By the Loomis Sayles Full Discretion/Multisector Team Dan Fuss, Kathleen Gaffney, Matt Eagan & Elaine Stokes

 

Turn Down the Volume!

 

Ever watch a sporting event with the volume turned down? Silencing the noises of the game takes away some of the excitement, but you also don’t have to listen to the idle chatter and biased views of the commentators. You can focus on what’s actually going on in the game. Exercising volume control can also be a good investing discipline. Tune out the chatter and focus on what’s really happening in the markets. Let’s take a look at recent events. Just three months ago, the risk trade was popular based on what many saw as surprisingly robust economic data. Inflation was a foremost concern, and fixed income investors were urged to avoid US Treasury debt, shorten portfolio duration significantly and focus on inflation protection. Sensible advice, no?

 

Well, in what seemed to many like a blink of an eye, market consensus appeared to reverse course. Worries about a “double-dip recession” came to the forefront, deflation became a watchword and the risk trade went into retreat. Market chatter declared, “forget inflation protection, buy US Treasurys and extend out the curve for goodness sake!” Have circumstances changed so much that the world has gone from imminent inflation to deflation in the span of three months? We don’t think so. Our advice is to tune out the noise and focus on the fundamentals.

 

The following paper provides our outlook and investment strategy as well as a discussion of the macroeconomic factors influencing the markets.

 

Outlook

 

Our overarching view continues to be that the world is entering a period during which interest rates will rise on a secular basis. To be clear, we are not concerned about inflation in the near term. While the seeds of inflation are likely being planted now, it could take quite some time for them to blossom and overcome powerful disinflationary forces that exist in the world today. If anything, the recent events in Europe and the deceleration of global growth suggest interest rates could remain low for longer than anticipated. We thought the path to recovery would be slow and uneven, so we have not been surprised to see some deceleration. The economy will likely grow at a disappointingly meager pace, but we project it will grow nonetheless.

 

Strategy

 

Our portfolio strategy is designed to deal with a transition period in which economic growth is lackluster and interest rates remain low and range-bound for an extended period. This transition phase will eventually give way to a rising rate environment, but we don’t see that happening for some time. How do we reconcile a macroeconomic outlook that leans toward disinflation in the near term but casts a wary eye to the prospect of rising rates at some uncertain period in the future? For now, we remain focused on the same four key themes that we wrote about in the spring.

• Maintain a yield advantage – We aim to improve portfolio return potential by building in a significant yield through an allocation to corporate bonds. We believe select corporates can offer favorable return potential for the estimated risks we foresee and the asset class should hold up well under a variety of economic scenarios.

 

Scenario 1 - Base case: The economic recovery continues at a slow pace and the Fed remains accommodative for an extended period. The yields on US Treasurys and corporate bonds would likely remain low and within range bound levels. Corporate bonds should benefit due to their yield advantage.

 

Scenario 2 - Deflation: If the economy falls back into recession, increased demand for US Treasurys could contribute to a considerably flatter yield curve. Typically, the yield advantage offered by investment grade corporate bonds helps them do well relative to falling US Treasury yields. As investors’ risk appetites decline, high yield spreads may widen while defaults possibly creep up. However, high yield total returns should remain positive given their yield carry.

 

Scenario 3 - Rising interest rates: US Treasury yields could rise and corporate bond spreads narrow. While investment grade bond returns could be dragged down by rising yields, they should outperform US Treasurys due to their yield advantage. High yield bond spreads could tighten and possibly generate strong total returns.

• Maximize specific risk – As in the past, security-specific analysis and bond picking play an important role in our strategy—particularly now when growth is decelerating and issue selection is critical. Based on the fundamentals, we believe the corporate sector is in solid shape. The wind is at the sector’s back in terms of the credit cycle. Corporate profits have rebounded strongly since the post-Lehman bust. More importantly from a creditor’s standpoint, corporations have been significant savers in the economy, with cash flows exceeding capital spending and bolstering balance sheets. In our view, favorable fundamentals are quite supportive of corporate bond valuations. In this bond-pickers’ environment, we leverage our proprietary research to help identify the most compelling opportunities in a capital structure. In certain instances, this can result in convertible bond investments where we may give up yield in the short term for the prospect of higher total return potential in the long term.

• Minimize market risk – US Treasury debt is unappealing given paltry yields and the prospects of massive issuance in coming years. Therefore, we intend to keep portfolio exposure to a minimum.

• Go global – We intend to maintain a healthy allocation to non-US-dollar-denominated bonds. We believe certain emerging markets are well positioned to capture a larger share of world economic growth. Emerging markets currencies, such as the Brazilian real and Indonesian rupiah, can offer positive fundamentals and attractive relative yields. In the developed world, we are focused on the commodity-bloc currencies of Canada, Australia and New Zealand. These countries have relatively low debt burdens and are leveraged to rising natural resource prices. Their currencies provide a hedge against inflation, particularly debtflation.1 We also believe these holdings can provide healthy liquidity.

 

A Market in Transition

 

Financial markets can be erratic during periods of transition, swinging from optimism to gloom at the drop of a hat. We estimate that the swings between risk-on and risk-off are a reflection of the market’s underlying unease regarding the following macroeconomic issues:

 

• The uneven pace of economic growth
• Large public sector debt burdens & interest rates
• Global trade imbalances

The market can’t seem to decide which of these issues really matters or what consequences might follow. In our view, getting economic growth on a sustainable path is the primary challenge, followed by resolving public sector deficits and rebalancing global trade. As long as these challenges are unresolved, worries are likely to fluctuate between deflation and inflation.

 

The Uneven Pace of Economic Growth

 

With global economic growth the primary challenge, it is important to highlight the uneven growth rates of developed versus developing economies and the influence this could have on interest rates.

 

Developed countries are hard pressed to use up spare capacity and grow fast enough to create a sufficient amount of jobs. While a slowdown is not atypical for this stage of the recovery, it is hard to see what will drive strong growth. Credit creation is weak, the private sector is in retrenchment mode and steps toward aggressive global fiscal stimulus are unlikely in a divisive political environment.

 

The picture in the developing world is different. Emerging markets are no longer the caboose of the global economy. Many have been growing quite robustly, becoming progressively less reliant on exports to the developed world. While emerging markets can’t be counted on to completely pick up the slack in demand from the developed world, they can provide quite a bit of forward momentum.

 

Putting these views together paints a picture of a global economy that could limp along at a painfully slow pace of growth relative to the tremendous amount of slack left over from the Great Recession. The combination of weak private sector demand and a decrease in government fiscal stimulus could mean the world economy remains dependent upon very accommodative monetary policies.

 

The good news is the Fed appears keenly aware of the risks to growth and seems to have signaled that it will do what it takes to help prevent the economy from slipping back into a recession. As such, we expect the Fed will be forced to maintain its zero interest rate policy until 2011 or possibly even 2012. Further quantitative easing may even become necessary if the nascent improvement in US unemployment trends reverses course. Bottom line, we don’t see interest rates moving sustainably higher until the economy is released from the “intensive care ward” and registers consistent growth that is no longer dependent on stimulus. That is likely to take time. In the meantime, we think deflation is the primary risk factor in the developed world in the case of a major policy blunder or exogenous shock.

 

Large Public Sector Debt Burdens & Interest Rates

 

Massive public sector deficits, and how they may influence future interest rates, are another major source of market angst. However, for now we believe worries about government debt burdens should take a back seat to the priority of addressing economic growth. Indeed, part of the public sector deficits are cyclical in nature and should therefore be corrected as the economy recovers.

 

We do recognize that economic growth may not be sufficient to address public sector deficits that are related to entitlement spending. We believe these structural deficits, if left unchecked, could have the effect of pushing interest rates upward on a secular basis. Pressure on interest rates could build as private sector demand revives at the same time as the government’s reliance on the credit markets grows. The private sector doesn’t look like it will get back on its feet anytime soon, so it may be a bit early to worry about rising rates and the possibility of debtflation. Nonetheless, we think it will be difficult to predict exactly when this shift will occur and the adjustment could come suddenly.

 

Global Trade Imbalances

 

In our view, rebalancing global trade is the final piece of the macroeconomic puzzle. In a nutshell, savers need to spend more and spenders need to save more. The major savers are China, Japan and Germany. The main spender is the United States. The economic model of recent years has been savers exporting goods to the spenders. The savers piled up massive foreign exchange reserves that were recycled back into the debt of the spending countries, thereby facilitating the means by which the spending countries could further increase leverage and continue consuming. This model has gone too far. Exporting countries need to save less and spur domestic demand while importing countries need to spend less and save more.

 

These adjustments will take time given the political nature of trade and the required coordination of policies. That said, changes have begun. China, for example, has agreed to once again allow exchange rate flexibility for its currency, the renminbi, which is likely to result in its upward adjustment. The country is also adopting long-term policies aimed at reducing its dependence on exports and encouraging spending from its enormous population. In the long run, we believe this dynamic will benefit China and its regional trading partners.

 

Conclusion

 

We recognize that the economy has entered a period of transition and that macroeconomic factors are contributing to investor uncertainty. Within this challenging investment environment, our objective is to provide long-term value to our clients by focusing on credit selection within the key strategies of maintaining a yield advantage, maximizing specific risk, minimizing market risk and increasing diversification through global investments.

 

1 Debtflation can occur when a debt-strapped nation debases its currency as a means of reducing its debt burden.

(c) Loomis Sayles

www.loomissayles.com