Western Asset says talk of stimulus removal is premature

Ian Edmonds is portfolio manager and Mike Story product specialist at Western Asset Management and both are based in London. The firm is part of Legg Mason and manages the Legg Mason Western Asset Global Multi Strategy (GMS) Fund.

Edmonds has been with Western Asset since 1994 and before that was an actuary with Bacon & Woodrow, while Story joined Western Asset in 2004, before which he had worked for First Federal Bank and the Federal Reserve Bank of San Francisco.

Here they give AsianInvestor their take on bonds, emerging markets and central bank policy, among other things.

What are your views on current central bank policy?

Mike Story: Monetary policy stimulus remains very supportive. As we saw, the Bank of England recently extended its asset-purchase programme and central banks remain very focused on ensuring that the economic rebound continues and evolves into a more structurally sound economic expansion in the normal business cycle from what we saw in the depths of 2008. 

We expect central banks to maintain their interest rates at very low levels. The US Federal Reserve continues to buy mortgaged-backed securities, although it has cut back on the degree that it's buying on a weekly basis, but that support remains in place.

More generally we tend to view talk of policy removals as a bit premature. We would expect that central banks will remain very much committed to ensuring that the recovery process remains very healthy.

How do you view the long-term performance of equities, high-yield and emerging-market bonds, and commodities generally?

MS: It's worth highlighting that there has been an across-the-board rebound following an across-the-board sell-off, as investors moved to cash. Looking forward, we continue to believe that cash will be redeployed across riskier asset classes and that there are gains to be had.

A second point to note is the durability of emerging markets. They were the last to sell off, maintaining current pricing through September 2008, finally getting hit in the financial crisis and then the first to rebound. They've performed incredibly well, and we continue to think emerging markets are a major engine of growth in the global economy and we want to make sure we have a meaningful allocation to this asset class in our portfolios. 

It's also important to look at the macroeconomics of the global economy. This has been a key theme for us and the driver of our investment decisions. We've referred to the gap between growth in advanced economies and emerging markets as the grand power shift, as global GDP continues to shift away from advanced economies towards emerging markets. It's worth noting that throughout the discussions about decoupling, and whether emerging markets could or could not decouple from advanced economies, the long-term trend of decoupling occurred some time ago.

The gap in growth between China and India, for example, relative to the US, Europe and Japan, was about 5% throughout 2004, 2005 and 2006. It's remained at those levels, even through the depths of the financial crisis. As global trade begins to reinvigorate and economic conditions normalise, we see that gap in growth differentials being maintained. It is possible that they could even rise from here, but it speaks for the optimism of the growth model in emerging markets and informs our decisions in that sector. 

What's the outlook for interest rates?

Ian Edmonds: The market is anticipating higher interest rates towards the back end of 2010 moving into 2011. The government bond yield curve also reflects that higher path of interest rates, and during the quarter the yield curve steepened. We've positioned ourselves at the longer end of the curve. We think that will continue to be the case, as inflation isn't really going to be an issue. 

What are you doing in terms of the various bond sectors you invest in?

IE: In terms of agency MBS2, spreads against Treasuries have really come in a long way, and the purchase programme that the Fed and the US Treasury have got in place will be winding down over the next several months. So we have continued to reduce our allocation to agency MBS2 and will continue to do so going forward.

Moving on to corporate bonds, there's been a recovery in all of the major corporate bond markets. It's been pretty dramatic this year and undoubtedly a lot quicker than most of us anticipated. That said, you can see the spreads are really back to where they were during the peak of the last credit cycle.

If you believe that growth is continuing to recover slowly, balance sheets continue to be repaired, capital markets are functioning again and companies can borrow again, then one can anticipate that spreads will gradually grind in over the next few years. So despite the strong rally we've had, there is still potential for further gain. 

At the end of September the investment-grade corporate bond market was pricing in cumulative default rates of over 15%, well above what we saw in the 1930s. So our outlook -- and I think most people would agree with this now -- is that default rates won't be as bad as this going forward. To us, that implies there is still a certain amount of liquidity premium in the corporate bond market.

Spreads are still wide, but not as wide as they were. However, if you look at the ratio of corporate bond yields to government yields, they're still very attractive, certainly when compared to the last credit cycle. So we continue to think this is an area we should continue to invest in. 

The most volatile sector has been subordinated financials, but that sector has recovered extremely well this year, despite the weakness we saw in Q1, and we continue to see banks trying to get their balance sheets straight and raise capital where they can. We've seen some new tier-one issues in the last quarter, which is very, very encouraging, and we continue to hold those securities that we own within the fund where we think they continue to offer good relative value. 

On to high yield -- again, this market has had an exceptional return this year, close to 50% at the end of September. Default rates are now peaking in the 12-15% range and market participants and agencies all seem to expect default rates to actually decline in 2010, down to mid-to-high single digits. If that proves to be the case, and you look at where spreads are now, that's similar to what we saw with investment-grade. 

It takes us back to a very similar credit cycle in 2002 and 2003. The high-yield spread gradually contracted as default rates declined and the total returns coming from the high-yield asset class in those years following 2003 was in high single digits. It wouldn't be unreasonable to assume a similar return path from this asset class over the next few years. 

Turning to the maturities of the high-yield universe, we are seeing some companies starting to look forward, look at their balance sheets and say: 'We've got a lot of debt maturing in 2012; I don't want to wait until then, so I'll go to the banks and the bondholders and see if we can exchange it now and refinance it further out, so we don't have this wall of refinancing that we're facing along with the rest of the market.' For us, that's an opportunity to improve credit quality and get some security on the assets we own. 

In terms of high-yield default rates, we put a lot of effort into our credit research -- through our analysts in Pasadena, London and Asia -- to make sure we have a default rate that's below the market. That's the key thing for us in terms of trying to make sure that we continue to squeeze as much out of the high-yield market as we can. 

Can you elaborate on why you are so optimistic about emerging markets?

MS: Our long-term optimism is based on the growth differential between emerging markets in India and China versus the G7. Currently, though, we continue to prefer an overweight to the developed corporate sector relative to emerging markets.

However, the underlying fundamentals are very strong in emerging markets, and we will begin to change our allocation as conditions shift. If you look across the quality spectrum, you can see a widening spread in emerging-market corporates relative to sovereigns. This continues to reflect partially liquidity conditions, but also a preference by the market to remain in the safer sovereign asset class. 

Within the emerging-market bucket, issue selection is becoming increasingly important, and we continue to focus on new corporate issuance, which is a growing share of the total emerging-market fixed-income universe.

What about local emerging markets?

MS: Local-currency bonds are important, and we continue to look at that area. We have reduced positions there until volatility continues to subside. We'd like to see some more normalisation in global growth before we get into that area, but the Brazilian real is one currency we do have a small allocation to at the moment.

More generally, we have seen the end of the easing cycles within emerging markets. There are a number of exceptions of course, Turkey being one. But in Brazil, for example, the growth story is very strong, yet inflation continues to moderate towards central bank levels and it is currently at comfortable levels. If inflation does rise, however, the market will begin to price in rate hikes. 

So we've seen a trough in the business cycle in emerging markets and a strong rebound since then. The sustainability of that rebound depends on the strength in advanced economies and questions remain over the sustainability of that. We remain guardedly optimistic, but will wait to reallocate towards local-currency emerging markets until conditions are a bit firmer.