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Market Commentary

Ken Leech
Chief Investment Officer

It was the best of times, it was the worst of times ... ~Charles Dickens

Executive Summary

  • In early 2018, financial reports of a “global synchronized recovery” were omnipresent and global growth optimism was pronounced. But since then global divergence has been extraordinary. Our outlook for a broad and sustained global recovery has been challenged on a wide variety of fronts.
  • The US stock market has reached its all-time high, with the bull market now the longest in US history. The economic picture is strong, and in the second half of 2018 we expect more of the same. But Chinese and EM stock markets have not just underperformed—they have plunged. Both are in full-blown bear markets.
  • This growth downshift came from very high and unsustainable levels. The crucial question is whether this downshift is the beginning of a decline, or whether a return to the more moderate (3.5%-4.0%) growth of the last few years is possible. We are in the latter camp, but acknowledge that risks have risen.
  • Why would anyone hold EM debt? Bear markets provide resplendent valuation opportunities. In our view, valuation and fundamentals will carry the day.
  • The key to our prognosis is a continuation of sustained moderate global growth.

The deep malaise that gripped the global economy in the aftermath of the global financial crisis (2010-2016) was starting to lift in 2017. The global recovery was broadening and becoming less fragile. For the US, seemingly every one of those years had started with Federal Reserve (Fed) optimism about growth, inflation recovering to target and potential rate hikes, none of which came to fruition. Starting in 2017, the global headwinds were abating. Growth in the US could move to above-trend, inflation would move slowly to the Fed’s target, and the Fed could finally accomplish its very gradual normalization of interest rate program.

In such an environment, risk assets would be extremely preferential versus Treasury and sovereign bonds, not only in the US, but globally. The sector that had struggled most severely in the post-crisis periods and whose assets were cheapest, emerging markets (EM), would be the prime beneficiary. In 2017 this played out according to script. In fact, as 2018 dawned, financial reports of a “global synchronized recovery” were omnipresent. Global growth optimism was pronounced. But as the year has played out, global divergence has been extraordinary, with mirrored results in the financial markets. The US stock market has reached its all-time high, with the bull market now the longest in US history. But the Chinese and EM stock markets, as measured by the Shanghai and MSCI Emerging Market indices, did not just underperform—they have plunged. Both are in full-blown bear markets.

Exhibit 1 shows a similar picture for fixed-income markets, displaying the excess returns of spread sectors for the year to date. As you can see, spread sectors in the US have held up reasonably well, while spread sectors outside the US have performed poorly.

Exhibit 1
Spread Sectors Excess Returns (Year to Date Ending 24 Aug 18)
Source: Bloomberg Barclays, J.P. Morgan, Western Asset. As of 24 Aug 18
*Bank loan excess returns vs. 3-Month LIBOR

In the US, the economic picture has been even better than we thought. Above trend growth, subdued inflation and a cautious Fed remain our base case. In the first half of 2018, growth came in at over 3%, while inflation flirted with finally hitting the Fed’s target of 2% after eight years of expansion. Better growth with subdued inflation had provided a sturdy backdrop for the outperformance of most US spread assets.

For the second half of 2018, we expect much of the same. Growth may come in between 2.5% and 3.0% as the fiscal stimulus continues to provide incremental help. Meanwhile, the inflation outlook remains muted despite the improvement in the labor market. We believe the sluggish trajectory we have seen in rising inflation rates in the US and across the developed world will remain. With this backdrop in place, the Fed has acknowledged the need for a more pragmatic approach to thinking about interest rates.

While a September hike is fully anticipated, Fed Chair Jerome Powell’s speech at Jackson Hole suggested future hikes are far from assured. Powell eschewed overreliance on economic models, distancing himself from those advocating additional hikes based on estimates of the neutral rate. In a telling reference to Greenspan’s restraint in the mid-1990s, Powell said that a “wait-and-see” approach may be more appropriate, as long as inflation expectations remain well anchored. Finally, Powell concluded his speech by noting “we have seen no clear sign of an [inflation] acceleration above 2 percent.” An attentive listener can easily put the pieces together: anchored inflation expectations, a “wait-and-see” approach and no sign of inflation acceleration suggest only limited rate rises from here.

Our outlook for a broad and sustained global recovery has been challenged on a wide variety of fronts. In our last note we reviewed the underperformance of economic indicators relative to expectations in Europe, Japan, China and non-China EM. This growth downshift came from very high and, in our view, unsustainable levels. This leaves the crucial question of whether this downshift is the beginning of a more precipitous decline, or whether a return to the more moderate (3.5%-4.0%) growth of the last few years is in the offing. We are strong proponents of the latter camp, but we have to acknowledge that risks have risen.

Uncertainty over the possibility of a broad-based trade war weighs heavily on the global outlook, particularly EM. Even if small, the possibility of a decline in global trade, let alone a full-scale secular retreat from globalization, presents a potential de-stabilizing scenario. On this front, we think concern needs to be heightened. The Trump Administration has meaningful incentives to find deals and end trade disputes before the November midterm elections. We continue to expect progress on NAFTA and we remain hopeful on negotiations with the EU. But the political success that US President Donald Trump has engendered by attacking Chinese trade is indisputable. This is an issue with which both Republicans and Democrats agree. We see that the Administration has little political incentive to end this combative tension in any short period of time.

Additionally, we have the accelerating positive feedback loop in EM currency declines leading to responsive policy rate hikes, and leading further to slower growth. Remarkably pessimistic expectations and currency decline overshoots do not necessarily correct in a timely fashion—indeed, they can cast their own reinforcing growth risks. Specific EM country difficulties also lead to contagion fears and recognition that downside risks of policy errors can be substantial. Turkey presents the latest flamboyant example of self-inflicted wounds that have put the solvency of the entire country in question.

In this devil’s brew of risks, why would anyone hold EM debt (EMD)? The key to bear markets, in this case that of EMD, is to avoid them. Failing that, you need to survive them. But bear markets provide resplendent valuation opportunities. In a world where developed market 10-year rates range from 0%-3% and spread product yield spreads are tight, EM 10-year rates of 7%-10% abound. Further, EM non-China currency levels are at a five-year low, having declined 35% since 2013. Still what might cause a price rebound? In this case, our argument is that global growth continues to remain the key determinant. Here, despite major market fears that unfortunately have plausible roots, the actual growth performance has remained solid. More specifically, these worst-case fears may not be realized. Trade tensions can abate. Certainly a NAFTA or EU deal would change the atmosphere. And while Chinese trade tensions may persist, they have also galvanized Chinese policymakers to provide sharply increased fiscal and monetary stimulus to improve their economic growth.

What might break the positive feedback loop in EMD presently and what about the timing? Ah, always the unanswerable question. In our view, valuation and fundamentals will carry the day, but timing prescience is elusive. Exhibit 2 is one we introduced in our last note. The chart shows the performance of emerging market debt and contrasts this with our proprietary Regression Comparison Returns model. Since this model is backward looking, it should fit well. It takes into account global growth, global commodity prices, the path of the dollar and developed market policy rates. Almost all major investment banks have such a model, and in truth, ours is not substantially different.

Exhibit 2
Quarterly EM Returns—Actual vs. Regression Comparison Returns Model
Source: Bloomberg, J.P. Morgan, Western Asset. As of 30 Jun 18
*The regression comparison is an internal calculation which uses the EM-DM GDP differential, S&P GSCI Commodity Indices and EUR/USD results to explain historical EM local currency performance. Coefficients of each variable of the analysis are determined by the regression output. They are static and are as follows: 1.08, 0.56 and 0.13 for EM-DM GDP differential, EUR and commodities, respectively. Past performance is no guarantee of future results. Regression comparison shown is developed with the benefit of hindsight and has inherent limitations.

Looking at the far right of Exhibit 2, the present model observation, what can be seen is that if one had known about all these variables at the start of the year, avoiding EM would have been the winning choice. But look at the degree of the overshoot in the actual underperformance of EM relative to the model prediction. It is spectacular. Clearly this reflects the enormity of the previously enumerated market fears. Let’s look at the three previous episodes (all circled) of such poor EM performance since the data series started. The first was 2008—possible global depression. The second was 2011—three years following the crisis with fears of a European periphery collapse leading fears of a global recession. The third was 2016—fears that $25 oil and a Chinese growth collapse leading fears of global recession. The fourth is today—plenty of fear abounds, but are we on the verge of a global recession? In fact, isn’t it possible we remain very much in the path of a sustained global recovery?

In examining this graph, look at the immediate aftermath of each of the circled observations. When global growth worries receded, what was the ensuing performance? In each case, extremely sharp recoveries resulted—while not a conclusive pattern, it’s a significant one. This is the challenge of this asset class. Violent and unwanted volatility can develop without much warning. That is why managing proportionality is so decisive. On the flip side, the total return opportunities far exceed developed market debt.

Exhibit 3 shows two simple displays of the EM opportunity going forward. One is the breakeven currency rates on a one- and three-year time frame, which shows the enormity of future declines an investor could withstand before underperforming developed market debt. The second shows the total return advantage of EM if current depressed currency rates merely hold their current levels. The valuation argument is straightforward, particularly if one expects global growth to remain broadly on track.

Exhibit 3
EM Valuation Looks Attractive
Source: Bloomberg, Western Asset, Citigroup. As of 30 Aug 18
*Note: The total return is the coupon over the relevant time horizon plus the change in price implied by the forward yield change over the relevant horizon, divided by the initial price. It assumes no change in FX or yield curve, but does include roll downs. There can be no assurance of any level of total return.

When investing in spread product instead of a Treasury or sovereign bond, you are trying to make your coupon. If you sell a Treasury bond to buy an investment-grade corporate bond today, can you make your coupon? We think that the answer is yes, but the risk/reward is not very compelling. The better outcome for spread product investing is spread compression, and in our investment-grade corporate example, we think there is not meaningful opportunity for much of that. But what about the case for EM? What is the real yield of EM relative to developed market debt? The real yield spread is now at a 12-year wide. In a world where developed market yields are low and spreads are tight, here is an asset with a substantial coupon. Can you make this coupon? If spreads merely hold, the answer is yes. Can you get spread compression? Can anything go right? Can any of these fears abate? We think the answer once again is yes. The key to our prognosis is a continuation of sustained moderate global growth.

The spectacular divergence of US asset prices and those of many outside the US leaves the ironic challenge of those of us who have held the slow but steady global growth narrative tormented from opposite perspectives at the same time. Will the developed markets overheat, suggesting you are too pessimistic on growth? Or will the EM markets face collapse, suggesting you were too optimistic on global growth?

We have always characterized this global recovery as a two-steps forward, one-step back process. The current EM setback presents yet another illustration of the one step back. But our view remains optimistic. We very much like our chances of the two steps forward.

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