Notes on Global Fixed Income Investing

Transcription

1 Investment Team Update 31 May 2018 Notes on Global Fixed Income Investing PERSPECTIVE FROM TEMPLETON GLOBAL MACRO EXECUTIVE SUMMARY We continue to have a positive outlook for US growth and we expect the US Federal Reserve (Fed) to continue raising rates this year. Resilient growth and exceptionally strong labor markets should continue to generate inflation pressures, in our assessment. We expect US Treasury (UST) yields to continue rising. There are also a number of technical factors that we expect to drive UST yields higher, such as the Fed s balance sheet unwinding, along with expansionary fiscal policy. Tax cuts and the growing fiscal deficit are expected to raise the borrowing needs of the US government, while the Fed simultaneously reduces its ownership of USTs. These factors should pressure yields higher. Markets had become accustomed to drip-fed, easy monetary policy for so long that we are bound to see some volatility and uncertainty as monetary accommodation is unwound. Strength in the euro during the early part of this year was a bit anomalous, in our view. We expect the euro to weaken against the US dollar given the differences in potential growth and the widening rate differentials between the US and the eurozone. There is more potential for US growth to surprise to the upside than eurozone growth, in our assessment. Michael Hasenstab, Ph.D. Executive Vice President, Portfolio Manager, Chief Investment Officer Templeton Global Macro Sonal Desai, Ph.D. Senior Vice President, Portfolio Manager, Director of Research Templeton Global Macro The European Central Bank (ECB) is not in a position to raise rates this year, in our opinion, given the eurozone s moderation in growth and subdued inflation figures. Eventual normalization in monetary policy will lag behind the policy tightening in the US, with the peak level in the rate differential still ahead, in our view. The Bank of Japan (BOJ) is also not in a position where it can pull back on its current levels of monetary accommodation, in our view, given Japan s need for sustained higher inflation. We expect the BOJ to continue with current monetary accommodation, and we expect the widening rate differentials between rising yields in the US and the 0.0% target on the 10-year Japanese government bond to depreciate the yen against the US dollar. In Brazil, regardless of who wins the presidential election in October, there is a broad recognition that the country needs pension reform. In the post-election environment, there may be different speeds at which some of the needed reforms are carried out, but we see little doubt in any of the different parties that these reforms need to be enacted. We continue to have a positive outlook on Brazil. In Mexico, it is looking more likely that Andres Manuel Lopez Obrador (AMLO) will be elected president this summer. While that outcome would be less desirable than a less-populist, more traditionally market-friendly administration, in our opinion, the institutional strength in Mexico should protect much of the fiscal advances the country has made over the past several years. With yields around 7.5% in the front-end of Mexico s local yield curve (as of May 3, 2018), there s a buffer against rising rates in the US. The Mexican peso remains undervalued, in our assessment, and we expect it to appreciate from recent levels against the US dollar. China is currently overextended from a credit perspective, in our assessment, to the point that it would have difficulty responding effectively to an external shock, such as an eventual contraction in the US. The Chinese authorities appear aware of what needs to be done and what measures are needed to improve financial stability, but we continue to watch for potential risks. There has been a lot of talk in the markets about the US imposing unilateral tariffs and starting trade wars with South Korea and China. The reality is that some specific concessions have been made without full-scale retaliations. There is always the chance that things could get out of control, but we don t see that as the baseline scenario. At this stage, the potential for full-scale trade wars appears to be just a tail risk, in our view. Part of the reason that the current expansion in the US has gone on for as long as it has is we didn t see high levels of investment. Regulations restricted the ability and incentives to invest. But now there is greater capacity to invest repatriations of cash, tax cuts, and financial and business sector deregulations. These policies can accelerate the business cycle and eventually bring us to the end of the current expansion. However, an eventual contraction can be more conventional this time around; it doesn t have to be as catastrophic as the last one.

2 Rising UST Yields We have been calling for higher rates for a long time. Last year we were talking about the 10-year UST yield approaching 4.0% or even exceeding 4.0% by the end of the current cycle. At that point, the 10-year UST yield was still around 2.3% (as of October 2017), so from our perspective the recent move to 3.0% is not surprising; we ve been expecting it. We think UST yields are going to continue to rise and that markets will absorb and support these higher levels. Markets had become accustomed to drip-fed, easy monetary policy for so long that we are bound to see some volatility and uncertainty as monetary accommodation is unwound. This has never been a secular stagnation story, in our view; it s about the US economy and financial system slowly moving back to normalcy. The return to higher rates is a return to the true normal, in our view. There are also a number of technical factors that we expect to drive UST yields higher, such as the Fed s balance sheet unwinding, along with expansionary fiscal policy. The administration doesn t appear to be reducing fiscal spending, and there is a lot of fuel being added to late-cycle growth. Furthermore, tax cuts and the growing fiscal deficit are expected to raise the borrowing needs of the US government. This is occurring simultaneously as the Fed is pulling back from the UST market, which transfers the proportional buying demand for USTs to price-sensitive investors. Those factors should drive yields higher. Additionally, inflation pressures are picking up in a US economy that is at full employment. Three-month annualized core CPI (Consumer Price Index) has been running close to 3.0%, with the annualized monthly figure at 2.1%. Resilient growth and exceptionally strong labour markets should continue to drive inflation higher, in our view, and drive rates higher. Expected Fed Policy and Interest-Rate Risks Overall, we expect the Fed to remain on course with its projected glide path of monetary tightening in the upcoming year. In the past, we ve been concerned that the Fed was running overly loose monetary policy and falling behind the curve. The policy response has improved more recently, but the economy may continue to run hotter, and the Fed will need to stay ahead of the curve on inflation. Currently, the Fed is achieving its dual mandate of maximizing employment and maintaining price stability, but it will need to continue to respond to inflation pressures, in our view. We expect the Fed to continue raising rates this year, and we continue to have a positive outlook for US growth. The biggest risk to a fixed income portfolio at this stage of the cycle is duration exposure, in our opinion. Many global fixed income indexes currently have some of their highest levels of duration on record. We think investors who are holding that duration exposure are going to see problems. It s highly improbable for the 10-year UST yield to drop to levels like 1.40%, as it did after the Brexit referendum in 2016 those conditions are a thing of the past, in our view. Thus the risks in USTs are highly asymmetric, and there is much more downside risk than upside potential to rally, in our view. Over the last eight years or so, markets have essentially been drip-fed continuously low rates by the Fed and by global monetary policy those conditions are coming to an end. The Euro The strength in the euro during the early part of this year was a bit anomalous, in our view. In 2017, euro strength appeared driven not only by the cyclical upswing in euro area growth, but also by an apparent belief that the political risks in Europe had vanished after French President Emmanuel Macron s election victory. Further euro strengthening in early 2018 made less sense and appeared driven by political concerns in the US, in our view. More recently, we ve begun to see a reversal in that euro strength, as we would expect given the yield differentials between the eurozone and the US. We expect the political risks in Europe to come back to the forefront of investors minds. Additionally, there is more potential for US growth to surprise to the upside than eurozone growth, in our assessment. We don t expect a collapse in Europe or anything to those kinds of extremes, but we do see signs of eurozone growth moderating after last year s peak. The differences in potential growth and the widening of rate differentials between the US and the eurozone should depreciate the euro against the US dollar, in our view. Monetary Policy and Structural Risks in Europe Financial markets appeared to get ahead of themselves last year and early this year in terms of where investors expected ECB policy to go, in our view. The ECB is not in a position to raise rates this year, in our opinion, given the moderation in growth and subdued inflation figures. Eventual normalization in monetary policy will lag behind the policy tightening in the US, with the peak level in the rate differential still ahead, in our view. Markets have appeared too forwarding-looking with respect to potential ECB hikes and not forward-looking enough with respect to the Fed. In reality, the Fed is likely to hike rates by 25 basis points (bps) four to six times before the ECB is even in a position for its first 10 bps rate hike in Looking ahead, Europe s main challenges are structural issues in specific countries, as well as political challenges that are making it more complicated to address the structural concerns. Low potential growth in countries like Italy reflect a lack of productivity growth and lack of needed structural reforms. There is essentially no government in Italy, and it has done little in policy and reforms that would allow it to grow. Debt sustainability in Italy will be a major longer-term concern, particularly when rates rise. Notes on Global Fixed Income Investing 2

3 Additionally, Angela Merkel s political power has weakened while euroskeptic populist factions have grown, making it more difficult to bring Europe together in a potential crisis. We don t expect an imminent catastrophe or an impending recession, but we do see strains on the eurozone s ability to resolve structural issues. We would be more constructive on Europe if we saw Macron and Merkel become a new engine of greater European integration, and implement a comprehensive plan on immigration and refugees. Renewed drives toward structural reforms in places like Italy would also be crucial to resolving the eurozone s structural vulnerabilities. Until there is progress on those fronts, we remain wary of the vulnerabilities in the eurozone. Japan In Japan, we think the market has been reading a bit too much into too little, and expecting the BOJ to begin pulling back from its current level of monetary accommodation. Japan needs inflation we ve begun to see the green shoots of inflation, but those levels will need to be consistently higher to get to a point where the BOJ could consider tapering monetary accommodation. We are still well below the 2% inflation target. The BOJ exited monetary accommodation prematurely twice in the past, and it proved costly. We think it s unlikely that they will be tempted into making the same mistake for a third time. Thus we don t see the BOJ exiting quantitative easing (QE) as early as the market has indicated at times. Expectations for a QE adjustment appeared to be a contributing factor to recent strength in the yen. Looking ahead, we expect the BOJ to continue with its current monetary accommodation, and we expect the widening rate differentials between rising yields in the US and the 0.0% target on the 10-year Japanese government bond to depreciate the yen against the US dollar. Emerging Markets Clearly not all emerging markets are the same, so it s difficult to talk about one singular emerging market cycle. For example, Turkey hasn t reached its low point of its asset price cycle, in our view, yet a number of investors and indexes have significant allocations to Turkish bonds. We still see enormous scope for the Turkish lira to weaken. There has been significant interference with the central bank at a political level, and monetary policy has been exceptionally dovish. The country has a large current account deficit, while fiscal spending has become unmoored at times, as was seen with the recent doubling of pension obligations. These are the types of emerging markets we are avoiding countries like Turkey have a long way to run in their current cycle. However, there are a number of countries that are fundamentally in much stronger shape, with healthier balances and macroeconomic resiliencies countries with responsible policy performance. Several of these countries, particularly the ones with relatively higher rate environments, are positioned for relative strength as rates rise in the US because of their rate buffers and underlying economic resilience. Brazil The political picture in Brazil right now is a bit hazy because we don t have a clear front runner for the presidential election in October. Campaigning has just begun in earnest in recent weeks. It seems increasingly likely that former President Luiz Inácio Lula da Silva is not going to be the face of the Worker s Party (PT) because of the recent rulings against him and the degree of uncertainty over how many appeals he can cast. But regardless of who wins the election, there is a broad recognition that the country needs pension reform. In the post-election environment, there may be different speeds at which some of the needed reforms are carried out, but we see little doubt in any of the different parties that these reforms need to be enacted. Even when Dilma Rousseff came in for her second term, she had already recognized the need to rein in fiscal spending to achieve a certain amount of structural reform. It was just too late for her, and Congress wanted her out. That political will to correct the mistakes of the past remains strong today, regardless of who wins the election. We continue to have a positive outlook on Brazil. Mexico and the Peso It is looking more likely that AMLO will be elected president this summer. While that outcome would be less desirable than a less-populist, more traditionally market-friendly administration, in our opinion, the institutional strength in Mexico should protect much of the fiscal advances the country has made over the past several years. AMLO cannot unilaterally explode the debt and the fiscal deficit; he would be checked by the congress. Additionally, the central bank has strong independence it s been an orthodox, well-respected institution since the Tequila crisis in the mid-90s. We don t see an AMLO presidency interfering with the central bank, and we would expect the central bank to continue to run orthodox policy responses. In short, if the peso continued to weaken, the Bank of Mexico would likely respond appropriately to bolster the exchange rate, regardless of who is leading the administration. With yields around 7.5% in the front-end of Mexico s local yield curve (as of May 3, 2018), there s also a buffer against rising rates in the US. Overall, the peso remains undervalued in our assessment, with fair value closer to 15.5 to 16.0 pesos per US dollar. We expect the peso to fundamentally appreciate from its recent levels in the 19.0 to 20.0 range. Regarding the North American Free Trade Agreement (NAFTA) negotiations, a lot of the overreaction in the markets appears tied to rhetoric from US President Donald Trump, but the actual negotiations are not taking place in 140 character tweets. There are teams of professionals negotiating on the Mexican and US trade representative sides. We have always held the view that NAFTA was a dated, clunky trade agreement that is due for an update. For example, there is no chapter on energy because when NAFTA was written the Mexican energy markets were Notes on Global Fixed Income Investing 3

4 closed. There is also no chapter on e-commerce because NAFTA was written before the advent of the internet. Thus there is a lot of potentially positive changes to NAFTA that could lead to better trade relationships. However, trade negotiations should be careful to recognize the positive trade relationships already existing between the countries as well. Setting aside autos, the US actually runs a trade surplus with Mexico, which is largely driven by agricultural commodities. Much of that agriculture comes from similar demographics that auto manufacturing supports, so intervening in one industry could risk consequences for other industries and other areas of the population. On the whole, we expect positive adjustments, and we don t expect NAFTA negotiations to derail trade between the US and Mexico. China With the removal of term limits in China, President Xi Jinping s political risks are largely behind him, and the authorities can now fully focus on addressing financial stability. China will need to slow its credit deleveraging, in our view, which will likely coincide with a slowdown in economic performance. It s possible that the moderation in growth could be more pronounced than we have become accustomed to because the authorities can now be more resolute since they no longer need to shore up political support. China is currently overextended from a credit perspective, in our view, to the point that it would have difficulty responding effectively to an external shock, such as an eventual contraction in the US. We think this is something markets should be prepared for moderating growth in China and a renewed focus on financial stability. Done appropriately, we shouldn t see sharp moves in monetary policy or other policies that would risk creating financial instability and a hard landing for the Chinese economy that would create risks for the global economy as well. The Chinese authorities appear aware of what needs to be done and how to carry it out, but we continue to watch for potential risks. Global Trade There has been a lot of talk in the markets about the US imposing unilateral tariffs and starting trade wars with South Korea and China. The reality is that some specific concessions have been made without full-scale retaliations. South Korea has responded by lowering some of its barriers. China has also discussed lowering barriers. Some of these tariff levels needed to come down South Korea has average tariff levels as high as Zambia, for example. Additionally, President Xi s Made in China 2025 initiative is at odds with World Trade Organization agreements, which would concern not only the US but also the eurozone. At this stage, the potential for full-scale trade wars appears to be just a tail risk, in our view. There is always the chance that things could get out of control, but we don t see that as the baseline scenario. There are still concessions that China may need to make, not only on tariffs but also on the non-tariff front, such as its subsidizing of industries and the defence of intellectual property rights. It hasn t been a level playing field on those fronts for quite a while, and it appears China recognizes that. Tensions in discussions could continue, but tense negotiations can still occur without it escalating into a full-scale trade war. Endpoint for the Current US Expansion Expansions don t die simply of old age; something needs to trigger an eventual recession. There can be devastating contractions such as the financial crisis, but it s far more common to have a more classic textbook recession from overinvestment and buildups of inventory. Part of the reason that the current expansion in the US has gone on for as long as it has is that we didn t see high levels of investment. Regulations restricted both the incentives and the ability to invest; consequently, we didn t see overinvestment and we couldn t go through a regular cycle. But now there is greater incentive to invest repatriations of cash, tax cuts, and financial and business sector deregulations. These policies can accelerate the business cycle and eventually bring us to the end of the current expansion. However, an eventual contraction can be more conventional; it doesn t have to be as catastrophic as the last one. The prospects for a US recession are still a year and a half to two years out, in our view. Until then, we continue to expect resilient US gross domestic product (GDP) growth, with the potential for an upside surprise. The Fed said at the end of 2017 that it expects 2.3% GDP growth for 2018 we think that s underestimated. A number of expansionary policies have been put into place since then that we expect to fuel growth. It takes time for tax cuts to reach consumers pockets and get redeployed into the economy, and for capital to find opportunities and get invested. Much of those effects on the US economy are still ahead, in our view. Notes on Global Fixed Income Investing 4

5 WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business, and social frameworks to support securities markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio, which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolio s initial investment. Notes on Global Fixed Income Investing 5

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