Notes on Global Fixed Income Investing

Transcription

1 January 11, 2013 Investment Team Update May 13, 2016 Notes on Global Fixed Income Investing PERSPECTIVE FROM TEMPLETON GLOBAL MACRO EXECUTIVE SUMMARY The 10-year US Treasury note s yield has recently ranged around 1.80%, significantly down from 2.30% at the start of this year. Yields have been suppressed by the US Federal Reserve s (Fed s) reluctance to raise rates beyond 0.25% as well as some lingering market fears of a US recession. However, we see strength in the US economy along with underlying inflation pressures, which we expect to drive rate hikes in the second half of the year, leading to higher yields. The US core Consumer Price Index (CPI) has been running at around 2.2% in If headline inflation reverts toward this underlying inflation level as the oil price effect fades away, we believe there is significant risk that markets will unpin the long end of the yield curve. With inflation running above 2.0% and real gross domestic product (GDP) growth of 2.0% to 2.5%, 10-year US Treasury note yields can reach the 3.0% to 3.5% range quite easily on a fundamental basis, in our view. In December 2015, the Fed said it expected four rate hikes in 2016, then it reduced that number in March to two hikes. The result of the Fed s dovishness was an implicit easing of policy, as the market essentially started eliminating priced-in rate hikes for This move effectively created more easing than the Bank of Japan (BOJ) and European Central Bank (ECB), which strengthened the euro and Japanese yen against the US dollar. 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 On the whole, we view the recent appreciations of the euro and yen as temporary and likely to reverse as the Fed ultimately hikes rates. Both the eurozone and Japan need currency weakness to support their export sectors and drive growth. We expect the ECB and BOJ to continue easing monetary policy as the Fed tightens policy, leading to a fundamental depreciation of the currencies against the US dollar. In recent months, we have seen some stabilizations in emerging markets after significant volatility earlier in the year. However, we see further room for improvement given how far valuations dropped during the volatility. We have continued to see a subset of emerging markets that we think have excellent value and better underlying fundamentals than markets have indicated, such as Mexico, Malaysia, Indonesia and the Philippines. Brazil remains in crisis but appears politically on course with its consolidation policies and the possible impeachment of President Dilma Rousseff. We have confidence in the institutional depth of the country and remain encouraged by the political will to consolidate and rein in the fiscal excesses of the Dilma administration. We believe investors in Brazilian bonds are being appropriately compensated for near-term risks through relatively high yields, and we continue to have a favorable outlook for the longer-term prospects of the country. Despite significant market chatter about low commodity prices and the risks of secular stagnation, we do not see lower commodity prices as having a negative impact on global growth. Much of the world predominantly imports commodities, including several large globally impactful economies such as the eurozone and China. Many of these economies benefit from lower energy costs. Not FDIC Insured May Lose Value No Bank Guarantee

2 Despite the International Monetary Fund s (IMF s) downward revision of its 2016 global growth forecast to 3.2%, 1 growth has actually remained on trend with its long-term average. Over the last 30 years, average growth in five-year spans has largely been between 3.0% to 4.0%. 1 The current pace of global growth remains healthy and within its historical average. We remain concerned that the Fed is falling behind the curve by not hiking rates at a requisite pace. If the Fed raises rates too slowly in 2016, it will likely be forced to raise rates rather quickly after headline inflation has risen above its target. We believe rate hikes are needed given the prevailing conditions and that a return to appropriate monetary policy in the United States can catalyze markets toward a broad fundamental recovery. We Continue to Expect US Treasury Yields to Be Pressured Higher The 10-year US Treasury note s yield has ranged around 1.80% recently, significantly down from 2.30% at the start of this year. Yields have been suppressed by the Fed s reluctance to raise rates beyond 0.25% and lingering market fears of a US recession. However, we see strength in the US economy along with underlying inflation pressures, which we expect to drive rate hikes in the second half of the year, leading to higher yields. We continue to see asymmetric risks in US Treasuries, as yields have far more room to shift higher but very little room to decline further. We think investors taking six to seven years of duration in their strategies are exposed to significant interest-rate risks. US Labor Markets Remain Strong While Underlying Inflation Pressures Persist Despite a relatively low GDP growth figure of 0.5% in the first quarter, we expect US growth of 2.0% to 2.5%, which is above its potential of 1.5%, by our assessment. The recent GDP figure should be viewed in the context that first-quarter US GDP has often been biased downward during each of the recovery years since the global financial crisis. Additionally, initial jobless claims approached lows in mid-april that have not been equaled since the early 1970s, indicating significant strength in the labor market. The US has been around full employment for a number of quarters, with relatively resilient payroll numbers. We currently do not see signs of an imminent recession in the US. Additionally, underlying inflation in the United States has not been adequately priced into bond yields in recent months, in our assessment, and we are wary of the lack of inflation being priced into bond yields across the globe. US core CPI has been running at around 2.2% in If headline inflation reverts toward this underlying core inflation level as the base effects from the drop in oil prices fade away, we believe there is significant risk that markets will unpin the long end of the yield curve. Ten-year US Treasury note yields can reach the 3.0% to 3.5% range quite easily on a fundamental basis, in our view, with inflation running above 2.0% and real GDP growth of 2.0% to 2.5%. Any normalization of inflation pricing in global bond yields and in US Treasuries would drive yields higher, by our assessment. We think markets have been underappreciating the underlying levels of inflation. We View the Recent Strength in the Euro and Yen as Temporary and Likely to Reverse We continue to expect the ECB and BOJ to ease monetary policy while the Fed trends toward tightening policy. Both the eurozone and Japan need currency weakness to support their export sectors and drive growth; both regions rely far more on weakness in their currencies than the US does. Additionally, both economic regions need inflation, particularly Japan. Quantitative easing measures from the ECB and BOJ have been supporting those efforts; however, the euro and yen recently appreciated against the US dollar with the persistent softness in US monetary policy, along with rallies to the major currencies. In December 2015, the Fed said it expected four hikes in 2016, then in March it reduced that number to two hikes. The result of the Fed s dovishness was an implicit easing of policy, as the market essentially started eliminating priced-in rate hikes for This move effectively created more easing than the BOJ and ECB, which strengthened the euro and yen against the US dollar. Going forward, ECB and BOJ easing measures will be more effective when they are deployed against a clear tightening move by the Fed. If the central banks ease at times when the measures are countered by even greater easing by the Fed, then the policies will have virtually no effect they need to be deployed as divergent counter-measures to Fed tightening to have appropriate impact. On the whole, we view the appreciations of the euro and yen as temporary and likely to reverse as the Fed ultimately hikes rates. Specific Emerging Markets Continue to Have Excellent Value In recent months, we have seen some stabilizations in emerging markets after significant volatility earlier in the year. However, we see further room for improvement; the recent recovery does not appear to be anywhere close to the full cycle of valuation strengthening, given how far valuations dropped during the volatility. We have continued to see a subset of emerging markets that we think have excellent value and better underlying fundamentals than markets have indicated, even with the recent improvements in valuations. Our focus remains on specific countries that have solid fundamentals but that have recently been priced as if they were in a crisis, such as Mexico, Malaysia, Indonesia and the Philippines. We also see value in specific distressed special situations that are in a crisis but that we see having a clear path for exiting that crisis over the medium term, such as Brazil. We anticipate that countries with relatively stronger fundamentals, such as Mexico, will likely be in a better position to potentially raise interest rates in conjunction with US interest-rate hikes. However, countries with relatively weaker fundamentals are likely to be negatively impacted by interest-rate Notes on Global Fixed Income Investing 2

3 hikes. As we continue to move through market stabilizations and increasing rates from the Fed, we believe markets will more clearly recognize the underlying valuations in specific countries and increasingly distinguish the stronger fundamental valuations from the weaker ones. Brazil Continues on its Path of Fiscal Consolidation While Brazil remains in an economic and political crisis, we continue to have confidence in the institutional depth of the country. There are no easy solutions for Brazil s economic woes, but the country appears politically on course with its consolidation policies and the possible impeachment of President Dilma. We expect continued fiscal consolidation and tight monetary policy from the current political order that aims to remedy the country s longer-term economic health, albeit at the potential cost of a deepening near-term recession. Most importantly, we see a continuity of the political will to consolidate and rein in the fiscal excesses of the Dilma administration, regardless of how a potential impeachment proceeds. This curing of the prior excesses will take time, and we may continue to see volatility and recessionary conditions as the country works to re-establish a stronger policy foundation. Overall, we continue to see positive trends in the direction of policy and the likely appointees to a new cabinet. We believe investors in Brazilian bonds are being appropriately compensated for the near-term risks through relatively high yields, and we continue to have a favorable outlook for the longer-term prospects of the country. Global Growth Is Not Dependent on Commodity Prices Despite significant market chatter about low commodity prices and the risks of secular stagnation, we do not see lower commodity prices as having a negative impact on global growth. Certainly, there are a handful of countries that depend almost entirely on commodities as their source of growth, such as Russia, Nigeria, Venezuela and large parts of the Middle East. However, much of the rest of the world predominantly imports commodities, including several large globally impactful economies such as the eurozone and China. Many of these economies benefit from lower energy costs. Thus the decline in commodity prices has had a positive effect on many countries, and we do not see it having a negative impact on the global economy. Additionally, despite the IMF s downward revision of its 2016 global growth forecast to 3.2%, 1 growth has actually remained on trend with its long-term average. Over the last 30 years, average growth in five-year spans has been between 3.0% to 4.0%. 1 Thus the current pace of global growth remains within its historical average. Higher levels of five-year average growth at 5.0% were most recently accompanied by a credit-fueled bubble that proved unsustainable and led to the global financial crisis. The current level of global growth that is moderately above 3.0% reflects a healthier pace, by comparison, and is well within the long-term norm. Nonetheless, there is persistent chatter about secular stagnation and specifically about how US GDP growth needs to be much higher. Accompanying such talk are discussions over using additional fiscal policy to generate additional GDP growth. However, potential growth in the US of 1.5% cannot be cured by fiscal and monetary policy; it needs to be remedied through structural policies that increase productivity. On the whole, we continue to see strength in the US economy and less need for overly accommodation monetary policy. The Fed Needs to Hike Rates We remain concerned that the Fed is falling behind the curve by not hiking rates at a requisite pace. If the Fed raises rates too slowly in 2016, it will likely be forced to raise rates rather quickly after headline inflation has risen above its target. Given the lags and leads in monetary policy, the Fed could easily find itself behind the curve in such a scenario. One could argue that the Fed is already behind the curve. In fact, we have reached a point where market participants are parsing the Fed s rhetoric to understand whether the Fed actually wants to remain behind the curve. We think the Fed is walking a fine line that risks chasing inflation and losing the effectiveness of policy. The Fed can anchor the short end of the yield curve through rate policy, but it cannot control the long end of the curve, particularly if inflation persists beyond its target. Such a loss of effectiveness would have a negative impact on broad financial stability and is likely to have a particularly negative effect on the bond markets. We believe the Fed has to stay ahead of the curve and adjust monetary policy appropriately for current conditions. We have also seen divisions within the Federal Open Market Committee there are certainly members who have similar concerns that Fed policymaking is in danger of falling behind the curve by remaining too dovish. Keeping rates extraordinarily low for such a long time, particularly in the context of a strong economy and underlying inflation pressures, runs the risk of encouraging bubbles across different asset classes. Additionally, if and when the US economy does encounter a downturn, the Fed would not be in a position to cut rates effectively because the low rate level leaves very little room for accommodative rate cuts. Thus exceedingly low rates essentially eliminate one of the Fed s primary tools for responding to a recession. If rates had been at 100 to 200 basis points earlier in the year, then market chatter about a potential US recession would not have led to scares of negative interest rates and fears of damage to overall financial stability. Bringing rates up to a suitable level is not only prudent for addressing underlying inflation and preventing bubbles, but it also helps bolster financial market stability during adverse downturns. We believe rate hikes from the Fed are needed given prevailing conditions and that a return to appropriate monetary policy in the US can catalyze markets toward a broad fundamental recovery. Notes on Global Fixed Income Investing 3

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