CIO Ken Leech discusses how Western Asset's outlook and positioning for slow and sustainable growth has paid off, even as the economic recovery experienced some pitfalls. A key has been the Firm's multiple diversified approach, which has worked to provide a cushion for volatility when growth has disappointed. Given the outlook going forward, he sees a continuing need for this flexibility.
Chance fights ever on the side of the prudent.
~ Euripides (480–406 B.C.)
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, favouring 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.
Credit or business cycle?
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. 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.
A better global outlook?
There is also room for optimism on the global recovery front. Global inflation looks to have finally stopped declining. 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, 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.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.