Legg Mason : Fixed Income Investors Should Seek Opportunity in Emerging Market and Investment Grade Bonds, Says Western Asset Management CIO

Pia Hahn Madelyn McHugh

(626) 844-9520 (212) 805-6039

Pia.Hahn@westernasset.com mmchugh@leggmason.com

Dovish Central Bank Accommodation Will Continue, and U.S. Federal Reserve is Unlikely to Raise funds Rates Until Conditions Improve

(Pasadena, CA, July 29, 2016) - In a market update webcast, Western Asset Management Chief Investment Officer Ken Leech described a global economy rife with problems - yet one that continues to grow, especially in the United States, even if slowly and with evident risks.

"We expect steady, unspectacular U.S. and global growth," Mr. Leech reported. "That's been our basic message: slow but sustainable growth globally. The fear the market had in the first quarter, that the slow growth rate might actually fall, is what got the markets in pretty dire straits."

During that first quarter, Western Asset did not believe the global growth situation was going to develop into a global recession, (a prediction that has so far proven correct), but it has warranted exceptional monetary accommodation.

"Policymakers have to be attentive to downside risks, especially in an environment where U.S. and global inflation remain exceptionally subdued," Mr. Leech said. "Fortunately, central bank accommodation is aggressive, and increasing. That means U.S. Treasury bonds and sovereign bonds will be underpinned by these low policy rates, which will continue around the world."

As for the U.S. Federal Reserve, which Mr. Leech said has made "a dovish pivot," he concluded, "The Fed is going to be very cautious, and is unlikely to be moving rates up any time soon."

Watch the replay of the July 21 Western Asset Management webcast, "Market and Strategy Update with CIO Ken Leech."

Mr. Leech continues to see strong opportunity ahead in investment grade (IG) corporate bonds.

"Where we've concentrated our efforts - and the majority of our risk budget - is in spread sectors. After a bear market the previous two years, and earlier this year at very depressed levels, they have the prospect for offering attractive returns relative to Treasuries or sovereigns."

Regarding Europe, the recent Brexit vote injected a high level of uncertainty into the outlook.

"First market reaction was negative, and given some of the policy responses it's turned positive," Mr. Leech said. "From an actual GDP outcome, I think the jury is still out. We had expected the Eurozone to grow roughly 1.75 percent, not a big number given how challenged growth has been historically. But if there were risks to that number, we would say they'd be on the downside."

"For the United Kingdom, the Bank of England has already pre-committed to cutting interest rates," Mr. Leech said. "We expect that to go forward in August. We expect it to expand its quantitative easing (QE) program, and we would not be at all surprised to see it include a wide array of assets in its purchase program."

"We expect that the European Central Bank (ECB) will expand its QE program, both in length of the program and the size. We have been very impressed and continue to believe that the ECB will be very aggressive in its buy of corporate bonds as part of its asset purchase program."

However, Mr. Leech noted, Europe's "negative interest rates obviously present quite a challenge from a net margin perspective. That's got to be watched pretty carefully."

Addressing emerging markets (EMs), Mr. Leech reported a generally positive outlook.

"There's a real case to be made for emerging markets, both in local currency and dollar-denominated bonds," he said. "That's an area we are focusing on even more meaningfully than coming into the year. The yield spread between EMs and developed has reached crisis wide. When you think about valuations and people needing yield, this is where yield is abundant."

"The two positions we've liked structurally have been Mexico and India. Over the course of the year we have been opportunistically investing in a number of others. One I'd highlight is Brazil."

To buy EM bonds, and take advantage of those yields, investors must buy their currencies. Mr. Leech reported that this has been a four-year-plus bear market that is turning around.

"The EM widening against developed market yields really provides an opportunity, but that opportunity exists due to weak global growth, challenging commodity prices and a lot of volatility. You have to be real thoughtful about your proportionality and do your homework."

"That is the backdrop for a remarkable change both in the currency and the local interest rate environment, and even in their corporate debt. We continue to be positive on that turnaround."

Turning to the topic of spread sectors, Mr. Leech observed they have shaken off "the extraordinary pessimism that unduly punished the market over the last previous couple of years."

"While we've had a terrific bounce, there's no reason to rush to the exits, given both the growth and the policy backdrop," he said. "We continue to think the valuations are pretty reasonable."

"Another reason to be optimistic is the enormity of the yield advantage, especially in the U.S. credit space, for global investors. Negative interest rates or near zero rates on sovereign bonds for such a great portion of the world make global investors challenged to find yields."

"There are really only two ways to get yield," he continued. "Either go down the credit spectrum, or go out the yield curve. Most people are much more comfortable going down the credit spectrum, depending on their risk tolerances, as opposed to going out the yield curve."

"The U.S. credit market has the greatest yield value, and also has the greatest market value. The U.S. also has the highest yield among all IG sectors. So we see an awful lot of global demand, particularly from Asia, and recently increasing from Europe, into the U.S. credit markets."

"When you look at the high-yield market, you see a similar picture," Mr. Leech said. "The U.S. high-yield market is much larger, having more attractive yields than either Europe or Asia. We've been believers that

high-yield was going to have a terrific opportunity this year, and basically we've stayed the course. Valuations are attractive, the backdrop is pretty positive, and compare and contrast how pessimistic default estimates are to reality."

Future plans of the U.S. Federal Reserve Board also framed much of Mr. Leech's analysis.

"Our position on the Fed has been that they have moved from a desire to routinely think about ways to move the funds rate up, to one that's much more opportunistic. While they would like to inch up, they need a lot of stars to align. We do not think they're going to be there for them."

"Last September, the Fed paused because they thought financial conditions were too tight," Mr. Leech said. "They went forward in December, then got that last peak earlier in the first quarter. I think they were stunned by how remarkably difficult the headwinds could be if they could not get that reversed.

Fortunately, we've seen financial conditions ease back pretty significantly."

"Basically the Fed is on hold unless they get three conditions," Mr. Leech detailed. "Obviously economic growth has to be in line with the Fed's forecast. They've expressed optimism that a 2 to 2.5 percent growth rate going forward is in the cards. That's what they're looking for as a backdrop. Financial conditions also have to improve significantly; reasonable people can differ on where we stand there. And the last one: inflation expectations need to rise. That's where we are hanging our hat, since we think the Fed is really going to need to be cautious. It hasn't gotten as much attention, and we might be a little bit of an outlier in our focus on this point."

"In Japan, Kuroda talks about the extraordinary difficulty of getting inflation expectations changed once they've been so low, for so long. In Europe, Draghi talks about how to arrest the decline in inflation expectations. Until recently, the U.S. has not had to take on this issue."

With inflation continuing to come in at lower-than-forecast levels in the U.S. and worldwide, Mr. Leech observed that market participants are slowly but surely starting to ratchet down their expectations to a lower rate of inflation over time. That has significant meaning to the Fed.

"When you look at equity markets you go, oh my gosh, they really are strong," he said of the Fed's thinking. "Why would the Fed have any concerns whatsoever? Contrast that with inflation expectations: over the course of the year, they are down in the U.S., Europe, Japan and Germany. After Brexit, they fell further in all four places. This is not supportive of the need to tighten policy."

"Then there's forecast uncertainty. The Fed's model suggests that if it doesn't move, inflation will move up north of 2 percent in pretty short order. If you look at the history of the Fed's growth and inflation forecast, it missed each of the last five years. It's behind schedule again this year. The Fed recognizes the global challenges Chair Janet Yellen stressed over 20 times in her March 29 speech, which are making the U.S. forecast not able to come to fruition. I think the Fed is cognizant of that, another reason why we expect the Fed to remain on hold."

While many of these macroeconomic factors are not new or surprising, one certainly is.

"The most immediate risk that's different than we would have talked about six months ago is Brexit," Mr. Leech observed. "Markets have responded pretty positively because policymakers were very aggressive in response. While markets are optimistic, you have to be thoughtful about the uncertainty, and the degree of difficulty, in trying to extricate yourself from very complicated negotiations which have to ensue over the next few years. That's fair reason for caution."

"Another point highlighted by the World Bank is the bumpy adjustment in China," he added. "China's growth is going to be slow. We need to be very thoughtful about it, but the policy adjustment in China was so aggressive that they could avoid a hard landing."

"As slack comes out of the U.S. economy and we reach full employment, you would expect the inflation rate to stabilize before it might move up. That would also have to be true for the global recovery, but we have the opposite picture. Developed market inflation is not only not stabilized, it's broken down. That's also a reason why policymakers need to be very, very accommodative."

"Global headwinds are straightforward. When you look at world GDP, we have been in the camp that a 3 percent growth rate, very slow by historical standards, can be maintained. A low bar, and it's going to take a lot of policy help. Fortunately, we've had that, which truncated some of the downside risk. But the major headwind of growth over time is the enormity of the debt burden around the world. It's going to take time, low interest rates and a continuation of policy support."

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Ken Leech is Chief Investment Officer of Western Asset Management Company. He joined the firm in 1990. From 1991 to 2016, assets under management grew from just over $5 billion to $460 billion. Mr. Leech leads the Global Portfolio, US Broad Portfolio, and Macro Opportunity teams. From 2002 to 2004, he served as a member of the Treasury Borrowing Advisory Committee. Mr. Leech and the Western Asset team were nominated for Morningstar US Fixed Income Manager of the Year five times over the last 13 years, winning the award in 2004 and 2014. He was inducted into the Fixed-Income Analyst Society Hall of Fame in 2007. Mr. Leech is a graduate of the University of Pennsylvania's Wharton School, where in four years he received three degrees, graduating summa cum laude.

Western Asset Management Co. is one of the world's leading fixed-income managers with $436.4 billion in assets under management as of June 30, 2016. From offices in Pasadena, Hong Kong, London, Melbourne, New York, São Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. To learn more about Western Asset Management, please visit www.westernasset.com.

Legg Mason is a global asset management firm with $742 billion in assets under management as of June 30, 2016. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

Investments in fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. An increase in interest rates will reduce the value of fixed income securities. 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.

The views expressed are as of the date indicated, are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to be reliable but cannot be guaranteed.