Legg Mason : With U.S. And Global Growth “Slow But Sustainable,” Fixed Income Spread Sectors Creating Opportunity for Investors

Pia Hahn Madelyn McHugh

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

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

Subdued Inflation and Dovish Central Bank Accommodation Underpin Global Economic Recovery

"Central banks continue to be supportive," Mr. Leech emphasized. "We continue to believe that is going to stay in place, even though the market may be questioning that at the moment."

"We do believe in a disinflationary, soft global growth world," he observed. "You do have to build macro strategies, and you have to keep them in place to help protect against the unexpected drawdowns or bumps on the road as we go through this global recovery process."

Watch the replay of the October 6 Western Asset webcast, "Market and Strategy Update with CIO Ken Leech," with PowerPoint slides.

"As a firm, we strongly resist the notion that we are going to have a meaningful monetary regime change in any imminent way," Mr. Leech said. "The U.S. Federal Reserve made a dovish pivot in the spring. It was key to underpinning confidence in financial markets and the global economy. The Fed would like - if all the stars align - to inch the funds rate up slowly but surely."

"But optimism that the Fed is about to accelerate meaningfully-we just don't see it." Pursuing the right strategies in these markets can lead to opportunity.

"Spread products have been the big opportunity set, and continue to be the opportunity," Mr. Leech reported. "The fears and the pessimism that lead to just extraordinary valuations in spread sectors relative to U.S. Treasuries or sovereigns have really opened up this opportunity."

Western Asset is pursuing a view Mr. Leech called "thoughtful without being Pollyanna-ish."

"We have been strong proponents of the view that slow but sustainable U.S. and global growth was the right way to think about the backdrop and the context for investing in fixed income this year" he said. "That's in conjunction with U.S. and global inflation remaining very subdued."

"That means central banks are aggressive and it's extraordinarily necessary to underpin the global recovery. In that broad context, Treasury and sovereign bonds should be underpinned by low policy rates. The exceptional opportunity for investors in our view has been spread sectors."

That's after two years in which spread sectors have taken what Mr. Leech characterized as "a terrific pounding," giving investors "the opportunity to rebound from depressed levels."

"The returns in these sectors should be very much better than you can get through sovereign bonds," he said. "That has been the biggest use of our risk budget across all of our products. We continue to believe that is the right way to go, albeit probably not as large a commitment as you would have seen when prices were even more attractive six months ago."

Emerging markets (EM) can also offer enhanced potential opportunity, according to Mr. Leech. "While we had a very, very impressive bounceback in EM local currencies, we still think there are opportunities there."

He also discussed ways to deal with bear markets, although he did not say we are in one.

"Obviously the key is to avoid them," Mr. Leech said. "That would be your first choice. Second, you have to survive them. But third, and very importantly, bear markets do present a restoration of valuation opportunity. You have to be able to capitalize on that."

On oil, Western Asset assembled a top-flight team that has been assessing the situation closely.

"Our strong view was that $40 a barrel would hold," Mr. Leech reported. "Recent developments suggest that some of the downside risk has been truncated. That's a reasonable bottom to think about. This trend in oil prices should hold and gradually improve, nothing flamboyant, but fears of a huge commodity break may be starting to fall behind us."

Banks also represent a significantly challenged sector of the economy.

"We think banks, especially in the United States, are in a much better position," Mr. Leech said. "But on a global basis, one of the unintended challenges of very aggressive monetary policy has been that banks and other financial institutions are challenged with negative interest rates and flat yield curves. The business model obviously remains under pressure. But we do not see this as a solvency issue or one that would cause a systematic challenge for financial markets."

Mr. Leech also noted the global debt overhang, which is up even from Financial Crisis levels.

"Japan, the U.S., Europe and China are very, very high," he said. "While we believe the debt overhang is manageable, it definitely creates an impediment to meaningful acceleration in growth. Earlier this year we had the exact opposite fear: that we might have a global recession led by a hard landing in China. We all remember the commodity price implosion, oil trading in the $20s, and thoughts that might cause all sorts of systematic danger. Banks have been under pressure from a business model perspective, all year long, and we have revisited at least some of the Deutsche Bank headlines more recently. We thought then - and we think it's still the right view - that the pessimism of a downside break in global growth was really unwarranted."

When looking at China, Mr. Leech stressed the power of policy stabilization.

"They are in a declining growth rate trend but we thought they would have stability there," he said. "The pessimism and the fear of an imminent hard landing were misplaced."

"The good news is that the policy they put in place all through 2015 has been moving, and has paid dividends in terms of arresting that downward growth spiral. But there have been a couple of costs and offsets. Credit continues to grow relative to GDP in China. That has got to be watched."

"One of the consequences of the tremendous amount of liquidity stimulus has been property prices moving up very sharply," Mr. Leech explained. "China has already been talking about what they need to do to dampen price increases in real estate. Maybe they have to tap on the brakes. That would be a challenge from a growth rate perspective. I think good news on the bottom side. A lot of capital was coming out of China, and that has abated. That's good news. China continues to be a key to understand the global growth outlook. Its growth rate is decelerating. We believe deceleration is manageable, but it is still something. This means that investors have to remain not only vigilant, but cautious."

Considering Europe, Mr. Leech called it "the big story in the fixed income markets this week."

"One of the things we point out is the correlation between U.S. Treasuries and German bonds is really starting to accelerate," he said. "Over the last of three to four months, it's been moving very sharply. This is important because the storyline for fixed income has been very positive. Even on the Treasuries side, it's slowing growth, low inflation, policy help: pretty positive."

"But then you look at the yields, and this is a pretty daunting level. The 10-year Treasury may look low, but when you look at it relative to Germany or Japan, or any of the developed markets, that's a much higher rate relative to other parts of the world. That part of the storyline can be challenged if global rates are moving up sharply. That's what we saw over the last few days."

"The question for us is whether a regime change is imminent," Mr. Leech said. "Is the European Central Bank (ECB) going to start to taper? We think the answer is no, the ECB will continue its program of quantitative easing. They may adjust the mix. They may adjust the capital."

"Look at what the ECB is trying to accomplish. ECB President Mario Draghi essentially has gone all-in since 2012, but his policy is designed predominantly to arrest the downward trend in inflation expectations. The way to do that is to put a floor under this low inflation rate and eventually move it up. The ECB has not even come remotely close to achieving their objectives. But the good news is that policy is starting to work. You are getting traction, and that's a good story."

Three months ago, Brexit caused fears of a deep and dark recession in the United Kingdom, which most watchers thought would also provoke a huge reduction in the growth rate of Europe.

"So everyone was marking their forecast down," Mr. Leech observed. "We saw risk markets all over the world collapse or draw down because of the fear that this could be an economically damaging event. That pessimism has led to all optimism, but this reversal may be a step too far."

"One of the big uncertainties surrounding the withdrawal from the EU is the negotiations. The key is the financial industry, which is critical to the EU's growth rates. We think it is going to be a very difficult transition, but we are not extraordinarily pessimistic, and we could become more optimistic over time. The Bank of England has come to the rescue. Fiscal policies are going to have to take the load, but monetary policy is going to have to stay engaged as well."

Mr. Leech also discussed the progress that Japan has been making - or to some, not making.

"In Japan there has been a lot of talk that the policies have been ineffective," he said. "There is a lot of pessimism. Maybe Japan is actually pulling back. The markets have taken a very pessimistic look. Over the last six to nine months, breakeven inflation rates in Japan have been coming down. Kuroda's number-

one objective is to get inflation expectations up. How do you get inflation expectations up for a society that has seen no inflation for an entire generation? This is an extraordinary challenge. That this has gone in reverse has also caused the NIKKEI to be weaker, the economy to be a little bit softer than they expected. Kind of a head scratcher."

"People say this shows that Japan's policy is becoming ineffective, and there is a lot of disappointment. But that's one side of the story. I think the Japanese might take the other side."

"What we see from Japan is a continuing commitment to extraordinary monetary combination. It's worked in getting wages up and the unemployment rate down. They got a little bit unlucky because they got a global slowdown, and lower oil prices, reducing their inflation rate. But think about the policy they have adopted, which is to basically focus on getting a zero percent rate."

"What if conditions actually change so that the output gap closes, and the inflation rate goes up? It's not much of a push, so that zero is too low for a 10-year rate. Think of the monetary combination they would need to continue to put into the market to make that work. Until they actually have the inflation rate running above two percent, they are committing to keeping the 10-year note rate at zero. This has the potential to be very, very helpful in underpinning global growth."

Discussing the high opportunities in the broad area of spread products relative to U.S. Treasury bonds or sovereign bonds, Mr. Leech focused on their rebound from early this year.

"To provide a vivid picture of just how sharp that rebound was from the February 11th lows, it has been nothing short of breathtaking," he said. "Obviously the biggest one, which knocks your socks off, is the rebound in high-yield energy: 59 percent. That shows how deep and dire the perception of that entire sector had become."

"When looking at these excess returns by sector, put it in a broad context. The first thing you see is enormous numbers. When you're investing in fixed income, especially in this period where rates have been somewhat range-bound and suppressed by central bank policy, the key is sector allocation. Where you put money, which of these buckets you put it in, is hugely important."

"Looking at the last three years, this has been a pretty tough period for spread product, a period where overweighting in spread product, by and of itself, would have been somewhat challenging. That's why you always think about having strategies in place that help mitigate the challenges when you have downdrafts in spread product, if you're going to have an overweight position."

"Opportunity was going to be much richer in the credit space specifically," Mr. Leech said. "We've had an overweight to that product that the U.S. CMBS line may illustrate. That's been a good sector to be in, certainly it's held up better than some of the others of previous years. That's the reason why, while we are optimistic about that sector, we feel the opportunities are a little bit more compelling in other sectors, particularly in the credit sectors. We are pretty overweight in investment grade and high yields. Those sectors are still attractive."

However, the Western Asset team is also concerned that a bear market may be approaching.

"We are starting to modestly reduce positions," Mr. Leech cautioned. "Given the high prices, we still think you've seen a growth backdrop that's favorable and a policy backdrop that's favorable. Valuations are fine, given that they had two previous years of such challenge. Where we have selected opportunities and we get full restoration or value, we want to start trimming positions."