In his quarterly market outlook webcast, Western Asset Management Chief Investment Officer Ken Leech observed that global economic growth is improving. In his view the U.S. will likely continue to grow at a 2 to 2.5 percent pace, Europe will likely turn upwards thanks to massive liquidity infused by the European Central Bank (ECB), China will likely experience a soft landing and emerging markets will likely provide opportunities for careful investors.
“I would characterise us as optimistic,” Mr. Leech headlined in his remarks. “The global recovery – despite all the challenges it’s faced – continues to move forward. We believe global growth is going to improve from last year. 2014 wasn’t a great year, but every year you go forward and have a little bit of improvement. We get further away from the financial crisis, with asset prices obviously returning to more normal valuations levels. That continues to be the major theme for us.”
“It’s been an unbelievable period of time that we’ve all been living through, with a lot of policy experimentation not only in the U.S., but around the globe.”
While the overall outlook is positive, there will be significant differentiation across regions.
“On the U.S., we thought maybe at most we might get 2.5% growth this year,” Mr. Leech said. “The Fed has actually moved its forecast down in line with that number.”
“Our feeling is this 2% to 2.5% range may be moving towards the higher end. We haven’t been able to get quite as optimistic as the Fed. From time to time it has moved to three percent projections and have been falling short of its target – for the last four years.”
“When you look at the U.S. GDP trend, both nominal and real GDP, it’s not a flamboyantly positive picture, but it’s not negative either. We think consumption is solid. The improvement in the housing market is slow, but steady. We would like to see a little bit better thrust from capital spending or manufacturing, but fundamentals in the U.S. are solid, if not spectacular.”
Europe continues to face challenges, but the Western Asset team sees prospects improving.
“When we look at Europe, probably the first time in four years, we’ve actually started to become more optimistic,” Mr. Leech said. “We raised our forecasts at the beginning of the year. Ironically, just like the U.S., the ECB has moved its forecast up. Now we’re closer to consensus there as well.”
Mr. Leech also believes the Japanese recovery “is positive, although it’s downshifting.”
“When you look at what Japan’s trying to accomplish, it makes both the ECB and the Fed pale by comparison. We’re talking about an unbelievable amount of liquidity provision in an attempt to get inflation expectations higher and get their economy on a stronger footing. The enormity of that, the combination of the ECB and the Bank of Japan, along with the Fed’s desire not to do anything to short circuit the U.S. recovery – we believe it’s going to be very positive for global growth.”
China will help, in Western Asset’s view, or at least not spoil the party.
“We’ve been believers in the soft landing,” Mr. Leech said. “The progress that China is making towards having more internal consumption and being less dependent on investment and export growth is on course. It’s going to be an uneven path and there are going to be challenges, but we think something like a 7% growth rate is in store for China this year.”
One area that has been more turbulent in these times is emerging markets.
“Emerging markets have been very challenged,” Mr. Leech said. He noted that Western Asset has been willing to have overweights in the emerging market space in a lot of our programs, which has been a headwind. Mr. Leech said he underestimated the severity of the decline in oil.
“One of the positives is simply the yield, the attractiveness from a valuation perspective of emerging market yields relative to developed market yields. They are very near the crisis high in a world that’s very challenged for a yield. You have to be very, very thoughtful, you have to do your homework, but these opportunities continue to be available. From a strategic point of view, we think emerging markets in Asia will have better growth dynamics than in Europe or Latin America.”
Among the bond market’s big themes is inflation, which has remained subdued.
“One of the real surprises over the last five years of recovery has just been how soft inflation has been,” Mr. Leech said. “The path to normalizing rates is really the path to normalizing inflation and that just hasn’t happened as of yet. That process is going to take time even though we’ve been serious believers that inflation was going to remain reasonably dormant.”
So how does this affect global bond market performance?
“Last year was a story of declining yields and a dramatically flatter curve,” he explained. “This year yields have declined, modestly, but the yield curve change has been more muted. There’s been a little bit of flattening in the sense that the intermediate and longer maturities have done a little bit better than the very short maturities, which haven’t changed much, obviously, with the Fed itself not changing. The performance across the curve has been more even.”
“When you look at Treasury notes from a fundamental perspective they don’t have a lot of value by any historical standards. But then when you look around the globe at a German investor who can sell a German bund at 30 bps and buy U.S. Treasury 10-year notes at close to 2%, that’s an enormous pickup in yield. Plus you have a currency that’s been going up instead of one that’s been going down; the relative attraction of the U.S. to other rates is very positive.”
“As fundamental investors, we don’t want to be long the Treasury market outright. We really don’t want to use our risk budget in an attempt to be short Treasuries. We would rather use it in other sectors, where the opportunity to provide return for our clients is better. So while we don’t have any real excitement or positive news to talk about in the Treasury market, we don’t have any positions of any note.”
When it comes to specific sectors, the Western Asset team sees targeted opportunities.
“We continue to have overweights in the non-agency mortgage market,” Mr. Leech reported. “Housing fundamentals have continued to turn for the better. The decline in housing prices is behind us. We’re finally starting to see a pickup in some housing-related activities.”
“We continue to think housing prices are on the upward trend. We’re not dramatically bullish, but something like a 3% to 5% - home price appreciation over time is in the cards. That’s more than sufficient to underpin the improving fundamentals in the space.”
Another area Western Asset likes is investment-grade credit, in which U.S. spreads have been widening relative to European spreads, which have been declining.
“That gap has really opened up,” Mr. Leech said. “You’ll be seeing us moving assets into portfolios which have global flexibility from Europe to the U.S.”
“You have to look through your credits very carefully. We’ve been very aggressive, starting with the energy opportunity. Some of these companies are well positioned to withstand quite a long period of energy prices in the $40 to $50 area, although our belief is that prices are starting to stabilize. If we’re right on global growth trends over time, we should see energy prices improve.”
In the high-yield space, Mr. Leech believes the buzz is all about energy.
“Energy had a difficult time last year,” he said, “a story we all know well because of the declining price of oil. When you look at this year, it’s been a sawtooth kind of a year so far. The first quarter was obviously very difficult. The second quarter, we had a balance and credit has generally been obsolete, energy specifically, only to have a renewed challenge in March.”
“For the year-to-date, the good news is that energy’s off to a positive start, but has not performed as well as other sectors of the high-yield market. We continue to think that the energy story is going to be one of the brighter performers over the course of the year.”
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