Notes on Global Fixed Income Investing

Transcription

1 January 11, 2013 Investment Team Update 17 February 2017 PERSPECTIVE FROM TEMPLETON GLOBAL MACRO EXECUTIVE SUMMARY US Treasury markets began to sell off in October 2016 on rising inflation expectations, resilient growth and a recognition that bond markets were significantly overvalued. The US election results in November added fuel to those existing trends. A number of Trump administration policies are likely to add to existing inflation pressures, in our view, notably fiscal spending, tax cuts and financial deregulation. Credit activity is likely to increase with deregulation, potentially stimulating investment and accelerating the velocity of money, which would be inflationary. The US economy has been growing above potential in an environment of full employment for several quarters additional policy stimulus at this late stage of the current expansion cycle can boost growth but also raise the prospect of overheating the economy. We expect continued resilience in growth over the upcoming year, with potential risks of a contraction likely a couple years out. Global trade has likely seen its peak as the political climate in the US pulls back from free trade policy. However, global trade is not going to end; rather the costs of trade will rise and likely be absorbed by US consumers and in some cases by corporate profit margins. 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 Mexican peso continues to be significantly undervalued, in our view, excessively pricing in trade-impact fears. A 20% border tax would adjust fair value up from around 13 pesos per US dollar to around 14 to 15, or even 16 at the extreme, in our analysis. Several emerging markets have already weathered severe shocks over the last year and are far more resilient to potential increases in trade costs at the margin than markets have been indicating, in our assessment. A number of emerging markets that export to the US are likely to benefit from a boost in US growth, and a select set of them remain undervalued, in our opinion. China s economy remains in a soft landing, but continued rebalancing is needed for the long term. The near-term picture looks fairly stable, in our view, but we have concerns for two or three years down the road. We anticipate continued monetary accommodation and low rates in Japan and the eurozone and rising rates in the US those increasing rate differentials should continue to depreciate the yen and euro against the US dollar, in our opinion. In Europe, our negative view on the euro is also driven by rising populist risks, as nationalist parties threaten to undermine the political will to uphold the European Union and the eurozone project. If the US Federal Reserve (Fed) continues with its recent pace of rate hikes, it would fall even further behind the curve under the new administration s policies. We think the Fed needs to continue raising rates. Overall, we continue to expect rising US Treasury yields, depreciation of the euro and Japanese yen against the US dollar, and strengthening valuations across a select subset of undervalued emerging markets, notably in Latin America and Asia ex Japan.

2 Growth and Inflation Are Likely To Get a Boost from the Trump Administration A lot of recent market activity around the world has been attributed to the Trump effect. But it s important to recognize the dynamics that were already underway and would probably still be underway regardless of Trump. The original selloff in bond markets began back in October, before the election results, when Hillary Clinton was projected to win. That selloff was based on the realization that growth was better than markets had been indicating, that inflation was actively rising and that US Treasuries were significantly overvalued. The subsequent election of Trump just added fuel to that already lit fire. The Trump administration s plans to increase fiscal spending, cut taxes and deregulate the financial system are likely to boost growth and inflation by adding an extra shot of adrenaline to an already strong economy that is growing at potential. There is still much debate over what Trump will be able to get through Congress tax cuts and deregulation would likely be passed through the Republican-led Congress, but fiscal spending plans are still under consideration. Deregulation would likely stimulate investment, increase bank lending and expand credit activity, the latter of which has been constrained so far during the recovery. In turn, the velocity of money would likely rise, amplifying inflation. Additionally, repatriation of corporate profits held overseas, which has both Democratic and Republican support, would add additional fuel to these trends. Typically, economies don t get this kind of stimulus policy so late in a business cycle the risk of overheating the economy grows when this much adrenaline enters so late in the cycle. While the upcoming year or two may look fairly good from a growth standpoint, we also need to consider that the added stimulus may get us to a point of overcapacity, accelerating the end of the expansionary phase of the business cycle, facilitating a future recession. Such a scenario is likely a couple years out, so rising growth and inflation are more important to portfolio positioning for the upcoming year, in our opinion, but we intend to watch the pace of the business cycle for signs of overinvestment and stretched credit expansion. Overall, the next year or so is likely to be good for risk assets, in our opinion, whether it be equities, emerging markets or other asset categories. The challenge for markets will likely develop as we get toward the end of this expansion cycle. It depends on whether we have a traditional recession with disinflation, which would be positive for longer duration assets, or we get stagflation because so much inflation has been built into the system, which would be negative for longer duration assets. We do have some time before those varying scenarios begin to develop, so our current focus remains on the expected surges in growth and inflation over the upcoming year or two, which we expect to be good for emerging markets and bad for US Treasury valuations. Restrictions on Free Trade Would Raise Costs for Consumers Broadly speaking, it appears global trade may have reached its peak. The political climate in the US appears to be pulling back from free trade, with the Trump administration pursuing protectionist policies and the Bernie Sanders wing of the Democratic party pulling even moderate constituents away from free trade. US consumers had been benefiting from free trade through low prices, but we will likely now see some tariffs put in place, which will drive prices higher. Some corporations may absorb portions of the higher trade costs in their profit margins, but most of the costs are likely to be broadly passed on to consumers, driving inflation higher. Additionally, the biggest potential for a trade conflict, in our view, is not from the country currently getting most of the headline attention (Mexico), but rather from China. China has been saturating US markets with steel, among a number of examples of trade tensions, but if the US were to take actions on any trade concerns there are several countermeasures China could use that would harm the interests of US companies. A trade war with China would also broadly raise global risks. The Mexican Peso Remains Fundamentally Undervalued The Mexican peso continues to be significantly undervalued, in our view, excessively pricing in trade-impact fears. However, trade is extensively integrated between the US and Mexico and will not end with tariffs, in our opinion, rather it will just become more costly. For example, Mexico exports auto parts that are used to build cars in the US, while Iowa exports massive amounts of corn to Mexico. There would be major disruptions to the auto industry and agricultural sector in the US if Mexico were shut out from exporting parts or buying agricultural products. Ironically, President Trump s reproaches have actually improved the competitiveness of Mexican exports over American goods by significantly weakening the peso. Even with a 20% tariff, Mexican goods would still be cheaper than they were pre-trump because of the exchange rate depreciation. In our assessment, a 20% border tax would adjust fair value for the peso from around 13 pesos per US dollar to around 14 to 15, or even 16 at the extreme. Markets valuing the peso at 20 to 22 have clearly overshot fair valuation, in our opinion. As the uncertainty around potential trade policies diminishes, we expect markets to recognize that the peso is extremely undervalued. Stronger US growth should also benefit the Mexican economy, in our assessment, helping to catalyze a recovery in the peso. Overall, the Mexican economy has been doing well and should not be fundamentally derailed by tariffs, NAFTA renegotiations or even a border wall, in our view. Rising Populism in Europe May Imperil the Eurozone The rise of populism and nationalism in Europe and the US is unprecedented in the recent era. It first started with Brexit, and 2

3 then we saw it in the US election. It s really only a matter of time before populism manifests itself in elections on the European continent. The consequences of populism can be pretty significant in terms of economics a lot of fiscal spending, inflationary dynamics, and short-term boosts to growth, but with longer-term inflationary and economic consequences thus the risks bear watching. If we think about why Europe survived the eurozone crisis, it was because of the strength of the political will to uphold the European Union and the eurozone project. There was a strong political will to come together despite some massive economic problems in terms of imbalances between the countries and significantly different national policies on how to manage finances or where policy should go. Ultimately, there was a strong political conviction to hold the European Union and eurozone together. But now, if any one of the countries within the eurozone elects an ultranationalist populist who wants to leave the euro, you start to undermine that political will that holds it together. That unraveling can have some pretty meaningful implications for the euro. Unfortunately, the factors that are driving the rise of populism in Europe, most notably immigration issues, the refugee crisis and terrorism, have not shown signs of diminishing. The manifestation of that effect is already underway new political parties that may question the eurozone construct have been gaining power. Overall, we have a negative outlook for the euro for two reasons: 1) expected fundamental weakening of the euro due to the growing rate differential between rising US Treasury yields and the low to negative yields in the eurozone from ongoing European Central Bank monetary accommodation, and 2) the rise of populism in Europe may further manifest in upcoming major elections, potentially leading to an unraveling of the political will to uphold the eurozone. Failed Experiments with Populism in Latin America Are Being Reversed Ironically, as populism rises in the US and Europe, we ve seen it decline in several parts of Latin America. Argentina went through a decade-long experiment with populism under the Kirchners, and it ended in economic disaster: rapid inflation, high unemployment, a lack of growth, a lack of investment and social unrest. Ultimately, the population had enough and voted out the Kirchner government, bringing in President Mauricio Macri, who has embraced more orthodox policies. The new Macri administration has started to allow the economy to function again by deregulating, opening trade and pulling back from previous manipulations of the exchange rate and utility prices. Certainly, Argentina is still in the early days of its policy turnaround, which will take a couple years to have effect, but just removing a lot of those toxic policies already has unshackled the economy and shown how it can function without the burden of heavy-handed government. We are now seeing a highly motivated administration that s actively working to put the country back on track. We are no longer seeing career bureaucrats in posts; instead we are seeing highly competent, highly trained Ph.D. economists across the government, from the central bank board to the ministry of finance. The result has been a return to responsible policymaking and re-energized investment in the country. This early stage of the turnaround story in Argentina is one of those unique periods in financial markets when a country may be experiencing both a rise in growth and a decline in inflation at the same time because the policies are aimed at bringing inflation down and opening up the economy. There is huge potential if these policies can continue to get enacted; however, some nearterm risks remain. Financial markets have priced in significant risk premiums in Argentina s local-currency markets, and we believe the premiums appropriately compensate investors for the nearterm risks. Overall, we remain optimistic for several countries in Latin America, specifically the turnaround stories in Argentina and Brazil, but also for the boost of growth in Colombia. After more than 50 years of civil war, Colombia is finally reaching a peace accord that we think can unlock the economic potential of the country, allowing it to expand infrastructure and reduce supply bottlenecks. The policymaking in Colombia has been appropriate for quite some time; it was just the domestic conflict that strangled the country s economic potential. Now Colombia is in position to re-start its economy and attract new investment, with the support of an orthodox central bank and ministry of finance. Select Emerging Markets Remain Resilient We ve seen a sea change of investor interest in emerging markets in recent quarters for about three years, emerging markets were an avoided asset class with poor performance. Much of the market view during those years was that higher US rates would derail these countries. The thinking went that China is slowing, so global growth is slowing, and therefore emerging-market growth is over. We disagreed with those assessments and concluded that the drivers of growth had changed but that growth in select countries remained resilient. Several countries have domestically driven economies that are more dependent on domestic issues within their countries than on global macro conditions. For example, Indonesia has gone through a huge stress test it s a commodity exporter, but commodity prices collapsed, and it trades with China, but China s economy slowed. Nonetheless, Indonesia is still growing at 5%. It appears that a number of investors are now seeing that several countries are far more resilient than markets have been indicating. Certainly, there are some weak spots in emerging markets such as Turkey, where the economy is strained because it s externally sensitive, or Venezuela, where its external debt has tripled over 3

4 the last decade while its international reserves have plummeted and inflation estimates have surged to around 1,000%. But countries like Indonesia or India, among others, have remained resilient. Additionally, a number of emerging markets that export to the US are likely to benefit from a boost in US growth. We ve now seen investors return to specific markets and back to emerging markets as a whole. A lot of foreign capital had left in prior years, so when it comes back in, the valuations in those asset categories tend to come back quickly as well. We think we are still at the early stages of foreign capital returning to a number of these emerging markets, and we still see a number of undervalued opportunities. China s Economy Remains in a Soft Landing, but Continued Rebalancing Is Needed for the Long Term Overall, China has engineered a soft landing on growth using monetary and fiscal stimulus and some policy measures in the real estate sector. Those monetary and fiscal measures can continue for the time being the near-term picture looks fairly stable, in our assessment, but we have concerns for two or three years down the road. If policymakers don t unwind the overcapacity that has built up and close down the inefficient stateowned enterprises before running out of monetary and fiscal tools to intervene, then the country could become increasingly vulnerable to external shocks. One of the largest concerns is that easy credit has flooded the Chinese financial system with liquidity. Much of that liquidity has also gone into propping up state-owned enterprises, keeping them afloat instead of closing them down. But the banking system as a whole is solvent, in our view it is state owned, state controlled and has enough assets. While we may see a rise in some nonperforming loans, we don t think a systemic financial collapse is likely. There are a number of second or third tier banks that may be more vulnerable than the big banks, but they are more likely to be taken over and absorbed by the larger banks than to threaten the viability of China s overall banking system, in our opinion. The greater concern is how much liquidity the policymakers can continue to pump through the banking system. Eventually, they will run out of tools, so the rebalancing needs to happen now. With regard to the currency, China has done a good job of managing its exchange rate policy. It has allowed its exchange rate to depreciate while also clamping down on the capital account. Chinese companies are finding it very hard to move capital out of the country. Some capital will always leak out, but the big state-owned purchases of real estate abroad and the big purchases of financial assets have been effectively shut down. We think the exchange rate policy is now appropriately orthodox and in equilibrium. The renminbi will likely continue to gradually depreciate, but we don t expect to see a sharp 20% depreciation or a rapid loss of all external reserves in a month. Instead, we anticipate gradual reserve accumulation and gradual currency depreciation. The Japanese Yen Is Poised for Continued Depreciation as Rates Rise in the US Japan s likely best course of action at this stage is to stay on track with its existing monetary policy and not make significant changes. The Bank of Japan (BOJ) already has effective policy in place that anchors the 10-year government bond yield at 0%. This gives the bank an unlimited amount of quantitative easing (QE) potential it can basically print money to keep the rate fixed at 0%. The central bank could essentially buy the entire bond market, if necessary, to keep the rate at its target. Eventually, the BOJ may run into some technical issues on what assets are available to be bought, and it may have to start buying equities in order to keep aggressive QE going. But certainly on the bond side, it can just buy the market to keep it at the targeted yield. Fortunately, Japan now has its monetary policies in a good place to essentially allow the Fed to do the work of depreciating the yen. During much of 2016, no matter what the BOJ did, the Fed s actions (or lack of action) determined the rate differentials and the currency valuations. When the Fed lowered expectations for rate hikes in March 2016, that move essentially washed out the effectiveness of any easing policies from the BOJ. The same can now be true in the reverse the BOJ doesn t have to do anything different from its current policy stance to get the depreciation it seeks if the Fed now resumes raising rates at a more meaningful pace. Rising Inflation Pressures Should Compel the Fed To Raise Rates The Fed has been ideologically leaning toward allowing inflation to build while using all means to stimulate growth, with the thinking that it can solve inflation later. However, growth and inflation are likely to look different under the Trump administration s policies. Deregulation of the financial sector should unleash a credit growth that we probably haven t seen this late in a business cycle before. If both banks and non-bank financial companies start to expand credit, the velocity of money will likely produce more inflationary effect than the pace of rate hikes by the Fed would contain. Thus the net effect on monetary conditions would be an easing effect, unless the Fed changes its approach and begins to aggressively tighten policy. We will see how the Fed reacts to this new policy mix from the administration and whether it shifts its ideology. We thought the Fed was behind the curve under the previous administration, which didn t have nearly the same aggressive growth stance of the new administration. If the Fed continues with its current thinking and its recent pace of hikes, it would fall even further behind the curve under the new administration s policies. We think the Fed needs to continue raising rates or the markets will continue to drive US Treasury yields higher without it. The sharp rises in yields that we saw at the end of last year were just the beginning of what we expect to happen in the upcoming year. 4

5 Massive amounts of capital across the core bond markets dissolved within days during those yield adjustments. Thus not only do we think it s crucial for investors to defend against interest-rate risks, we also think it s important to construct a portfolio that may benefit from rising rates. 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. IMPORTANT LEGAL INFORMATION This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as of the publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user. Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction. Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California , (800) DIAL BEN/ , franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments U.S. registered products, which are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation. 5

6 Australia: Issued by Franklin Templeton Investments Australia Limited (ABN ) (Australian Financial Services License Holder No ), Level 19, 101 Collins Street, Melbourne, Victoria, Austria/Germany: Issued by Franklin Templeton Investment Services GmbH, Mainzer Landstraße 16, D Frankfurt am Main, Germany. Authorized in Germany by IHK Frankfurt M., Reg. no. D-F-125-TMX1-08. Canada: Issued by Franklin Templeton Investments Corp., 5000 Yonge Street, Suite 900 Toronto, ON, M2N 0A7, Fax: (416) , (800) , Dubai: Issued by Franklin Templeton Investments (ME) Limited, authorized and regulated by the Dubai Financial Services Authority. Dubai office: Franklin Templeton Investments, The Gate, East Wing, Level 2, Dubai International Financial Centre, P.O. Box , Dubai, U.A.E., Tel.: Fax: France: Issued by Franklin Templeton France S.A., 20 rue de la Paix, Paris France. Hong Kong: Issued by Franklin Templeton Investments (Asia) Limited, 17/F, Chater House, 8 Connaught Road Central, Hong Kong. Italy: Issued by Franklin Templeton International Services S.à.r.l. Italian Branch, Corso Italia, 1 Milan, 20122, Italy. Japan: Issued by Franklin Templeton Investments Japan Limited. Korea: Issued by Franklin Templeton Investment Trust Management Co., Ltd., 3rd fl., CCMM Building, 12 Youido-Dong, Youngdungpo-Gu, Seoul, Korea Luxembourg/Benelux: Issued by Franklin Templeton International Services S.à r.l. Supervised by the Commission de Surveillance du Secteur Financier - 8A, rue Albert Borschette, L-1246 Luxembourg - Tel: Fax: Malaysia: Issued by Franklin Templeton Asset Management (Malaysia) Sdn. Bhd. & Franklin Templeton GSC Asset Management Sdn. Bhd. Poland: Issued by Templeton Asset Management (Poland) TFI S.A., Rondo ONZ 1; Warsaw. Romania: Issued by the Bucharest branch of Franklin Templeton Investment Management Limited, Buzesti Street, Premium Point, 7th-8th Floor, Bucharest 1, Romania. Registered with Romania Financial Supervisory Authority under no. PJM01SFIM/400005/ , authorized and regulated in the UK by the Financial Conduct Authority. Singapore: Issued by Templeton Asset Management Ltd. Registration No. (UEN) E. 7 Temasek Boulevard, #38-03 Suntec Tower One, , Singapore. Spain: Issued by the branch of Franklin Templeton Investment Management, Professional of the Financial Sector under the Supervision of CNMV, José Ortega y Gasset 29, Madrid. South Africa: Issued by Franklin Templeton Investments SA (PTY) Ltd which is an authorized Financial Services Provider. Tel: +27 (21) Fax: +27 (21) Switzerland: Issued by Franklin Templeton Switzerland Ltd, Stockerstrasse 38, CH Zurich. UK: Issued by Franklin Templeton Investment Management Limited (FTIML), registered office: Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorized and regulated in the United Kingdom by the Financial Conduct Authority. Nordic regions: Issued by Franklin Templeton Investment Management Limited (FTIML), Swedish Branch, Blasieholmsgatan 5, SE Stockholm, Sweden. Phone: +46 (0) , Fax: +46 (0) FTIML is authorized and regulated in the United Kingdom by the Financial Conduct Authority and is authorized to conduct certain investment services in Denmark, in Sweden, in Norway and in Finland. Offshore Americas: In the U.S., this publication is made available only to financial intermediaries by Templeton/Franklin Investment Services, 100 Fountain Parkway, St. Petersburg, Florida Tel: (800) (USA Toll-Free), (877) (Canada Toll-Free), and Fax: (727) Investments are not FDIC insured; may lose value; and are not bank guaranteed. Distribution outside the U.S. may be made by Templeton Global Advisors Limited or other sub-distributors, intermediaries, dealers or professional investors that have been engaged by Templeton Global Advisors Limited to distribute shares of Franklin Templeton funds in certain jurisdictions. This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. Important data provider notices and terms available at Please visit to be directed to your local Franklin Templeton website. franklintempletoninstitutonal.com Copyright 2017 Franklin Templeton Investments. All rights reserved. 2/17