strong fundamentals, including very low inflation, and has now overshot to the downside.
     
Q&A Highlights
  • Long duration US government bonds continue to be an attractive hedge relative to the rates available in the rest of the developed world.
  • Regarding Italy, our view is that conditions have improved but we still need to be thoughtful; the determination of the Italian government to stay within the EU fiscal parameters is a positive.
  • A meaningful breakdown in NAFTA could be very difficult for the economic progress of the US, Canada and Mexico. We expect the AMLO Administration to try to have a more prudent economic policy and relationship with the United States. Early signs so far have led us to be optimistic.
  • While trade tensions are currently front and center in the news, tariffs thus far are not meaningfully disruptive to global trade.

 

Definitions:

Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

AMLO is Andres Manuel Lopez Obrador, the newly-elected future President of Mexico

NAFTA is the North American Free Trade Agreement, a treaty between the U.S., Canada and Mexico.

Top

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.

High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

Asset-backed, mortgage-backed or mortgage related securities are subject to additional risks such as prepayment and extension risks.

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. Treasury securities, 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.

IMPORTANT INFORMATION: All investments involve risk, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice.  Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not  take into account the particular investment objectives, financial situation or needs of individual investors.