Market Commentary

If matters go badly now, they will not always be so. ~Horace (65 BC-8 BC), Roman Poet
Ken Leech
Chief Investment Officer

Executive Summary

  • Credit spreads have moved so violently in recent months that current pricing embeds not only a recession, but the strong possibility of systemic stress.
  • We believe the Fed is now on hold until credit market conditions ease meaningfully, inflation expectations increase and economic growth conditions improve to where they are in line with the Fed’s forecast. Achieving any one of these goals will prove challenging. Achieving all three will take quite some time.
  • China is casting a very large shadow over global growth and commodity price outlooks. The pessimism here is extraordinary. We continue to believe the downturn in Chinese growth is manageable.
  • We see the odds of a global recession as very low. With the US, Europe and Japan growing modestly, the global recovery will move forward even if key segments of the emerging markets are challenged. If our base case is even close to right, the opportunities in spread sectors are substantial.
  • If policymakers recognize the absence of inflation as a ramp to become more accommodative/less restrictive, the returns could be as breathtaking on the way up as they were on the way down.

What gives? The savage pummeling the credit markets have taken is so out of proportion to other markets, or to the current economic and Federal Reserve (Fed) narrative, that there almost appear to be two parallel realities. The first is that the US economy is in reasonable shape, exhibiting modest growth. Unemployment continues to fall, the consumer is fine and the Fed is considering how to continue on its path to normalizing interest rates. The credit markets are tightening in contrast. Credit markets are not only pricing in a recession, but have gone even further, pricing in a premium for systemic stress. Investors are faced with divergent paths. Looking at the economic data, the situation seems reasonably serene, yet the credit market’s black cloud suggests exceptional peril. We believe such extreme pessimism is unwarranted.

Exhibit 1 shows the excess return of investment-grade credit versus Treasury bonds in some historical perspective. The 332 basis point negative return in just the first 6 weeks of 2016 is astounding, matching or almost matching the full-year experience of some of the credit market’s most difficult episodes. Consider that this year’s challenges are already greater than in the calendar year 1998, which brought the Russia government default, as well as in 2011, when the European peripheral debt fears raised concerns of another global banking crisis. This year’s early credit debacle is 70% of the return of 2007, marked by the undertow of declines in housing and subprime securities.

Exhibit 1
Investment-Grade Credit Excess Returns
market-commentary-2016-02
Source: Barclays. 1Year-to-date ending 11 Feb 16.

Exhibit 2 displays long maturity corporate and banking spreads over the last 18 years. Despite the enormity of bank recapitalization and deleveraging since 2008, US bank spreads are now not only wider than 2007, they are moving toward their European crisis 2011 wides. Industrial corporate spreads have widened so sharply that they are now already past 2011 highs. Indeed, current industrial spreads have been exceeded only in the global financial crisis of 2008.

Exhibit 2
OAS Spreads On Long Financials & Industrials
market-commentary-2016-02
Source: Barclays. As of 09 Feb 16.

The economy cannot withstand these tighter credit conditions. Even if current data appear resilient, the Fed cannot afford to let the tightening of credit conditions linger. The Fed is facing this challenge, even as the pace of US growth seems to have slipped modestly from its 2.5% forecast. More important still, inflation expectations, which the Fed has consistently cited as being well anchored, are now falling.

We believe the Fed is now on hold until the following three conditions are met: credit market conditions ease meaningfully, inflation expectations increase and economic growth conditions improve to where they are in line with the Fed’s forecast. Achieving any one of these goals will prove challenging. Achieving all three will take quite some time.

Acknowledging and underscoring the substantial changes in inflation expectations would be a very straightforward way for the Fed to signal a much more cautious approach to interest rate normalization. The Fed has heretofore emphasized the importance of having inflation expectations well anchored. Exhibit 3 shows the inflation expectations from the University of Michigan and the Fed’s own New York survey. Both are clearly declining. Also shown there are TIPS’ 5-year forward break-even inflation rates, which the Fed has pointed to on many occasions as an important signal. Not only is it signaling lower inflation, it is at the lowest level in 7 years, since the financial crisis.

Exhibit 3
Long-Term Inflation Expectations
market-commentary-2016-02
Source: Bloomberg, New York Fed, Federal Reserve Board. As of 17 Feb 16.
Note: University of Michigan Survey refers to inflation expectations 5-10 years ahead, NY Fed survey refers to expectations 3-5 years ahead, and TIPS breakevens are 5-10 years ahead

As the Fed reassesses its outlook, the prospects for acknowledging the material decline in inflation expectations are good. This would present a plausible case for the Fed to pause its hiking cycle. Combined with current credit conditions and economic growth uncertainty, the odds suggest the Fed is on hold.

Markets can be wrong—current conditions may prove transitory, but the Fed’s ultimate responsibility is financial stability. Tightening into markets suffering broad-based credit stress is likely to stifle growth. Tightening into markets with clear bank credit stress is dangerous. The lesson of the 1930s, the 2007-08 crisis and the European crisis of 2011 seems pretty clear: banking stress is a sign of potential systemic risk. Tightening needs to be off the table.

We believe investors have to take a two-tiered approach to their economic outlook. The base case needs to be developed in a way that recognizes the challenges stated previously. The downside risk case has to be evaluated very carefully, as the stressed level of market pricing suggests fears that are orders of magnitude away from the base case. When investors eschew 4%+ investment-grade corporate bonds to buy 1.70% 10-year Treasuries, fear is dominant.

Reconciling investment strategy when your base and risk cases diverge meaningfully is not easy. Let us be clear: we think current pricing is sharply diverging from what we believe are the reasonable probabilities based on economic fundamentals. But we respect markets: the signals they are giving off need to be addressed.

We have previously highlighted our belief that global growth has downshifted, and we felt strongly that portfolios had to have a cushion to protect against any further reductions in growth. This is why in our broad market accounts we have maintained longer-than-market durations even in the face of an imminent Fed hiking cycle. While our duration overweights have helped, the markets have priced in outcomes so difficult that the duration overweights have proven inadequate.

We believe global growth will continue at a roughly 3% rate, sluggish but not horrible. We think Europe is on track for just under 2% growth. This is not overly heroic given the many recent years of subpar growth. We understand that the banking challenges in Europe are significant. The deleveraging process was never as complete for European banks as it was for their American counterparts, but this is a long way from implying solvency issues or a systemic crisis. Furthermore, the European Central Bank is adamantly looking for further steps through which they can improve liquidity, shore up growth and raise inflation.

China is casting a very large shadow over global growth and commodity price outlooks. The pessimism here is extraordinary. We continue to believe the downturn in Chinese growth is manageable. How the authorities achieve a transition from an investment- and export-led economy to a more service-based and consumption-driven one is crucial. The process is very uneven.

Currently, the challenge for the Chinese authorities is currency alignment. Markets fear another wave of deflationary impact should the yuan be devalued more sharply. One key point that we would make is that by tying the yuan to the dollar, China is effectively importing US monetary policy. It can ill afford tighter policy. Here, too, a meaningful pause in Fed rate normalization would be a distinct positive.

We see the odds of a global recession as very low. With the US, Europe and Japan growing modestly, the global recovery will move forward even if key segments of the emerging markets are challenged. If our base case is even close to right, the opportunities in spread sectors are substantial. If policymakers recognize the absence of inflation as a ramp to become more accommodative/less restrictive, the returns could be as breathtaking on the way up as they were on the way down.

At the moment, though, we are in for a very difficult slog. There are many issues upon which to be anxious or negative, but growth and healing conditions develop more slowly. We believe the Fed is migrating to a pause in its normalization process, but it will take time before it announces an official reassessment of its economic outlook. Ever since the crisis, policymakers have been engaged in a long grudging battle to help reflate the global economy. Market gloom is premised on the realization of more dire outcomes. Policymakers would do well to short circuit such fears.

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