In a quarterly webcast to provide market updates and strategy insights, and to reflect on volatility and the recent Federal Open Market Committee meeting, Western Asset Management Chief Investment Officer Ken Leech said that, while not surprised at the U.S. Federal Reserve’s inaction, “Global growth uncertainty is now very high.”
Western Asset, which manages $453 billion in assets and is one of the world’s largest fixed income managers, believes that the process of normalising interest rates process will proceed.
“Accommodative monetary policy not only remains crucial, but it can accelerate and we believe it will. Ultimately we will have higher rates, but this is going to be a long and slow process.”
“If we’re right about this, spread sectors continue to have opportunity and are well priced with good valuation to outperform government bonds.”
Looking at the impact on bond markets, Mr. Leech said, “With the exception of the Taper Tantrum, long-term U.S. Treasuries have been a pretty good diversifier to risk.
“They help provide a portfolio balance and actually provided positive returns when other sectors have been negative. That’s a strategy we’re continuing to use. This works particularly well in a disinflationary environment, which we feel very strongly we’re in. I think people can get nervous about this strategy, and where reasonable people can differ is in a very robust economy where the Fed accelerates tightening beyond people’s expectations.”
“You can get movement negatively in spreads and rates at the same time, so this strategy is not without some risk, but by and large … when risk to growth has been declining, risk to inflation has been declining, and spread products come under pressure, the beneficiary has been long-term U.S. Treasuries.”
Mr. Leech noted that spread products have been under pressure for more than a year.
“So while equity markets, especially in the U.S., are waking up to this challenge, fixed income markets have been under pressure for 15 months. That’s important because it sets up the point we have been trying to make: that it’s not ‘what’s your view?’, but ‘what’s the market price?’.”
This creates opportunity in certain sectors of the bond markets.
“Investment-grade always trades wide to the actual default rates, but fundamentals are ultimately the key to our process,” Mr. Leech said. “Investment grade credit is pretty reasonably priced.”
“High yield has a similar backdrop. The fundamentals matter and high yield has been widening pretty sharply. There is fear defaults may be increasing. We think that’s going to be happening in the energy and commodity space, without doubt, but this minor move up, let’s say towards 3 percent, is not going to be enough to invalidate the movement we’ve seen in spreads. We still think they’re pretty attractive and think this is a sector that needs to be in our plus portfolios.”
Much of Mr Leech’s presentation focused on the Fed’s recent decision not to raise interest rates.
“Inflation is much more subdued than the Fed would have otherwise thought,” Mr. Leech said. “That has to do with global growth and to some extent commodity challenges. Our perspective is that if U.S. growth stays at a 2 to 2.5 percent track, we envision the global economy – while having experienced a mild downshift – continues on its recovery course. Then we would see inflation rates stabilize and move up, but this may take longer than people think.”
Mr. Leech emphasised that the timing of the Fed’s moves is less important than the substance.
“Whether the Fed moved in September or December is not a major event for the bond market,” he said. “The bigger picture is not when and whether the Fed moves that first funds rate – inches it off zero. It’s really how aggressively and how far the Fed ultimately intends to move rates.”
The Western Asset team believes the Fed’s thought process has evolved: they think the fed funds rate indeed will be moving to a higher level, but it will be taking a longer period of time.
“That’s the communication,” Mr. Leech said. “The Fed is trying to change the communication focus from the first lift-off to the path and trajectory. How worried should market participants be given the pricing in the market of a very, very slow and gradual path of increase? The policy path is going to be one of normalizing rates in a very slow fashion. Inflation is going to be very slow to normalize and move up. The bond market therefore is going to have reasonably low rates for longer than market participants might’ve otherwise thought at the beginning of the year.”
In Q&A, Mr. Leech was asked what influence the Fed’s inaction might have on Europe or Japan.
“I think (ECB President Mario) Draghi’s position is that given the weakness in inflation, which is coming largely from weakness in commodity prices, it may give him the ability to extend the QE program for a longer period of time,” he answered. “We would not be surprised to see that at all … That is why we think the backdrop for monetary accommodation is pretty positive.”
“Similarly, our Tokyo team feels that we were going to get more monetary stimulus out of the Bank of Japan. That may not come for another quarter or two, but they have been missing their inflation targets and have the latitude to expand QE even further.”
Asked about reported recent sales of U.S. Treasuries by the Chinese, Mr. Leech said, “From a macro perspective, we are not concerned by the Chinese selling of U.S. Treasuries. What they’re trying to do is basically defend their currency and keep its volatility within certain bounds … but we do not think their selling of U.S. Treasuries is going to derail U.S. growth.”
Asked about opportunities in investment-grade bonds, Mr. Leech pointed to the financial sector.
“When it comes to sectors, the total returns are not really the key. It’s really the subsector and issue selection … and investment-grade financials have been the best performing sector. Banks and finance – bank paper – will continue to improve relative to the corporate average.”
