Ken Leech, Chief Investment Officer. Legg Mason Affiliate Western Asset
Looking ahead, we think global growth will slowly improve with inflation remaining modest – continuing to favour spread sectors.
KEY TAKEAWAYS
- We continue to believe that US and global growth will be resilient, and that overall monetary policy will remain accommodative.
- Our economic outlook has been supported by our strongly held view that inflation would remain very subdued and that the process of inflation normalization would be not only long and drawn out, but would also require sustained monetary stimulus. Central banks have finally come around to this conclusion.
- If inflation continues to be modest, then we expect central banks will not tighten policy for a long time.
- Our view for next year is that the US economy will once again post moderate growth with subdued inflation.
- We are optimistic that economic growth prospects will continue to slowly improve, keeping the favorable backdrop for spread sectors intact.
“Inflation is always and everywhere a monetary phenomenon.”
Milton Friedman
Our investment strategy this year has been underpinned by two dominant investment themes. The first is that global and US growth would prove to be resilient. Second, global and particularly US monetary policy would have to turn much more accommodative. The investment implications should these themes play out were straightforward. Spread sectors should handily outperform government bonds.
Exhibit 1: Spread Sector Year-to-Date 2019 Excess Returns
Source: Bloomberg Barclays, J.P. Morgan, S&P Global Market Intelligence, a division of S&P Global Inc, Western Asset. As of 15 Nov 19. ¹S&P/LSTA Performing Loans Index excess return vs. 3-Month LIBOR Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Underlying our economic outlook has been our strongly held view that inflation would remain very subdued and that the process of inflation normalization, which must precede any potential interest rate normalization, would be not only long and drawn out, but would also require sustained monetary stimulus. From our perspective, it seems like central banks have finally come around to this conclusion. Almost 10 years into the expansion, devel¬oped market (DM) core inflation rates not only remain below central bank targets (Exhibit 2), they have barely risen. The risk of a downside break should economic growth falter has galvanized central bank efforts to more directly target inflation outcomes.
“Monetary policy acts with long and variable lags. The benefits of the global monetary easing may not show up immediately, but slowly and surely, global growth will improve.”
— Western Asset
This change in the central bank reaction function, while overdue, is welcome. The Bank of Japan has focused on inflation expectations and desired inflation outcomes as the focal point of its policy for the last six years. The European Central Bank moved to this approach with the resumption of quantitative easing in July and by tying its longevity directly to the achievement of attaining the target inflation rate. In the US, we believe that the Federal Reserve (Fed) has essentially adopted this approach, even if it has not openly acknowledged it.
Exhibit 2: G10 GDP Weighted Core Inflation
Source: J.P. Morgan. As of 30 Sep 19. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
The easing of policy three times as inflation expectations continued to fall further and further below target—at the same time GDP, unemployment and financial conditions (stock market at all-time highs) would previously have precluded cutting rates—provides the ultimate proof in the category of “watch what I do, not what I say.” More importantly, Fed Chair Jerome Powell’s answer to the question of when the market should expect rate rises was clear:
“So I think we would need to see a really significant move up in inflation that’s persistent before we even consider raising rates to address inflation concerns.” – Jerome Powell, October 2019
If inflation remains in the modest channel we have seen over the last decade, which is our view, then central banks will not be tightening for a long time. Indeed, their reaction function will be extremely asymmetric. They will be quick to ease on weaker economic conditions, but very slow to tighten—waiting for inflation rises to prove to be “persistent.”
Central banks’ goal of achieving higher inflation rates and inflation expectations will depend on the evolution of growth fundamentals. There is a lot riding on the sustainability of growth. It is why central banks cannot afford to take chances. It is also why an improvement in trade policy would help reduce downside global growth risks, and why the risk markets gyrate so violently on any trade rumour. While the economic expansion appears to be long in the tooth (given the number of months in the cycle) it has not come close to many previous business cycles in eliminating economic slack. We are in a low nominal GDP world. Low growth with low inflation feels unsettling. The downside risks are too apparent, even if the actual current conditions are reasonable.
Our view for next year is that the US economy will once again post moderate growth with subdued inflation. We think global growth next year should best be characterized as “less slow.” In Europe, the storm clouds from Italy and Brexit appear to be lifting. But the success for this forecast rests largely with China. There the outlook is somewhat opaque. We have been believers that the sustained and varied stimulative programs of Chinese policymakers would ultimately lead to at first a stabilization, and then a pickup in growth. As of yet, the evidence is not compelling. Clearly, a diminution in trade tensions between the US and China would be a big help. For non-China emerging markets (EM), the very challenged growth environment of the last few years should start to relent. DM central bank interest rates are lower, and this has paved the way for extensive monetary policy easing from EM central banks all over the world. Monetary policy acts with long and variable lags. The benefits of the global monetary easing may not show up immediately, but slowly and surely, global growth will improve.
"The benefits of the global monetary easing may not show up immediately, but slowly and surely, global growth will improve."
— Western Asset
This brings us back to our investment strategy. Even though spread sectors have performed exceptionally well this year, we believe that the odds favour further outperformance over Treasury and DM government bonds. Given this year’s substantial rally, favourable opinions need to be more modest. But global fixed-income investors are being starved for yield. Central banks will not soon re-raise short-term rates. Monetary policy is positioned to remain accommodative. We are hopeful that economic growth prospects will slowly improve. This suggests that the backdrop for spread sectors will remain favourable.
Definitions:
U.S. Treasuries are direct debt obligations issued and backed by the "full faith and credit" of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
A Commercial Mortgage-Backed Securities (CMBS) is a type of mortgage-backed security that is secured by the loan on a commercial property.
A Mortgage-Backed Security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.
Standard & Poor's (S&P) is an American financial services company that publishes financial research and analysis on stocks and bonds and is also known for its stock market indices such as the U.S.-based S&P 500.
Spread sectors refers to sectors of the bond market, such as taxable bonds that are not Treasury securities, and includes securities such as agency securities, asset-backed securities, corporate bonds, high-yield bonds and mortgage-backed securities.
The S&P/LSTA U.S. Leveraged Loan 100 Index is designed to reflect the performance of the largest facilities in the leveraged loan market.
The London Interbank Offered Rate (LIBOR) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities. LIBOR is used as a base index for setting rates of some adjustable rate financial instruments, including Adjustable Rate Mortgages (ARMs).
Developed markets refers to countries that have sound, well-established economies and are therefore thought to offer safer, more stable investment opportunities than developing markets.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
Real gross domestic product (GDP) is a nation's total output of goods and services in constant dollar, or inflation-adjusted terms. Nominal GDP has not been adjusted for inflation.
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Unmanaged index returns do not reflect any fees, expenses or sales charges.
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