Legg Mason : Global Economic Growth Will Be “Sturdy but Unspectacular,” Potentially Enhanced by U.S. Boost Under Trump Administration

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Global Economic Growth Will Be "Sturdy but Unspectacular," Potentially Enhanced by U.S. Boost Under Trump Administration

Western Asset CIO Says Spread Sectors Will Again be Top Opportunities for Fixed Income Investors in 2017

(Pasadena, CA, January 23, 2017) - Proclaiming that "our best case is that we're looking at sturdy but unspectacular global growth," Western Asset Management Chief Investment Officer Kenneth Leech headlined his quarterly webcast with optimism tempered by downside risk.

"There are asymmetric upside growth prospects in the U.S.," Mr. Leech said. "Markets reacted to those pretty aggressively. The other point is downside risk, always something to protect against. If there is a downside risk in the global growth picture, it would emanate from China."

"I think the uncertainty principle needs to be applied in a very healthy dose here."

The full Western Asset webcast, "01/12/17: Market and Strategy Update with CIO Ken Leech," with accompanying PowerPoint slides, can be accessed via this link: http://www.westernasset.com/us/en/research/viewwebcasts.cfm?mvar=011217

The global economic recovery continues a "slow but steady" recovery, in Western Asset's view.

"The good news is that global inflation has stopped declining," Mr. Leech reported. "We think U.S. growth and inflation are going to rise with fiscal stimulus. On the other side, central banks - which have been a big force in this global recovery - are becoming a little less accommodative."

"But because policy continues to be accommodative around most of the world, and it's a global marketplace, government bonds will continue to be underpinned by low policy rates. So we do not see the huge surge in interest rates that perhaps some others do."

This will have practical impacts for investors on U.S. and global fixed income markets.

"In this environment, it's going to be tougher to make money in the spread products sectors," Mr. Leech said. "Although our position sizes are much smaller than they were last year, spread products should probably outperform U.S. Treasury and sovereign bonds. That's still our base case. When it comes to spread products though, issue selection, and sector rotation are going to be crucial. It's not going to be a wave of spread product yield spread normalization, like last year."

As for U.S. rates, Western Asset believes they already reflect growth and optimism.

"We have some modest overweights to duration," Mr. Leech said. "We believe the market is too optimistic about how things are going to play out. We do respect that could be a misjudgment on our part, the upside risk to U.S. growth. We need to be attentive to how fiscal policy changes."

On the other hand, Mr. Leech said that portfolios must have protection against downside risks. "Part of our program is not to fully hedge out our lower rated credits and high-yield. If rates were

straightforwardly going up, you would not do as well as if you fully hedge them out. But in these risk-off periods, that can be very challenging. You can lose money on both sides if you have short Treasury positions against long, lower quality, higher yielding positions. Some of our duration overweight - I'd call it a soft duration - is actually an underhedged weaker credit."

"We need to do that because there is, and continues to be, the possibility that we could have a risk-off environment. If that were to happen, the most likely culprit would be the imbalances we see in China and the policy prescriptions that they're going to have to take in response to that."

When considering sectors for opportunity, Mr. Leech started with corporate bonds.

"Investment grade corporates have tightened of 37 basis points," he said. "We think it's more an income story, more of a positioning story. You have to be more cautious about your overweight. We cut our overweights across our spread products because the valuations are not as powerful and not as attractive as they were last year. But if interest deductibility actually does pass, you're going to have a much different environment when it comes to the corporate finance."

"The sectors we are in are metals, and mining and energy. We have been big believers in the banking sector, but the election of Donald Trump helped that process along: a better economy, the possibility of higher short-term rates, the possibility of losing regulations, all bode well for banking. Subordinated bonds could be a particularly attractive sector."

Western Asset also believes that despite recent tightenings, a case can be made for high yield.

"There was a real fear that high-yield defaults were going to move up on a sustained basis," Mr. Leech said. "Now predicted high yield defaults fall again. We expect better earnings in 2017. Part of that is the energy story coming back, but prospects for corporate tax reform are also straightforwardly positive for corporate earnings after tax. These underpin the case for high-yield credit. But our focus is more about issue selection and positioning and less about an overweight being carried by the kind of major bull market of spread normalization we saw last year."

Considering mortgage-backed bonds, Western Asset thinks the housing market is improving.

"House prices are moving up," Mr. Leech said. "The fundamentals in terms of people being able to afford them are very positive. Delinquencies are collapsing. If we get continued growth, let alone improvement in growth, the pent-up demand for housing can be a positive. That speaks well for the risk transfer market as well as those issues securitized by the housing market."

With global investors thirsty for yield, Mr. Leech discussed the prospects of emerging markets.

"Despite having a terrific year, the last the part of the year was difficult for emerging markets. That is easy to understand with the election of Donald Trump, but the market's expectation of much higher yields with fiscal policy, that U.S. rates will be raised, traditionally is very tough for emerging markets. In addition, possibilities of protectionism and border taxes can be difficult."

"But in a world where developed market yields are low by any historical standard, the spread between emerging markets and developed continues to be near what we saw in the Financial Crisis. Those valuations are made even more compelling when you look at currencies, which have been in a bear market for the last four years. Even with last year's sideways move, currencies relative to developed markets are still at very, very historically favorable levels."

As for specific countries, "Russia, India, Brazil and Mexico will continue to be our favorites." Regarding the U.S. outlook, much will depend on the Fed, and the new administration.

"When we came into last year, the market thought the Fed was going to tighten meaningfully," Mr. Leech said. "They were actually forecasting four tightenings. That optimism quickly gave way to pessimism as the global recovery faded. The Fed instituted a very dovish pivot."

"With a new administration, we are looking at the possibility of all sorts of changes from a fiscal perspective. The Fed's mandate is unemployment and inflation. Unemployment is below where they were forecasting. Inflation is starting to get into their zones, so [Fed Chair] Janet Yellen is saying is they are very close to meeting their objectives, to start this process of normalization."

"Our thought all along has been that the Fed would look for, and take any opportunity, to inch the fund's rate up. It really does portray the uber gradual nature of this process that they need to have the economy come in line with their forecast, which is always standard."

The question, as always, is how fast will the Fed move?

"Uncertainty is probably higher than it would be, which is why some of the inflation expectation numbers have moved up," Mr. Leech observed. "The market has really embraced the optimism that U.S. growth is going to get better, that fiscal policy is going to help charge growth. We think it may be too far, too fast. We need to see what really happens in these policies as they come."

"We did take the opportunity, with inflation breakevens a little bit lower, to increase our TIPS position. We think TIPS are an important part of any portfolio, and that's been a positive from a performance perspective. But this gradual and very constrained inflation expectation environment means that Fed policy will be moving slowly."

Western Asset also believes U.S. governmental policy changes will take time to implement.

"The Trump proposals are not a surprise, that the Republican sweep would lead to the possibility of implementation of lower taxes," Mr. Leech said. "Given the political vitriol, this is going be a challenging process that will take significant time. We have less optimism on infrastructure spending being passed on a bipartisan basis than on tax policy, which can be passed on a single party line. The markets have placed optimism based on this fiscal thrust, and I think rightly so."

"But the first trade coming out of the box, when it was obvious that Trump was going to win on election night, was actually risk-off. That was based on the fear that his trade policy might be damaging. The challenges of a disruption to global trade would be pretty difficult. This is an area we have to be attentive to because the possibility of disruption of the global trade flow could be very difficult for global growth.

That is a downside risk that needs to be watched carefully."

Globally, Mr. Leech noted the surge in policy determination, which he called "really enormous."

"There's just unbelievable policy experimentation, between the QEs and forward guidance and negative rates," he said. "You have to be pretty humble about knowing exactly how that's going to turn out. Policy experimentation has unintended consequences. It has long and variable lags. You have to be thoughtful about how those things can change and how you react to them."

"That's particularly true as we look forward this year and we start to see policy divergence in different parts of the world. In the U.S., we obviously have the possibility of enormous policy change, not just on the economic side, but perhaps even on the foreign policy side. That's something we're going to have to monitor closely."

"So while we have positions and very strong thoughts on how we want to position, we need to be mentally flexible and willing to change as circumstances warrant."

Inflation and its potential impact on global growth also drew Mr. Leech's attention.

"The inflation rate and global developed market inflation has finally stopped declining, and that's a positive," he said. "That was a big part of the fear of the downside risk last year."

"But let's be straightforward: this is an extraordinarily low rate of inflation. The good news is it stopped declining, but we are still on a very, very low global rate. That means we have to be thoughtful of the downside risk. Policymakers, fortunately, are very attentive to those features. You see tremendous policy accommodation coming out of Europe, and a very aggressive policy, which was revamped, coming out of Japan. That can continue to provide power for the global recovery even as the U.S. and perhaps China have to become a little less accommodative."

Mr. Leech noted that global growth, while positive since the Financial Crisis, has been slowing.

"The reason people are thoughtful about why that growth rate has been slow by any historical standard and has had difficulty breaking out, obviously, are some of the real strong headwinds," he said. "One we highlight is debt loads around the world, that have really been an impediment to growth. That's still the framework we need think about the secular slow growth environment."

"While we see optimism coming from the U.S., we think about how that's going to play out in the context of a global environment. Global growth looks more favorable and is becoming much, much more sustainable, about 3 percent, but that's still not a strong measure by any means."

The reason Western Asset remains worried about the downside is the story of China.

"We need to be very attentive to their economy because it is such a big percentage of the year-to-year change in the growth rate of the global economy," Mr. Leech explained. "The Chinese growth rate is slowing. I think the Chinese want growth to slow. That's in a perfect world, a perfect transition that the Chinese are trying to accomplish between an export and an investment-driven economy, and one that's going to be more consumption and export-led."

"The challenge, of course, is this is a pretty ambitious project to transition the economy like that. There are imbalances they need to correct. Last year, as their growth rates started to really slip, there was tremendous fear that this actually could turn into a very disorderly kind of slowdown. That process culminated in the bottom of the spread product market in February of last year."

"I'd say fear of a potential Chinese crisis or recession, in addition to the commodity price declines, led to a 20-month credit bear market. It basically meant that the credit cycle is kind of interesting. While people talk about the credit cycle in the U.S. being the same as the business cycle, what we really saw was a