Key Issues for 2015: The View from Western Asset

by Sponsored Content from Legg Mason Investor Services LLC, 1/27/15

Market and Strategy Update

2015 may be marked by global slow growth, although we may see a mild improvement from the previous year
The U.S. is the bright spot of the global picture, while European growth has been faltering
A Chinese growth rate of 7% in 2015 seems achievable
We favor the spread product sectors, taking advantage of the higher yields than Treasuries

December 2014

This document reflects the opinions, views and analysis of Western Asset regarding conditions in the economy and markets, which are subject to change, and may differ from those of other professional investment managers.

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2015 Global Outlook

Our thesis since the crisis has been that the global and US recoveries would be ongoing but very slow by historical standards and would need a lot of policy accommodation.
This recovery continues to be best characterized as a “two steps forward, one step back” process, as we saw throughout 2014.
2014 really reinforces the importance of fixed-income allocation. Sector and issue selection is crucial, but so are macroeconomic strategies, which help provide a ballast when the recovery takes a step back.
In 2015, we have a similar starting point as last year: while global growth is slow, we expect it to improve mildly from the previous year.
The US is the bright spot of the global picture. The recovery is ongoing and moderate growth is still in place. Our rough starting growth forecast is 2.5% for next year.
On the negative side, European growth has been faltering. We’ve been very pessimistic on the outlook for European growth.
In addition to providing as much stimulus as possible given some of its constitutional restrictions, the European Central Bank (ECB) has also managed to avoid the worst risks for the periphery and the banking sector. However, growth is very slow, which presents a major challenge. Our 2015 growth forecast of under 1% is less than the consensus.
China is a tough place to read because the data are a little bit opaque but we are optimistic about its ability to manage the process of a soft landing. In 2015, a 7% growth rate seems achievable.
The Japanese recovery has downshifted, and the country may be in a technical recession (depending on possible revisions to 3Q14).
From a financial perspective, there are a lot of challenges in emerging markets (EMs), but from a growth perspective, it is still the fastest-growing segment of the globe and a key contributor to global growth.

Global Inflation

Central banks can afford to be ultra-accommodative because global and regional inflation rates have downshifted. That’s a big change over the last three to six months and has caused some market caution.
On the negative side, declining inflation suggests demand is weakening, but, on the positive side, it provides a greater ramp for further policy accommodation because the biggest impediment to keeping rates low is a higher inflation rate.
US inflation is flattening out because of the decline in oil prices. It may be in the 1% area next year, which is the forecast.
Over a period of three years, the Chinese inflation rate has gone from 6.5% down to just over 1.5%, which is quite precipitous.
In Europe, there’s the possibility of deflation, as its inflation rate has moved sharply toward zero, which is why the ECB has been trying to act in a more aggressive fashion.

Central Banks Remain Accommodative

In the US, the recovery has allowed the Federal Reserve (Fed) to take the position that emergency policy should only be used for emergencies. The banking system has largely healed, the housing market has stopped declining and deleveraging is close to complete.
The last element of emergency policy is the 0% funds rate, which the Fed has communicated it wants to exit by mid-2015. We agree with this forecast and think it won’t be as subject to small variations in the growth rate as many suspect because the Fed has telegraphed this move in a way that won’t surprise the market.

US Yield Curve

The big story in the US this year was that interest rates didn’t increase. There was a feeling that bonds, especially long bonds, might rise in yield and there was a lot of tightening priced into that.
The biggest beneficiary of Quantitative Easing (QE) were the short intermediate securities, which could be held in large positions when the Fed was guaranteeing a 0% funds rate, but certainly couldn’t after the transition to a more data-dependent world. This explains the incredible underperformance of the front-end.
Given the flattening of the curve, we have a less favourable view of the longest-dated bonds.

December 2015 Expected Policy Rates

This year, there has been a huge divergence in where policy rates are expected to be at the end of next year. There has been a pretty sharp reversal in expectations in England as the Bank of England has signaled its intention to postpone raising rates.
The US shows a pretty flat line because the Fed has been signaling that it would like to start raising rates in the middle of next year and it doesn’t want to surprise the market.
The change in expectations for Europe has been the most remarkable. There have been aggressive policy changes, which strengthened expectations that low rates will remain in place for a while.
Our forecast for US growth is probably more in line with the Fed’s than it has been in a while, but we differ in that we’re slightly more cautious about the housing sector because we think consumers will be a little more cautious.
After the housing market crisis, people have been very reticent to jump back in and we think this caution could impact consumer spending.

European Growth is Slowing

European bank lending has been contracting for close to the last 18 months, which is one of the reasons why the ECB is concerned and has been so proactive with policy changes. Without stronger bank lending, Gross Domestic Product (GDP) will suffer.
Over the last four years, the story has been that although the European periphery countries were weak, the core was strong. That has changed with signs of industrial production weakness turning up in France and Germany.

China: Slower Growth, Greater Global Influence

China is using all of its macroeconomic levers to keep growth on a slowly declining trajectory and we think they will continue to manage this process of rebalancing towards domestic consumption and shifting away from an export-driven regime.

Japan

Up until the last few quarters, GDP growth in Japan had been improving nicely. Consumption tax hikes in April had a larger-than-expected impact on the growth rate and the Bank of Japan moved very aggressively to increase its liquidity.

Emerging Versus Developed Bond Yields: Valuation Gap Still Remains Wide

We know EMs are a challenging story with the downshift in global growth and some downgrades to certain EM countries.
The spread between EM yields and developed market yields is the widest it’s been since the crisis. From that perspective, being selective is important as the opportunity set in EMs relative to developed markets continues to present potential.

Emerging Markets: Current Account Sensitivity to 10% Commodity Price Decline

Certain countries are very exposed to lower oil prices while others actually benefit from a current account balance perspective.

Investment-Grade Credit Spreads: Credit Spreads Marginally Wider—Large Dispersion Between Winners and Losers

When it comes to asset selection, our biggest theme is selectivity.
We’ve been very optimistic with respect to investment-grade credit: the improvement in the fundamentals of US investment-grade credit and the management of companies has been pretty positive.
But this year, given the challenges of the past six months, spreads have actually retraced all the tightening in the first half of 2014 so we’re pretty much flat on the year.
There has been a marked difference in the performance of the different sectors of high-grade bonds.

Investment-Grade Credit Spreads

In the yield curve, with respect to investment-grade, it’s a very different story. The Intermediate Credit Index actually has an excess total return of 90 basis points (bps) so that’s been a positive story of people trying to get some extra yield but staying in the short duration space.
Sector selection and yield curve location are crucial.

Energy Sector Underperformance

It’s very important to be differentiated across the defensive, cyclical and energy sectors of the high-yield market.
We’ve assembled an oil task force to evaluate the different risks and scenario analyses of how the different sectors will perform with changes in energy prices.
Dramatic declines in some of these sectors actually present opportunities. There are many companies that may remain strong with energy prices at current levels—or even lower—but they’ve been unduly hit.

Housing Fundamentals

We are not too optimistic—we think 3% home price appreciation over time is not an unreasonable forecast, which isn’t very exciting.
However, even though it has been a slow process, the housing market is healing.
While a lot of the spread compression is behind us, we continue to think total returns and yield levels are attractive in this space.

Concluding Remarks

Our basic thesis of an ongoing recovery continues to be the major thrust of our portfolio strategy.
One of the challenges has been how to think about oil. In the short run, we think there could be some actual challenges to some of the emerging countries that are dependent on oil exports.
However, the US, Europe, Japan and China are all bigger users of oil than exporters so lower energy prices should be a positive, in addition to the monetary accommodation framework.
While we acknowledge a modest downshift in global growth and we do think global inflation is very subdued, we expect monetary accommodation and the slow-but-steady process of this recovery to continue.
We favour the spread product sectors, taking advantage of the higher yields than Treasuries, but occasion ally using opportunistic views of duration to try and mitigate downside risks.

Definitions

The U.S. Federal Reserve, or “Fed,” is responsible for the formulation of a policy designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.

A basis point is one-hundredth (1/100, or 0.01) of one percent.

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.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

A current account balance summarizes the flow of goods, services, income and transfer payments into and out of a country

The Intermediate Credit Index measures the performance of investment grade corporate debt and agency bonds that are dollar denominated and have a remaining maturity of greater than one year and less than ten years.

Investment grade is a level of credit rating for stocks regarded as carrying a minimal risk to investors.

The yield to worst is the lowest potential yield that can be received on a bond without the issuer actually defaulting.

A spread is the difference in yield between two different types of fixed income securities.

Illiquidity describes a situation in which a security or other asset cannot easily be sold or exchanged for cash without a substantial loss in its value.

Emerging markets 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.

Duration is a measure of the price sensitivity of a fixed-income security to an interest rate change of 100 basis points. It is calculated as the weighted average of the present values for all cash flows.

The federal funds rate is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.

Investment Risks
The opinions and views expressed herein are subject to change and are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice.

All investments involve risks, including loss of principal. Past performance is no guarantee of future results. An investor cannot invest directly in an index. Yields represent past performance and there is no guarantee they will continue to be paid.

Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls.

International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.

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.

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A credit rating is a measure of an issuer’s ability to repay interest and principal in a timely manner. The credit ratings provided by Standard and Poor’s, Moody’s Investors Service and/or Fitch Ratings, Ltd. typically range from AAA (highest) to D (lowest). Please see www.standardandpoors.com, www.moodys.com, or www.fitchratings.com for details.

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