By Ken Leech
Looking across today’s ebullient U.S. and global fixed income markets, the most prevalent view has swung from “secular stagnation” to the “reflation trade,” a synchronized global recovery, buttressed with super-charged U.S. fiscal policy, that must mean risks to growth and inflation are only to the upside.
We don’t agree with this outlook, nor do we believe U.S. inflation is rising significantly. We believe the process of inflation normalization and interest-rate normalization will be very slow to develop. Markets, on the other hand, have shifted quickly and sharply to higher inflation expectations. This disparity highlights the importance of utilizing diversified investment strategies in today’s markets.
The good—and the bad—news about diversified strategies is that some can win while others lose. Ideally, portfolios have more winners than losers and the money made on the winners is more than the money lost on the losers.
As optimists on the prospect for steady but slow global and U.S. recoveries over the most recent expansion, we have invested in the higher-yielding spread sectors that benefit from improving economic fundamentals. Yield spreads have narrowed, reducing the margin for error. Our overweights in developed country spread sectors have been substantively reduced.
In our view, the greatest opportunity is in emerging market debt, particularly local currency-denominated debt. Yield spreads are historically attractive, at a time when global growth fundamentals have reversed from the headwinds of prior years into powerful tailwinds.
Yet relative volatilities can change dramatically in different market environments. What seemed a modest position can turn into a meaningful winner or loser if volatility erupts dramatically.
Volatility across all asset classes was subdued almost all last year, only to jump sharply in February 2018. Nearly everyone appreciated that volatility was historically, perhaps unnaturally, low. In building bond portfolios, not only were assessments of the economic and financial environment central to sizing decisions, but basing those decisions on more normal volatilities also proved important.
While our focus on spread sectors benefited from market sentiment toward future economic growth, our use of macro strategies, supported by our belief that central banks will be slow to remove accommodation, has been challenged by market sentiment favoring quickly rising future global and U.S. inflation.
Assessing the U.S. Treasury yield curve since the start of the year, rates have moved up, and the long end of the curve has suffered the most. Our decision to retain an overweight to duration was a distinct negative. Splitting our overweights between the very front end and the very back end of the yield curve was a modest mitigating factor.
Owning duration based on market confidence that the U.S. Federal Reserve funds rate will ultimately exceed the Fed’s goal of 2.75 percent has the benefit of asymmetry. If downside risks occur, the Fed is unlikely to continue its expected path of tightening.
The Fed and other central banks are unwinding the greatest monetary experiment of all time: not only raising interest rates, but shrinking balance sheets too. If our favorable view develops, the Fed can persist in its tightening path and raise rates roughly once per quarter.
The failure of core inflation to achieve central bank objectives is a global phenomenon. The Fed, the European Central Bank and the Bank of Japan have endeavored mightily with extraordinarily accommodative policy initiatives to raise core inflation to the 2 percent bar—all without success.
Tightening monetary policy in a low-inflation environment to offset cyclical strength must be done cautiously, as it’s replete with downside risks. Portfolios need buffers against adverse events, and U.S. Treasury securities remain the best diversifying hedge.
It’s difficult to see the future clearly. Forecast error is rampant. Investors need strategies that not only benefit their base cases, but that also help them weather more adverse scenarios. While optimism is pervasive, protection against unpleasant surprises remains a crucial priority.
We believe the low inflation world will not change quickly. Global economies are mending. Central bankers should be able finally and gradually to withdraw stimulus. If this outlook proves broadly correct, spread sectors and especially the emerging market should do well. If there are any meaningful wobbles, U.S. Treasury bond gains should help provide a cushion.
Ken Leech is the Chief Investment Officer for Western Asset Management, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment.
