In this Q&A, Western Asset Portfolio Manager and Research Analyst John Bellows discusses the outlook for growth and inflation, the impact of recent tax cuts, the maturity of the current business cycle and where to find value in the market when everything seems expensive.
A: We continue to be optimistic on growth. For the last few years, we’ve been consistent in our assertion that the global recovery would continue slowly but surely, aided by accommodative monetary policy. There is enough slack in the global economy that we can see continued growth without hitting major speedbumps or a turn in the business cycle. Our view here hasn’t changed.
In the US we expect growth to be slightly above 2% in 2018. The prospects are a little better abroad, where monetary policy is more accommodative, there is arguably more room to grow and the excesses seem fairly limited.
That said, our optimism is tempered somewhat by a few things. First, high security prices already reflect a lot of optimism about good global growth and positive dynamics with regard to US corporate taxes. It goes without saying that the optimism may not be realized. Chronic headwinds—such as high debt loads, aging populations, low productivity and muted wage growth—have not dissipated and could lead to disappointment, relative to lofty expectations.
Second, there is the always-present risk of the unexpected. For example, nobody thought oil was going to fall in 2014. Today, geopolitics is on our list of concerns.
A: The corporate rate cut went further than most people expected (down to a corporate tax rate of 21%), while the headline in terms of dollars was perhaps a little bit more than expected—especially considering its front-loaded nature. This is straightforwardly positive for US growth in the near-term. The tax cuts could be even more meaningfully positive for US corporate bonds than initial market reaction has reflected. Shareholders are taking home a much larger share of cash flows. That will increase retained earnings and at some point could increase investment, which could in turn increase productivity. That could further bolster US growth. It’s interesting to think about what this could mean for debt issuance. It wouldn’t be entirely surprising to see less issuance as corporate CFOs fund projects from retained earnings. Less issuance would be a positive for corporate spreads. Even in the face of a fairly strong market reaction, we continue to be positive on US corporate dynamics and how far we could see repricing go based on the impact of tax reform.
A: “Everything is expensive” is a common concern and certainly a challenge. We make a few observations for investors who ask this question.
First, not everything is expensive; there are pockets of value. Emerging markets stand out with high real yields and, equally important, as a place where the fundamentals have actually gotten better recently. Central banks in emerging markets have done the right thing by raising real rates to bring down inflation and stabilize currencies. Emerging markets have fairly low debt loads and good demographic trajectories, and are usually the high-beta assets of global growth. A continued recovery should be really positive for emerging markets.
It’s also not clear that US corporate credit is overpriced. Spreads are tighter, but we see current prices as close to fair. If the spread price is fair, investors earn more than the default risk premium: the reward is a credit risk premium on top of that. Investors need to be thoughtful about how much and what names they hold because it is as much about avoiding the losers as it is about picking the winners. If done right, holding fairly priced US spread products can provide returns.
Second, the most important thing to do when “everything is expensive” is to diversify, now more than ever. When prices are high, investors need to balance their portfolios because risk assets can correct quickly. We’ve all seen it. Diversification in any portfolio becomes absolutely essential when corrections come. We continue to think Treasuries are the best diversifiers. Low inflation translates into low bond yields especially at the back end of the curve, but it also keeps the Fed easy. And if optimism is not realized, Treasury yields could reprice lower.
A: Even though we are optimistic on growth and the impact of corporate tax cuts, we do not see that translating into inflation. We still see inflation overall as fairly muted, weighed down by dynamics of high debt loads, aging populations and low productivity.
Inflation has been at remarkably low levels, so some type of pickup would not surprise us, but any acceleration is likely to be limited. Frankly, we would be surprised if inflation moved above the Fed’s 2% target. Inflation has been consistently below 2% since 20131, and our concern is that it could continue to undershoot the mark.
At her last press conference, Fed Chair Janet Yellen was asked, “Is there anything you wish you had done differently?” Her answer was very telling: “What we left undone is the inflation side of our mandate.” Of the Fed’s two mandates, unemployment is down—but inflation failed to hit 2% during Yellen’s entire tenure. The Fed is worried about inflation and will respond with fairly cautious, gradual rate hikes.
It’s also useful to point out what’s going on with inflation in emerging markets. Like it is in the US, emerging market inflation has been either low or falling, which has in turn provided an anchor to bond yields. Low inflation should also help currencies. Some of the best opportunities in emerging market bonds have come when growth has been below expectations, but inflation fell: Russia in 2015, Brazil in 2016 and maybe Mexico in 2018. These episodes often follow periods when inflation was a problem, which then led the central banks to raise interest rates in order to support currencies and bring down inflation. In most cases high rates eventually had their intended effects, and inflation and bond yields subsequently fell. This is currently playing out in Mexico, where the central bank has raised rates to 7.25%. Given the high rate structure, we expect inflation to come down sharply in coming years, which would allow the central bank to eventually cut rates, and then we’d expect bond yields to fall as well. Good opportunities for bond investors in emerging markets can come when inflation’s fall is not necessarily timed with the growth cycle.
A: A few years ago this was a popular question. But, now we’ve sailed passed the eight year mark, and accordingly people talk less about the business cycle lasting eight years. Some argue that tax reform and better growth have extended the cycle. Nonetheless, it’s useful to return to the question about the business cycle length, if only because it is a profoundly wrong way to think about the economy. Nothing in economics is based on a set number of years; instead, everything is based on magnitudes.
The right question is not how long have we been growing, but how much have we grown? The answer is: not very much. Even with a few quarters of 3% growth last year, this is still far from a normal business cycle in terms of the magnitude of the recovery. Growth has been tepid; 2% to 3% is not normal for the US. As a consequence, we have not built up much excess: there has not been a lot of opportunity for banks to extend too much credit, consumers are not taking on too much debt and corporations have been fairly reasonable. We believe we can continue to grow for a lot longer.
- Inflation source: PCE ex Food and Energy
Last reading above 2%: 1Q12 (2.1%)