Western’s Leech stays short the euro, long Asia

Kenneth Leech, ‘chief investment officer emeritus’ at $456 billion Western Asset, says recent bets on the euro’s weakening have yet to come to fruition, but still believes European Union efforts to save the currency will also lead to its depreciation.

Meanwhile, the firm remains bullish on Asian debt markets, but he is growing more wary of the burden to tighten monetary policy that is being placed on the region’s central bankers due to their importing of US interest rates.

Leech, who is based in Pasadena, California, also expresses unease with regard to his title. “Calling me ‘emeritus’ makes it sound like I’m retired,” he says.

He oversaw Western’s rise from a modest boutique, with $18 billion of assets in the mid-1990s, to a top-tier player. By the mid-2000s, thanks to Western’s size, he was frequently compared with Pimco’s Bill Gross, and declared by some as the ‘king of bonds’.

It wasn’t a comparison Leech has promoted, although his colleagues like to trot out the moniker. He differs from Gross, both in temperament (Leech is low-key) and in avocation: although, like Gross, Leech is a macro guy, his firm built its reputation as a corporate bond house.

Health reasons forced Leech to step down from his role as CIO in 2007, allowing his partner of 20 years, Steve Walsh, to take over. (“I picked a good time to get out,” he jokes.) Leech returned full time in 2009 to run the global investment portfolio, a $42 billion book of business. (Western also has a separate dedicated emerging-market bond portfolio of $22.4 billion, but this is not run directly by Leech.)

The firm’s direction will increasingly tilt to Asia and other emerging markets, he says. “That’s where you see the greatest leadership in the global economy. The problem with developed countries is they have too much debt, little growth and unfavourable demographics. Emerging markets are the mirror image.”

In contrast to the 1990s, when strong US growth led to tighter monetary policy that harmed weak Asian markets with a link to the US dollar, today Asia is importing easy money, which it doesn’t need. This is putting a tailwind behind inflation. “The inflation outlook is as uncertain as any I’ve ever seen,” Leech says.

Each government is dealing with inflation in its own way, via a mix of hiked reserve requirements, foreign-exchange controls and raising interest rates.

“This is the first cycle where tightening and counter-cyclical leadership is beginning in Asia, so we are overweight Asian currencies,” Leech says. He says the firm is using a variety of instruments, including non-deliverable forwards, to make those bets; he declined to discuss any particular trades.

But volatility is rising due to inflation pressures, and valuations on bonds across many Asian markets are rising. “We’re value investors, so we have to use good risk management, and that means being as diversified as possible,” Leech says.

The biggest unknown is how Asian governments will balance local political needs while fighting off inflation, and how aggressive they can be in combating rising prices. That will require a mix of policy responses that will vary by market. This would have been the case anyway, but Leech argues US monetary easing, which he terms “aggressive”, has put the burden of counter-cyclical tightening on Asia.

“Asia is driving the global economic recovery but it’s now being forced to hit the brakes,” Leech says. “I’m optimistic about the region, but there are fears that growth rates can’t be sustained. We think growth rates can be, but this needs to be watched closely.”

Meanwhile, Western is pursuing a strategy of going short the euro. Western was underweight the eurozone and had no exposure to peripheral countries until it saw spreads blow out. Now it has taken some bets. But Leech is sceptical about the confidence in Europe that seems to follow each bailout, and scratching his head over the European Central Bank’s move to start raising interest rates.

Leech believes Europe has the means and the will to contain its debt crisis. The peripheral countries are small enough to manage. But over the longer haul, they are not competitive – and nor are big countries such as Spain and Italy, where the unit labour cost structure is out of sync with Germany’s.

This leads to some difficult questions, including whether the ECB can walk the tightrope between German tight monetary policy and the need for easing in the periphery, and if there is a restructuring of debt, what happens to the exposed European banking industry.

Leech says Western is long financial credits in Northern Europe because he believes European policymakers will ultimately hold the line and do what it takes to keep the eurozone together. But that implies, he believes, the Germans giving in to weak monetary policy, because the austerity required otherwise is politically impossible. That means a weaker euro.

“So far the strategy hasn’t worked,” Leech concedes, noting the bet has been put in place for the past few months. But he hasn’t changed his mind, and just recently the ECB decided against a further rate hike after much speculation that it would tighten policy.

The US is a mixed bag. On the fiscal front, he is optimistic. Both the Republicans and Democrats are talking about cutting government spending, and the proposal by Paul Ryan has raised the level of debate to specifics. “It’s a positive first step and suggests possible support for the US dollar,” Leech says.

But he is critical of the monetary response. He felt the first round of quantitative easing was already quite aggressive. ‘QE2’ was far more so, because the $600 billion asset-purchasing programme began nearly two years after the 2008 crisis, when liquidity in the system was already ample. Although QE2 has succeeded in raising asset prices, it has also fuelled a bull market in commodities. High oil prices are now biting consumers in the US, undermining much of the gains of both fiscal and monetary stimulus.

Leech reckons that the Federal Reserve will begin to reduce its balance sheet and normalise interest-rate policy in 2012, but given the steepness of the yield curve, he doubts interest rates will rise sharply, particularly at the long end.