Notes on Global Fixed Income Investing

Transcription

1 Investment Team Update 23 October 2018 Notes on Global Fixed Income Investing PERSPECTIVE FROM TEMPLETON GLOBAL MACRO EXECUTIVE SUMMARY US Treasury yields have risen sharply in recent weeks, and we expect them to continue to rise. Resilient US growth and exceptionally strong labour markets should continue to generate inflation pressures in our assessment. Deregulation and tax cuts are also driving investment and pushing growth above potential. We expect the US Federal Reserve (Fed) to continue raising rates to normalize policy and stay ahead of rising inflation pressures. We don t view the recent flatness in the US yield curve as a sign of an impending recession. The Fed s massive levels of quantitative easing (QE) since the global financial crisis have created price distortions across many asset classes, most notably the US Treasury curve. Those artificial effects are still in the early phases of being unwound. We expect yields in the medium- to longer-term range of the curve to shift higher over the upcoming year. Trade tensions have the potential to raise costs for consumers, but on the whole tariffs should have a marginal impact on the US economy, in our assessment. However, trade disputes could chip away at global trade agreements, making it more difficult to agree to mutually beneficial compromises during more challenging times. The potential deterioration in diplomacy is the bigger longer-term concern, in our view, while the actual impacts to the US economy and the global economy are relatively modest by comparison. Michael Hasenstab, Ph.D. Executive Vice President, Portfolio Manager, Chief Investment Officer Templeton Global Macro Calvin Ho, Ph.D. Vice President, Deputy Director of Research Templeton Global Macro Emerging markets (EMs) saw heightened volatility in August, but valuations have largely stabilized in recent weeks. Since the taper tantrum in 2013, we ve seen several of these types of overdone selloffs in EMs, and there s been a subsequent snap-back almost each time. We expect valuations in select countries with stronger fundamentals to continue to strengthen as the risk aversion dissolves. The other key factor for current EM valuations is the level of interest rates in specific countries, and a country s ability to weather rising rates in the US. EMs like Mexico, with yields around 7.9% in the front end of its curve, have a large cushion over US rates. However, EMs with low yields could be more vulnerable to rising rates, particularly if the interest-rate differential flips. In Europe, growth has moderated from its cyclical peak in The slowdown in growth combined with subdued inflation across the eurozone allows the European Central Bank (ECB) to remain accommodative for longer. We expect eurozone rates to remain exceptionally low in upcoming quarters, and we expect the widening rate differentials with the US to weaken the euro against the US dollar. Additionally, rising populism and nationalism across Europe is likely to continue to be a threat to ongoing European integration, in our view, as the factors that have driven populist sentiments show no signs of diminishing. These trends will continue to test the foundations of the monetary union, in our opinion. Recent debt sustainability concerns in Italy are not just about Italy, in our assessment; they reflect the problems of the euro area construct as a whole. The lack of ability to run its own monetary policy and the fiscal constraints from the EU limit the country s ability to respond to economic cycles. Immigration issues and the moderation of eurozone growth add additional macroeconomic pressures on Italy that go beyond its domestic control. Argentina has been making the right policy moves, in our view, despite harsh market reactions in August. These are very orthodox policy responses; it will just take some time for conditions to stabilize, in our assessment. The International Monetary Fund s (IMF s) US$57 billion program should leave no questions for Argentina s ability to service its debt. The debt picture is more stable than markets have been pricing, in our view, but it will take some time for inflation to come down and for monetary accommodation to eventually normalize. Overall, our investment convictions remain largely unchanged, despite the escalation in EM risk aversion in recent months. Many of the countries that we believed were undervalued earlier this year became even more undervalued during the recent risk-off cycle. Longer term we continue to have a positive outlook on a number of local-currency markets that we believe are fundamentally stronger than markets have been indicating. We also continue to expect rising rates in the US and depreciations of the euro and yen against the US dollar.

2 Rising US Treasury Yields We expect US Treasury yields to continue rising. Around a year ago, when the 10-year US Treasury yield was closer to 2.0%, we said that it could easily push up to 3.0% in the next year, but there were a lot of sceptics who questioned that. The 10-year US Treasury yield is now a bit above 3.0%, and we think it can easily move above 4.0% in the upcoming year. Again, we re seeing some scepticism on that view, but we think yields will keep moving higher. There s a perfect storm lining up behind the rate environment, in our view: strong expansion of the US economy fuelled by ongoing deregulation and tax cuts that are driving investment and pushing growth above potential. On the inflationary side, the labour market is running at full employment, and we re starting to see an acceleration in wage pressures. Trade disputes will also continue to drive consumer prices higher US consumers had been benefiting from cheaper imports from China for decades, but tariffs will raise those costs. Each of these factors is inflationary, in our assessment. Additionally, US fiscal spending is expanding. In the past, a Republican administration would have traditionally shown some fiscal restraint, but that s not currently the case. Fiscal deficits are growing. At the same time, there is less buying demand for US Treasuries the Fed has ended its QE program and is unwinding its balance sheet holdings, so it s not financing the deficit as it did in the past. Additionally, foreign buyers such as the major oil-exporting countries and China are no longer accumulating reserves at the levels they were five or 10 years ago. That equates to a significant decline in buying demand for US Treasuries. All of these factors should pressure US Treasury yields higher in the upcoming year, in our view. Flat Yield Curve Regarding the flattening of the yield curve, we don t see that as a signal for a potential recession in the US. The Fed s massive levels of QE since the global financial crisis have created price distortions across many asset classes, and that s been especially true across the US Treasury curve. It s impossible to compare the yield curves of 15 years ago, or decades ago, to the curve of today because QE has had an unprecedented effect on valuations. Unwinding QE has also never been done before, so the effects on the curve have no historical comparison to model against. What concerns us most is that the Fed can have some degree of control over the front end of the curve through rate policy, but it has little ability to control the long end of the curve without another massive QE program. That makes the long end of the curve highly vulnerable to yield shifts, in our view. We think there is a tremendous amount of asymmetric interest-rate risk built into the medium- to longer-term ranges of the US Treasury curve. Trade Policies Trade tensions have the potential to raise costs for consumers, but on the whole tariffs should have a marginal impact on the US economy, in our assessment. The US is a relatively closed economy with imports accounting for less than 20% of GDP (gross domestic product). On a first order basis, the tariff effects on growth are quite small, in our analysis. In fact, deregulation and tax reform stimulus should easily offset the relatively small impacts from trade tensions, in our view. Additionally, some of the trade tensions have actually led to positive compromises between countries. South Korea has renegotiated some of its trade quotas with the US in specific sectors. South Korea has had significantly higher average tariffs, around 10%, while US average tariffs are much lower at around 3.5%. Reducing South Korea s tariff levels would actually open up more trade, not constrain it. We ve also seen Canada, Mexico and the US agree to renegotiated trade terms. However, the major concern going forward is the potential damage to trust and diplomacy between the various countries. Trade disputes could chip away at the inherent trust across global trade agreements, making it more difficult to agree to mutually beneficial compromises during more challenging times. During the global financial crisis in , several countries came together to ease interest rates and deploy fiscal stimulus in coordinated responses. However, if trade tensions alter those relationships and brew mistrust among the governments, there may be less good will to collectively work together on recovery measures. To us, that s the bigger longer-term concern, while the actual impacts to the US economy and the global economy are relatively modest by comparison. Emerging Markets EMs saw heightened volatility in August, but valuations have largely stabilized in recent weeks. In our view, the key to investing in EMs is to have the right time horizon. If you have a three-month time horizon, then investing in EMs is going to be very difficult as you can get caught in these extreme cycles of risk aversion. But if you have a two- to three-year horizon or longer, you can step into fear-driven selloffs at underpriced valuations and hold the positions as fundamental pricing recovers. Since the taper tantrum in 2013, we ve seen several of these types of overdone selloffs in EMs, and there s been a subsequent snap-back almost each time. The selloffs that occurred in August 2018 haven t completely snapped back yet, in our assessment, but we expect certain countries with the right fundamentals to eventually recover. We ve already seen localcurrency markets in Argentina and Brazil rebound, among others, and we expect similar trends to emerge as excessive risk-aversion dissolves. It s also important to remain active and selective in the EM space in our view, as not all countries are the same. Notes on Global Fixed Income Investing 2

3 Over the past few decades, we ve generally seen three stages develop in EM crises. The first stage occurs when a country reaches a peak exchange rate, which often corresponds with a current account deficit. That puts a lot of pressure on the country, and eventually the exchange rate corrects. Market concerns for one group of local-currency EM assets can trigger worries for other EM assets, justly or unjustly. The second stage occurs when investors and analysts begin to question whether the country s debt is sustainable. This occurred in Thailand in 1997, triggering the Asian Financial Crisis. Finally, the third stage involves the IMF stepping in with programs to restore financial stability. Over the last few years, there have been numerous periods of exchange-rate selloffs, or the first stage of a potential crisis. However, the most resilient countries have snapped back from those pressures. For example, the Brazilian real recently depreciated against the US dollar, rising to more than 4.0 reais per dollar. It eventually snapped back to the 3.7 range. Yet we haven t seen any major corporate defaults in these types of places or major sovereign defaults from the weaker exchange rates. This indicates to us that the ripple effect of a weakening exchange rate triggering a debt crisis has been diminished for the countries that have built up their domestic and external resiliencies. A number of countries in Latin America and Asia have learned the lessons from past crises and made the adjustments to their financial and monetary systems to protect them from repeating those mistakes. In August, we saw the exchange rates driven down for weeks, but it didn t cause credit distress in the resilient EMs essentially stage 1 got tested, but the crises never developed to stage 2 or stage 3. Identifying which countries have the resiliencies to withstand those pressures and snap back is the key to EM investing, in our view. The other key factor for current EM valuations is the level of interest rates in specific countries, and a country s ability to weather rising rates in the US. Countries like Mexico, with yields around 7.9% in the front end of its curve, have a large cushion over US rates. However, EMs with low yields can be more vulnerable to rising rates, particularly if the interest-rate differential flips. We have focused on countries that have a higher yield advantage, as well as better dollar to local-currency liability management. We also look for countries that don t have huge debt loads and have responsible fiscal and monetary policy. Eurozone Growth and the Euro Eurozone growth in 2017 was the strongest in 10 years, expanding at 2.4%. That cyclical peak led to a broadly stronger euro in In 2018, eurozone growth has moderated and the euro s strength against the US dollar has partially reversed. We expect that trend to continue in upcoming quarters. There is greater potential for a downside surprise to growth in the eurozone than in the US, in our view. Market expectations are for 2.0% eurozone growth in 2018 and 1.8% in But it wouldn t surprise us if eurozone growth fell below 1.8% in The slowdown in growth combined with subdued inflation across the eurozone also allows the ECB to remain accommodative for longer. While the ECB intends to cease its QE purchases at the end of 2018, ECB President Mario Draghi has also indicated that rates will likely remain unchanged until at least the middle of That means monetary policy will continue to remain highly accommodative for a while. The ECB holds more than two trillion euros worth of assets in its QE programs, which will continue to rollover as they mature. Thus the massive levels of liquidity will remain in place even after QE expansion ends. Additionally, any moves to raise rates can have political consequences for elected governments and implications for debt sustainability in countries like Italy. Those kinds of political and economic constraints on the ECB make it difficult to tighten policy. On the whole, we expect ECB monetary policy to remain highly accommodative, and we expect rates to remain exceptionally low in upcoming quarters the widening rate differentials between the low rates in the eurozone and the rising rates in the US should weaken the euro against the US dollar, in our view. European Political Risks For a monetary union to work, there needs to be a reliable political union. The immigration crisis and the rise of nationalist political movements makes it difficult to maintain that political union across the eurozone, particularly if a crisis were to develop. During the European debt crisis, eurozone countries came together, despite not having a fiscal union or a banking union, to shore up the monetary union and bolster the financial system. It worked because there was a strong collaborative political will to maintain the eurozone. Today, that political resolve is less certain. Unfortunately, rising populism across Europe is likely to continue to be a threat to European integration, in our view, as the factors that have driven populist sentiments don t show signs of diminishing. The issues that people used to vote on have changed dramatically. Economic issues, employment and public finances used to be the top concerns as recently as five years ago. Now it s the refugee crisis, terrorism and immigration. That shift has fuelled rising popularity for parties at the extreme ends of the political spectrum, such as the Five Star Movement in Italy, or the far-right parties in Hungary and Poland, or the nationalist-leaning government in Austria. It s also led to a diminishment of the grand coalition in Germany and the highest support for a nationalist party (the AFD) in Germany in the postwar era. These trends make it increasingly difficult for the EU to maintain a political union. Ultranationalist voter sentiment and the concomitant political mandates lead to more inward-looking policy rather than coordinated policy efforts across the European Union. The other problem with the recent populist trends is that many of these parties appear inclined to spend a lot of money. That s not a good direction for the eurozone it cannot sustain itself without fiscal responsibility. Back in 2011, Germany stepped in to shore Notes on Global Fixed Income Investing 3

4 up unsustainable Greek debt that type of intervention is not as politically viable today. If a country like Italy starts spending irresponsibly under a Five-Star and Northern League coalition, it s not likely that Germans will want to step in to subsidize Italian debt. Without a firm agreement on a common fiscal union, the financial stability of the eurozone will always be at risk. Given the political trends toward nationalism and the lack of a political and fiscal union, we think the foundation of the euro as a currency will be significantly challenged over the next five to 10 years. Italy What s happening in Italy is not really just about Italy; rather it reflects the problems of the euro area construct as a whole. None of the countries have their own monetary policy that s a significant constraint, as ECB monetary policy may be appropriate for one subset of countries but not for others. Additionally, fiscal policy is constrained by the Maastricht Treaty s stability rule, limiting a country s ability to respond to economic cycles. Add the immigration issues and the moderation of eurozone growth as a whole, and you get a lot of macroeconomic pressure on a country like Italy, notably from external constraints beyond its domestic control. There are policies that the European monetary union will have to address if it wants to endure, in our view. The first initiative would be structural reforms if a country cannot change the nominal exchange rate, it will need to change the competitiveness of the real exchange rate. Another option is to allow people to move more freely from weaker economies to stronger ones. However, cultural barriers and language differences without a binding political union often make those transitions infeasible. The third route would be to pursue a fiscal union in which a stronger country s resources are more readily shared with weaker countries. In actuality, a fiscal union would likely require a political union, which at this stage is not widely supported given the rising trends of nationalism and populism. A fiscal coalition was barely possible during the intervention with Greece in 2011, yet today, Italy s debt levels are significantly higher. Thus the political trends toward nationalism and the magnitude of the debt loads make it very difficult to envision a viable fiscal union for the eurozone. Argentina Argentina has been making the right policy moves, in our view, despite the harsh market reactions in August. These are very orthodox policy responses; it will just take some time for conditions to stabilize. In actuality, the IMF s US$57 billion program should leave no questions for Argentina s ability to service its debt. The IMF program is a pretty strong endorsement of Argentina s policy-making, in our view. The IMF does not just go ahead and install a US$50+ billion credit line without being very confident that the right debt sustainability policies are being pursued. The debt picture is more stable than markets have been pricing, in our view, but it will take some time for inflation to come down and for monetary accommodation to eventually normalize. Politically, President Mauricio Macri s popularity has been dinged a bit by the financial volatility, but he s continued to respond appropriately on the policy front. Elections are a year away (27 October 2019), which gives Macri sufficient time to recover his political support, assuming financial conditions continue to stabilize over the months ahead. But ongoing reforms are also not solely dependent on Macri s mandate. There are a number of politicians, such as the current governor of Buenos Aires among many others, who are advocating for Argentina s turn toward more orthodox policy and away from the failed policies of the Kirchner government. Additionally, the Peronists have split between the radical Kirchner wing and the more moderate wing. Macri s party has worked productively with the moderate Peronists to pass important reforms, demonstrating the common political will to move Argentina in the right direction. Overall, we see a lot of political outcomes that could continue to be positive for the Argentina. Turkey In Turkey, the policy mix is very difficult to comprehend. Inflation figures have been 25% year-over-year for consumer prices, but we think that the actual figure is even higher, closer to 30% to 35%, or more. The monetary policy response has been the opposite of what one should do in the face of high inflation instead of raising rates, the government has insisted on cutting rates. The fiscal side is not any better, as the president s son-inlaw holds the finance minister position, and there s a lack of transparency into what the actual finances are and what the agenda should be. Additionally, Turkey has a massive external debt load that needs to be rolled over every year. In short, the external environment is a major concern, while domestic policy is highly unorthodox and irresponsible. Taken together, this is the type of country we avoid investing in. Brazil Brazilian elections have been showing us that the population doesn t want a return to the policies of the former Workers Party (PT) governments: populism, high levels of corruption and excessive spending. Even the nomination of Fernando Haddad as the PT candidate did not reflect a desire to move back to the policies of the Dilma administration. The platforms of both Haddad and Jair Bolsonaro on the far right have reflected the voter desire to crack down on corruption and reinstate more responsible fiscal policies. There s been some stronger voter support for Bolsonaro s tougher stance on corruption and spending. We ll need to see what the actual economic platform will be after the second round of the election, but there appears to be a collective political will across Brazil to keep moving the country forward on the reform front, and back toward more market-friendly, fiscally responsible policies. The IMF has also indicated that Brazil needs pension reform, and nearly all of Brazil s political parties have acknowledged that need as well. We expect to see more progress on that front after the elections. Notes on Global Fixed Income Investing 4

5 Mexico The recent renegotiation of NAFTA (North American Free Trade Agreement) into the USMCA (United States Mexico Canada Agreement) is generally a positive development for Mexico. At a minimum, the trade agreement removes the uncertainty that had been disrupting potential investment over the last year and a half or so. Now that people have a sense for what the rules will be, they can start making informed decisions again. One of the key areas of the agreement focuses on increasing the share of vehicle production in the regions (US, Mexico and Canada) from around 62.5% to 75%. A second key component increases the high wage share of production in the sectors from around 40% to 45%. That will likely move more of the high wage production to Canada and the US, and increase the amount of lower wage production in Mexico, by essentially transferring some of the current lower wage production that s happening in China over to Mexico. Thus, while Mexico may see a reduced share of high wage production, it should see an increase in its share of low wage production. Overall, the impacts are largely marginal, in our assessment. More importantly, the trade agreement should refortify investor confidence in Mexico s extensive trade relationships with the US. That renewed confidence should support local-currency valuations in Mexico, in our view. 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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