The Shifting Investment Landscape

Q3 2019 Market Commentary

The Shifting Investment Landscape

Despite drastic changes in the investment backdrop, short-term pessimism about growth is overdone and higher rates are likely only in the distant future.

“Intelligence is the ability to adapt to change.”
Stephen Hawking

Key Takeaways

  • Market sentiment has declined markedly over the second quarter of 2019 based primarily on deteriorating global growth prospects and ever-lower inflation expectations.
  • The negative backdrop has pushed global central banks back to the dovish side, intensifying their attention on “inflation-based outcomes.”
  • Struggling to find consensus, the Fed is likely to move cautiously toward additional easing.
  • If growth remains resilient, we think the Fed will have time to implement a more appropriate policy position.
  • Until inflation reaches or exceeds the long-standing 2% target, we don’t see policy rates going any higher.
     

Market Commentary

Three months ago, in May 2019, the fixed-income world seemed pretty placid. The Federal Reserve (Fed) had been on hold since the beginning of that year. The US economy was growing in line with expectations. The Fed held interest rates steady at its May 2019 meeting, citing the strength of the economy, low unemployment rate and positive financial conditions. Fed officials shrugged off the undershoot in inflation, attributing it to factors that were merely “transitory.” At the European Central Bank (ECB) General Council meeting on June 6, 2019, ECB President Mario Draghi gave an upbeat assessment of European growth, noting that there was very little chance of a recession in Europe. And while he noted that the ECB’s policy toolkit was adequate if downside risks arose, there was no immediate issue on the horizon. A fixed-income investor could have been reasonably forgiven for not gleaning any sense of urgency from those remarks.
 

Exhibit 1: US Share of Global Investment-Grade Fixed-Income Yield

Source: BofA Global Broad Market Index. As of 15 Aug 2019Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Fast forward to August 29, 2019: yields across the global investment-grade universe have plummeted. $16.7 trillion of debt trades at negative yields. The US market is the only place where positive yields are available in abundance as the US has 95% of the positive yield in the investment-grade space (Exhibit 1). The ECB has strongly intimated that it will be cutting interest rates to further negative levels and is considering reinstituting quantitative easing (QE) as well. In the US, the Fed has cut interest rates and is suggesting more cuts are coming. Both central banks note a downshift in global growth, focusing particularly on manufacturing and the weakness in global trade. They draw specific attention to the increase in uncertainty and downside risks (this is essentially code for the global slowdown and the protracted nature of the trade war). A fixed-income investor today is in a truly excruciating position. Yields are at or near historic lows in the developed world, spreads are tighter than they have been in the recent past and, most importantly, there is very little prospect that central banks will provide any higher interest rates in the reasonably foreseeable future.
 

Exhibit 2: G3 5-Year Breakeven Inflation Rates

Source: Bloomberg, as of 16 Aug 2019. Past performance is no guarantee of future results.  This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

In the several weeks before the end of August 2019, two things changed. The global outlook has darkened, particularly with the manufacturing sectors around the world, as uncertainty over the trade war continues to weigh heavily on capital expenditures. Just as importantly, the global inflation picture has shifted downward. Inflation expectations have moved decisively lower. Markets appear to be questioning whether policymakers can actually achieve their 2% inflation goal in Japan, Europe or now even in the US (Exhibit 2). These developments have forced central banks to move monetary policy more dovishly, and to accelerate their emphasis on what we might term “inflation-based outcomes” in addition to their more traditional GDP forecasting.

Bank of Japan Governor Haruhiko Kuroda talks about the challenge of raising inflation expectations in a society that has not seen inflation in over a generation. His solution is to promise to run an extraordinarily accommodative monetary policy until inflation exceeds the target for “a sustained period of time.” While 2% seems far off in Japan, the focus on the inflation outcome is instructive—and don’t expect any tightening of policy unless and until inflation is over target for a sustained period.

In Europe, Draghi also has much to worry about. Growth has downshifted. The global trade uncertainty weighs very heavily upon Germany, where the risk that it may enter at least a technical recession is very real. The politics of Italy and Brexit meaningfully complicate the growth outlook. Additionally, the chronic undershoot of inflation has been the bedrock of the ECB’s extremely dovish monetary policy. Indeed, the further downward shift in inflation expectations has spurred Draghi’s call for further rate cuts and potential implementation of further QE. And even though that day may also seem far off, he too speaks of the need to achieve above-target inflation for a substantial period of time.

Now consider the Fed. We would argue that it is moving, even if haltingly, to more inclusiveness of inflation outcomes as an integral part of its policy-making approach.

Consider the Fed’s pivot to a dovish policy in June 2019. With unemployment at multi-decade lows, the stock market at record highs and GDP data coming in as forecast, a Fed ease would have seemed virtually inconceivable based on the Fed’s approach over the last 30 years. At best, one might devise a risk management case for “an insurance cut.”

Importantly, an inflation-centered approach yields a meaningfully different policy implication. The Fed has forecast the return of above-target inflation in each of the last eight years, yet missed it every time. Inflation remains below target, and inflation expectations are falling. Fed Chair Jerome Powell has written and spoken at length about the persistent nature of long-term structural inflation challenges. He has stressed the need for “inflation credibility” (i.e., convincing people that the target will someday be achieved). In this context, the policy impulse would be to unambiguously ease.

In explaining how the Fed is balancing these two overlapping but distinctly different approaches Powell is inconsistent. Usually, he muddles through, talking about growth uncertainties, but referencing low inflation. Clearly the entirety of the Fed Board does not have consensus. Since Powell is either unable or unwilling to stay on the inflation point, we continue to expect the Fed to move slowly toward greater easing. The risks to growth both here and abroad as trade uncertainty continues to put manufacturing under pressure augurs for “insurance” at a minimum, even as the undertow of inflation and expectations suggest greater alacrity is needed.

Given this backdrop, we would like to make two investment points. In the short term, we think the heightened pessimism around global and US growth is overdone. If growth is resilient, the Fed will have time to get to a more appropriate policy position. But clearly we need growth to hold. Anxiety over both growth and Fed policy will provide heightened volatility for risk assets.

Longer term, we think the prospect of any renewed tightening campaign by central banks will be a very long time in coming. The inability to get inflation to—let alone above—targets is sobering. We think the operative policy for tightening going forward will be a wait-and-see approach. No more tightening will be allowed based on central bank forecasting. Instead, inflation will actually have to show up. Only when it rises above target, and stays there for the hoped-for “sustained period of time” (which seems to mean at least a year), will we see any higher policy rates. In our view, that is a long way off.


Definitions:

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

G3 refers to the world's top three developed economies: US, Europe and Japan.

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

Break-even inflation is the difference between the nominal yield on a fixed-rate investment and the real yield (fixed spread) on an inflation-linked investment of similar maturity and credit quality.

The BofA Global Broad Market Index tracks the performance of investment grade public debt issued in the major domestic and eurobond markets, including 'global' bonds.

"Brexit" is a shorthand term referring to the UK vote to exit the European Union.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

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.

Top

Important Information

 

All investments involve risk, including possible loss of principal.

The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. 

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.

Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.

Past performance is no guarantee of future results.  Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.

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.

The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).

This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc.  Unless otherwise noted the “$” (dollar sign) represents U.S. Dollars.

This material is approved for distribution in those countries and to those recipients listed below. Note: this material may not be available in all regions listed.

All investors and eligible counterparties in Europe, the UK, Switzerland:

In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office 6th Floor, Building Three, Number One Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4, D04 EP27. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.

All Qualified Investors in Switzerland:
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.  Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.

All investors in the UK:
In the UK this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0)207 070 7444

All Investors in Hong Kong and Singapore:

This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.

This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.

All Investors in the People’s Republic of China ("PRC"):

This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC.  The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission.  Investors should read the offering document prior to any subscription.  Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only.  Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.

This material has not been reviewed by any regulatory authority in the PRC.

Distributors and existing investors in Korea and Distributors in Taiwan:

This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.

This material has not been reviewed by any regulatory authority in Korea or Taiwan.

All Investors in the Americas:

This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.

All Investors in Australia and New Zealand:

This document is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827).  The information in this document is of a general nature only and is not intended to be, and is not, a complete or definitive statement of matters described in it. It has not been prepared to take into account the investment objectives, financial objectives or particular needs of any particular person.

Yields and dividends represent past performance and there is no guarantee they will continue to be paid.

U.S. Treasury Inflation Protected Securities (“TIPS”) are bonds that receive a fixed, stated rate of return, but they also increase their principal by the changes in the CPI-U (the non-seasonally adjusted U.S. city average of the all-item consumer price index for all urban consumers, published by the Bureau of Labor Statistics). TIPS, like most fixed income instruments with long maturities, are subject to price risk.

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