Notes on Global Fixed Income Investing

Transcription

1 Investment Team Update 29 November 2017 Notes on Global Fixed Income Investing PERSPECTIVE FROM TEMPLETON GLOBAL MACRO EXECUTIVE SUMMARY Financial markets tend to focus on the level of the fed funds target rate and the effect it will have on the yield curve, but we think markets have not focused enough attention on the US Federal Reserve s (Fed s) plans to unwind US$1.5 trillion in assets from its balance sheet over the next three years. Two of the major areas of foreign official buying (China and major oil exporters) are now largely out of the US Treasury (UST) market, with the third major buyer, the Fed, now also in retreat. This transfers the burden of buying USTs back on the private sector, specifically pricesensitive US domestic investors. We expect those price-sensitive dynamics to put additional upward pressure on yields. We are in the later part of the current US expansion but not near the end, in our view. US policy adjustments such as tax reform, repatriation of profits, deregulation and fiscal spending on infrastructure may stimulate growth and accelerate the pace at which we get to overcapacity. However, the US is not yet at the levels of investment and capacity that typically precede a cyclical downturn, in our view. 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 We expect tightening US labor conditions and deregulation from the government to add to inflation pressures. In the labor market, job openings in the US are exceeding the rate of job hires, indicating that companies are finding it harder to fill open positions. Additionally, immigration policies from the Trump administration have tightened the labor pool across a number of skill sets. We expect these dynamics to increase wage pressures. On the deregulation front, credit growth from the official banking sector, as well as non-official financial companies, has started to pick up again. We expect to see increasing leverage as deregulation continues. Some of the inflationary effects of quantitative easing (QE) were delayed by the regulatory environment and an unwillingness to lend by the banks. As that begins to turn and credit activity picks up, we expect those delayed effects to begin passing through to inflation. Although the European Central Bank (ECB) will be reducing the pace of its monthly bond purchases, it is likely to remain in a highly accommodative posture over the upcoming year. Any move by the ECB toward normalizing policy is likely to lag the normalization path of the Fed. We expect widening rate differentials with the US to weaken the euro. Additionally, the political dynamics across Europe remain a concern. Since Emmanuel Macron beat Marine Le Pen in the French presidential election in May, we have seen renewed optimism about Europe. But those positive sentiments have often been at odds with the strengthening nationalist movements across the continent. The political will to uphold the union is not as strong as it was during the last crisis in Europe remains vulnerable to an external shock, in our view. Several emerging markets are in stronger shape today than they were 20 years ago. In the mid-1990s, many countries were largely dependent on borrowing in US dollars and they required daily flows of capital. Several had large fiscal deficits, ran external imbalances and had huge current account deficits. But today, several countries no longer rely solely on US dollar funding, and they have much healthier finances. It would be a mistake for investors to extrapolate the emerging-market environment of 20 years ago to today s markets. As rates rise in the US we could see the interest-rate differential between Australian government bonds and USTs disappear, leading to weakness in the Australian dollar against the US dollar. Additionally, we have seen a historical correlation between weakness in the Australian dollar and periods of declining valuations in emerging markets. From an investment standpoint, short Australian dollar exposure may help offset the risks associated with a broad-based decline in emerging markets, or a China-related shock.

2 In recent months, markets have appeared concerned about NAFTA negotiations between the US, Canada and Mexico the potential for trade-related impacts has appeared to weigh on the Mexican peso. However, we think the currency depreciation is overdone. NAFTA may see some meaningful changes, with specific rewrites and new chapters added, but the agreement will not be completely abandoned, in our view. The US economy has become dependent on the lower costs of production in Mexico, and it continues to rely on Mexico as a trade partner. Brazil continues to see positive change there have been more positive reform efforts in the last year than during the entirety of the previous decade. Pension reform stands a reasonable likelihood of being passed in the upcoming year, in our assessment, which would be a key achievement for Brazil s fiscal future. On the whole, we continue to have a positive outlook for Brazil, despite recurring political disruptions. Congressional elections in Argentina in October were highly supportive of President Mauricio Macri s political coalition, significantly strengthening his governing position. He s been working to reverse the economically damaging policies of the previous government. He s also allowed the central bank to assertively hike interest rates. We think the political situation is in the right place in Argentina, and we remain optimistic for the country s ongoing turnaround. In India, Prime Minister Narendra Modi has taken on a number of bold reform initiatives that we expect to have positive longer-term effects on the country. Some of the tougher measures may suppress growth in the short term but ultimately provide greater benefits for the long term. Overall, Modi is largely moving India in the right direction, in our view. China s economy looks fairly stable in the short term, in our assessment. However, the greater concern is that China needs nearly five times more credit to generate a unit of GDP (gross domestic product) than it did in the aftermath of the GFC (global financial crisis) in If China has not reduced its credit dependence in a couple years and we get an exogenous shock, such as a recession in the US, then China s ability to stimulate its economy will be substantially less effective than it was during the last US recession. Fed Balance Sheet Unwinding Should Pressure UST Yields Higher Financial markets tend to focus on the level of the fed funds target rate and the effect it will have on the yield curve, but we think markets have not focused enough attention on the Fed s plans to unwind US$1.5 trillion in assets from its balance sheet over the next three years. The Fed s incremental departure from the UST market removes a key buyer of USTs. Several other foreign official buyers have already curtailed their UST purchases in recent years. China notably reduced its reserves by a trillion dollars, while several Asian exporting countries similarly stopped acquiring USTs. Additionally, several oil exporting countries, such as Saudi Arabia, have drawn down their reserves since oil prices collapsed ( ) and have now become net borrowers, running fiscal deficits. Thus two of the major areas of foreign official buying (China and major oil exporters) are now largely out of the UST market, with a third major buyer, the Fed, now also in retreat. This transfers much of the burden of buying USTs back on the private sector, specifically US domestic investors. Domestic buyers have represented about 35% of the UST buying since These buyers would need to roughly double their proportional percentage of UST purchases to fill the upcoming Treasury funding gap over the next three years. But one of the crucial differences between those official governments as buyers and the domestic private sector is that private investors are far more price sensitive. The Fed was largely insensitive to prices, buying instead on a targeted volume. Reserve-building foreign official governments were similarly less sensitive to pricing. However, domestic private investors, such as mutual funds, insurance companies, banks and financial companies, are more concerned with valuations and overall yields. We expect those price-sensitive dynamics to put additional upward pressure on yields. The US Economy Appears Poised for Continued Expansion The current US expansion has been going on longer than we typically see in recovery periods, but this doesn t mean the end is imminent. Cycles don t just end from old age; they end from specific conditions, such as overinvestment and a buildup of overcapacity, or a series of events, such as aggressive rate tightening by the Fed, or a financial market correction to asset prices. We are certainly in the later part of the current expansion, but not near the end quite yet, in our assessment. US policy adjustments such as tax reform, repatriation of profits, deregulation and fiscal spending on infrastructure may stimulate growth and accelerate the pace at which we get to overcapacity. However, the US is not yet at the levels of investment and capacity that typically precede a cyclical downturn, in our view. Underlying Inflation Pressures Are Rising US inflation dynamics during the current expansion have been different than past cycles. We eventually got back to full employment and closed the output gap, but arriving at each of those points took a lot longer than they have for other post-war recoveries. The inflation figures typically lag reaching those thresholds, so there has not yet been a persistent surge in inflation. However, it s only a matter of time before those fundamental pressures work their way back into an economy at full throttle. We expect tightening US labor conditions and deregulation from the government to add to inflation pressures. Notes on Global Fixed Income Investing 2

3 In the labor market, job openings in the US are exceeding the rate of job hires (as indicated by the JOLTS survey), indicating that companies are finding it harder to fill open positions. We ve seen labor shortages for specific skill sets. Companies often wind up paying a bit more to fill specific roles, in an attempt to either draw new participants out of the unemployment pool or to pull people from competing companies. We ve only just recently crossed that tipping point of full employment where wage pressures begin to grow, and we expect those pressures to rise from here. Additionally, immigration policies from the Trump administration have tightened the labor pool across a number of skill sets. Barriers to both legal and illegal immigration have been tightened, affecting sectors such as services, construction and agriculture, among several other areas of the economy. If tighter immigration policies were put in place when unemployment was at 10%, it would probably have had less material impact. But we currently have an already tight labor market, and we are shifting the labor supply curve in the opposite direction, tightening the supply of labor at a time when the demand for labor is exceptionally high. We expect those dynamics to increase wage pressures. The other inflationary driver we see is deregulation. One of the reasons we didn t see inflation accelerate during the years of QE from the Fed was because of the lack of credit expansion from the banking sector. Banks did not significantly resume their lending activity and instead held cash in reserves. That kept money velocity and the money multiplier suppressed. However, credit growth from the official banking sector, as well as nonofficial financial companies, has started to pick up again. Reserves at the Fed are starting to be drawn down, and money velocity has risen. We may not get fully back to the levels of credit expansion that we saw before the GFC there was an extraordinary amount of leverage in that cycle. However, we do expect to see increasing leverage as deregulation continues. Some of the inflationary effects of QE were delayed by the regulatory environment and an unwillingness to lend by the banks. As that begins to turn and credit activity picks up, we expect those delayed effects to begin passing through to inflation. The Euro Remains Vulnerable to Widening Rate Differentials and Political Risks across Europe Although the ECB will be reducing the pace of its monthly bond purchases, it s likely to remain in a highly accommodative posture over the upcoming year. Strength in the euro tends to undermine European exports and restrain growth, thus an accommodative monetary stance has been a key component of the current growth cycle. Even when the ECB begins to move more toward normalizing policy, it would still lag the normalization path of the Fed. The pace of normalization may eventually change when a new ECB president arrives, but we expect to see highly accommodative rates continue in 2018 and likely through the end of Mario Draghi s term in Additionally, the political dynamics across Europe remain a concern. Since Emmanuel Macron beat Marine Le Pen in the French presidential election in May, we have seen renewed optimism about Europe. But those positive sentiments have often been at odds with the strengthening nationalist movements across the continent. In Germany, the Alternative for Deutschland party got its highest level of voting support in its history during the October elections. That party started as an anti-euro party and has morphed into an anti-immigration nationalist party. In Austria, the newly elected chancellor is a nationalist, interested in pulling back from European integration. Countries to the east, such as Poland and Hungary, have been pursuing nationalist interests and not acting like they are part of the European Union. Several countries have also been reenforcing their borders, while suspending the Schengen Treaty that guarantees free movement of people through Europe. All of these factors have the potential to increase frictions across Europe, and to tear at the collective efforts of integration. The real test for Europe will likely not come in the next year or so, in our view. The greater test will come when there is an external shock. The institutions that were present in 2011 literally saved Europe by politically coming together and bailing out Greece. Today, that institutional fortitude is not as certain, and the general populations support for European cohesion has diminished. Countries appear far less receptive to the idea of bailing out a neighboring country like they did in Yet a number of countries still remain structurally vulnerable, such as Italy, which we believe would face a debt sustainability crunch if yields on its 10-year debt were pushed above 4%. Those underlying issues could be forced to the surface again during a shock, but this time there is far less institutional commitment to reaching a common solution. On the whole, all of these factors point toward a weaker euro in upcoming quarters, in our opinion. Thus negative exposure to the euro against the US dollar provides a low-cost hedge against those larger structural risks across Europe, while it also can potentially benefit from widening rate differentials with the US that depreciate the exchange rate. Notes on Global Fixed Income Investing 3

4 Select Emerging Markets Appear Better Prepared for Rising US Rates Emerging markets were a lot more uniform 20 years ago. In the mid-1990s, many countries were largely dependent on borrowing in US dollars and they required daily flows of capital. Several had large fiscal deficits, ran external imbalances and had huge current account deficits. All of these factors made countries highly vulnerable to US rates. But today, several countries are in a much stronger standing they no longer rely solely on US dollar funding, instead capital is sourced from their domestic markets. This smooths their access to capital, allows them to lengthen their term structures and makes them far less vulnerable to US rates. Additionally, several countries have stronger finances Indonesia is a notable example with debt now below 30% of GDP. Thus it would be a mistake for investors to extrapolate the emerging-market environment of 20 years ago to today s markets many countries are in far better condition. Nonetheless, we do expect some impact to the broad emergingmarket asset class as rates rise in the US. Some domestically driven economies with higher, maintainable rate differentials appear better positioned for rate increases, in our assessment. Argentina has rates around 25% in the front end of its yield curve. Mexico has short-term yields around 7% that s one of the largest yield gaps to the US in recent history. If rates move higher by 100 to 200 basis points, these types of yield differentials have ample room to absorb the adjustment. However, countries with low yields such as South Korea, Singapore or Taiwan could be more vulnerable to higher US rates, potentially flipping the yield differentials and depreciating the exchange rate. Thus we ve been looking to identify countries that have both higher interest-rate differentials and economic resilience. There may be some rough patches for the broad asset class as US rates rise, but we see specific countries that appear better positioned to absorb higher rates. Short Exposure to the Australian Dollar May Hedge Broad-Based Risks in Emerging Markets In Australia, we anticipate ongoing rate accommodation from the Reserve Bank of Australia in upcoming quarters. As rates rise in the US, we could see the interest-rate differential between Australian government bonds and USTs disappear, leading to weakness in the Australian dollar against the US dollar. Additionally, we have seen a historical correlation between weakness in the Australian dollar and periods of declining valuations in emerging markets. When there is a shock to commodity markets, it tends to ripple across the emergingmarket asset class, regardless of whether a specific country is a pure commodity exporter or not. Thus from an investment standpoint, short Australian dollar exposure may help offset the risks associated with a broad-based decline in emerging markets, or a China-related shock. Mexico s Economy Remains Resilient despite Headline Noise on Potential Trade Adjustments In recent months, markets have appeared concerned about NAFTA negotiations between the US, Canada and Mexico the potential for trade-related economic impacts has appeared to weigh on the Mexican peso. However, we think the currency depreciation is overdone. NAFTA may see some meaningful changes, with specific rewrites and new chapters added, but the agreement will not be completely abandoned, in our view. The US economy has become dependent on the lower costs of production in Mexico, and it continues to rely on Mexico as a trade partner. We ve likely seen a peak in the level of overall integration between the countries, but we don t see those trade channels being completely shut down. Additionally, Mexico remains on relatively stable ground in terms of its fiscal accounts. The government has run responsible fiscal policy for several years, and the central bank has upheld a highly orthodox approach, staying ahead of the curve with its rate responses. Mexico has seen some aggressive market activity against the peso, but the central bank has proven quite adept at patiently dealing with those stress points accordingly. Overall, our outlook for Mexico remains positive. Brazil s Reform Efforts Continue despite Near- Term Political Disruptions Brazil will be entering an election season next year. It s a bit too early to tell how the election will turn out, but on the whole, the country has continued to move forward with important reforms this year, despite the ongoing political noise surrounding the corruption scandals. Although the anti-corruption drives can be destabilizing to Brazilian markets in the near term, we expect them to be quite good for the country over the long run. The cleansing can remove some of the unhealthy political excesses and bring new cohorts of political leaders into the system. Nonetheless, it s an evolving process that will certainly encounter some bumps along the way. From a big picture standpoint, Brazil continues to see positive change there have been more positive reform efforts in the last year than during the entirety of the previous decade. Pension reform stands a Notes on Global Fixed Income Investing 4

5 reasonable likelihood of being passed in the upcoming year, in our assessment, which would be a key achievement for Brazil s fiscal future. On the whole, we continue to have a positive outlook for Brazil and its ongoing reform efforts. Strong Coalition Support in October Elections Bolsters Argentina s Reform Efforts Congressional elections in Argentina in October were highly supportive of President Macri s political coalition, significantly strengthening his governing position. The election results were seen as a public endorsement of Macri s policies. He s been working to reverse the economically damaging policies of the previous government. He s also allowed the central bank to assertively hike interest rates. It often takes some time for growth to respond to reform measures, and it takes a while for inflation to come down after monetary policy tightens. But the election results indicate that the population remains confident in the policy direction and has the patience to stick with those reform efforts for the longer term. That support is critical, because one can have the right orthodox ideas but without the political authority and the confidence of the population it s nearly impossible to get those ideas through. We think the political situation is in the right place in Argentina, and we remain optimistic for the country s ongoing turnaround. India s Economy Remains Resilient despite Near-Term Headwinds from Longer-Term Reform Policies In India, Prime Minister Narendra Modi has taken on a number of bold reform initiatives that we expect to have positive longerterm effects on the country. Some of the tougher measures may suppress growth in the short term but ultimately provide greater benefits for the long term. Modi has pushed through bankruptcy laws and dealt with bank recapitalization those efforts are expected to restrain growth in the short term as banks have to pull back and deal with some of their bad loans. Demonetization efforts also had a short-term negative effect, but those measures should help the country bring money into the formal economy and improve tax collection. Modi has also supported independence for the central bank, which has turned to inflation targeting and kept interest rates elevated to stabilize prices. Higher rates can restrain growth in the short term, but should help build greater longer-term credibility for the central bank. Overall, Modi is largely moving India in the right direction, in our view, and we continue to have a positive outlook for the reform efforts and country s overall economy. China s Economy Appears Stable but Growth Has Become Increasingly Dependent on Credit China s economy looks fairly stable in the short term, in our assessment. It s a closed financial system, which limits the potential for a banking sector crisis or a credit crisis that could occur in an open economy. The government can close the capital accounts and control the credit system as needed to prevent a crisis. However, the greater concern is that China needs nearly five times more credit to generate a unit of GDP than it did in the aftermath of the GFC in If China has not reduced its credit dependence in a couple years and we get an exogenous shock, such as a recession in the US, then China s ability to stimulate its economy will be substantially less effective than it was during the last US recession. This creates the possibility of synchronized downturns in a couple years a US recession triggering contractions in Europe and China. That scenario is not imminent, in our view, but it bears keeping in mind. 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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