Ken Leech, Chief Investment Officer at Western Asset Management (a Legg Mason affiliate)
While slow by historical standards, worldwide economic growth is improving, U.S. growth and inflation may be moderating, and central banks – the U.S. Federal Reserve (Fed) and European Central Bank (ECB) prominent among them – are signaling paths to normalization.
Global economies are continuing to mend. That is the major takeaway: we still are in a global growth upturn, even if it’s soft. Core inflation remains persistently low. We are still a little bit surprised at how low inflation is. That suggests that this path to central bank policy normalization is going to be very, very slow. That means treasuries and sovereigns will remain underpinned by low policy rates. We don’t see any major or sharp rises in the near-term. That won’t be the best opportunity set given the low rates we see there. Spread sectors, therefore, would continue to outperform; our bias being a little bit outside the United States than inside the U.S.; and particularly emerging markets as our opportunity set.
United States growth rate forecast
For 2017, we moved our growth rate forecast for the first half up to 2 percent to 2.5 percent, matching the Fed's forecast. Probably still less than many market participants. We are thinking we may have to downgrade that forecast. The upturn we were hoping for, while it was a little bit of pickup, is starting to moderate. Our working forecast for the second half of 2017 is much more in the 1.5 to 2 percent range.
Central bank policy
Global inflation, while increasing from a low level, is still very subdued. Central banks are starting to signal a path toward normalization. They all would like to get from that uber accommodative stance to a less accommodative stance. Obviously the Fed has already started on this process and they continue to signal that they want to continue that path. As you look around the world, I think that is going to be the key issue for all of us, how that process unfolds going forward.
US employment, inflation
Where we all have to watch very carefully is whether or not we’re finally going to see the wage inflation we might have thought would come as the unemployment rate has been this low, and the economy has been able to continue in its growth path. But it just hasn’t show up yet. Unemployment is really underemployment, so a lot of people who have been able to get jobs don’t have the jobs they want. When you look at the prime age workers, 25 to 50 years old, we’re not even back to where we were at the end of the last crisis, even after 10 years of an expansion. The same is true with capacity utilization.
Fed Chair Janet Yellen was very aggressive when she tightened in June. She said the decreases in inflation were transitory and they would soon be reversed. That would give the Fed the straightforward confidence that they can maintain their small increases in interest rates, or inching up if you will, in combination with unwinding their balance sheet. We’re just not so sure. We have really been struck by how stubborn this rate is… The last three months the core CPI had been near zero. That’s well below the Fed’s target of two percent. That’s not a ceiling, that’s what they want to be the middle of the range. It’s not obvious that they’re going to get the pickup that they’re expecting. As the rates inch up, that might be even more challenging.
Impact of the Trump Administration
We came into the year feeling that the market optimism that the Trump legislative agenda would be adopted with the speed they hoped for was really misplaced. Trump’s margin in the Republican party, even as the majority, is very thin… Keeping everyone on board in a big coalition is always hard. When you have such thin majorities it’s even harder.
Deregulation, we think is still pretty positive, pro-business, and that’s proceeding. But healthcare has failed. Tax reform has been delayed. We think tax cuts are coming, but not a broad-based tax reform. Infrastructure has been delayed and is not in the immediate picture.
“What does that mean in terms of 10- year yields and break-even inflation rates? A little bit better growth but inflation just not following any kind of traditional pattern. Break-even inflation rates are under 1.8 percent, the Fed’s target is 2 percent, so the market is basically saying, ‘we’ll take the under.’
Government bonds are still probably the least attractive sectors. Spread sectors should continue to be the best for fixed-income investors. They should be able to outperform sovereign and Treasury bonds over the medium and longer term.
The good news is that the fear that global growth was decelerating, and might actually move down too sharply, gave way to optimism as global growth has picked up. The big headwind that continues to be intractable, is the debt burdens we see all around the world. The debt burdens are still higher than they were during the crisis. This continues to be an impediment to growth.
Global spread sectors, following even last year’s tremendous rally, really put in a terrific first half of the year. We were overweight spread sectors. In every one of these spread sectors, with the exception of U.S. mortgage-backed securities, the big story has been lowering our overweights in U.S. sectors and increasing our overweights in non-U.S. sectors. The big theme has been emerging markets. We still believe that’s the biggest opportunity set available for investors who can take advantage.
The banking and finance sector continues to be one of the biggest beneficiaries of the Trump victory. Dodd-Frank and the Basel Accords are still very positive in terms of keeping leverage, capital ratios and risk-taking constrained. But application of those regulations will be much lighter, much more favorable in our view. Higher short rates and better growth, are also positive.
One of our big stories, both in investment-grade and high-yield, has been our absolute desire to be totally out of the retail space. That’s been a sector that as we all know has been a very, very difficult situation.”
By contrast, high-yield bonds have had a terrific run. Moderate growth, low inflation and central bank caution have been a really favorable backdrop. Non-energy, non-commodity defaults are at very, very subdued levels. The lowest levels we’ve seen in quite some time. That is why high-yield has been able to rally so successfully.
The fixed-income sector I like most is emerging markets. The spreads, relative to developed market yields are near their 2008 wide. It’s really attractive yields, valuations… So why did we have such a big bear market? Because of fear of global recession, fear of China, fear of deflation, obviously commodity price breaks.
The more powerful arguments are valuations, which are really compelling, followed by fundamentals, which are really improving. Improving global growth and stabilizing commodity prices are tremendous changes in the fundamentals.
China’s GDP really picked up. They put a tremendous amount of stimulus in their economy. It was fantastic. It turned a fear of global recession, as early as 2016, into a much more beneficial, benign environment that’s been much more positive. The consequence – there are always pluses and minuses – was debt to GDP rose. They have talked about how they have to scale back infrastructure. They’ve already started to make moves. Earlier this year the real challenge was in reserve loss. They’ve stemmed that. They’ve had to use a tremendous amount of capital controls, telling corporations to bring their money back. This tightening of internal monetary conditions has showed up in their bond market. The point here is not to make some kind of China crash story. That’s not our story at all.
A more neutral policy backdrop should lead to slower Chinese growth next year.
The story of Europe is obviously a story of two halves, the north and the south. Growth in the north has really been buoyant. We think growth in the north stays OK, but should calm down a little bit over time. As central banks start to withdraw the punch bowl, this suggests the rate of growth is unlikely to accelerate in any meaningful way.
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