Pasadena Investment Executive Sees Central Bank Actions Key to Ongoing Global Recovery

The Chief Investment Officer of Pasadena-based Western Asset Management says the precarious global recovery should continue – but only if the world’s central banks play their cards right.

Ken Leech said that despite the turmoil of the last three months, the global economy will continue to grow — but at lower rates than the U.S. Federal Reserve (Fed) forecasts, and only with continued accommodation from central banks.

“Our view has been that the global recovery, while very fragile, is going to be ongoing, and it’s going to take a lot of policy help,” Leech reported. “You’ve seen from some of the central banks around the world exactly that view expressed.”

“Three months ago, there were concerns about a possible global recession, interest rates had fallen to all-time new lows, there was discussion of whether or not European yields—particularly German yields—would be going into negative territory on a sustained basis, and certainly fears that commodity prices would lead the inflation rate lower in many countries—even negative or further negative, in Europe. A lot of those fears have abated, and that’s a good thing.”

“But we all recognize that we’re living in a period of extreme volatility with respect to interest rate changes as people try and gauge the future course of the economy.”

To Leech the key takeaway is that when confronted with uncertainty, the Fed has chosen “a dovish course.” He expects this to be the case going forward as well.

“The growth and inflation backdrop in the U.S. has been so subdued for so long,” he said. “The Fed has consistently overestimated growth … It has consistently expected the economy to do much better than actually turned out to be the case.”

This makes it difficult to predict when the Fed will move to raise interest rates.

“[The Fed’s] message reflects the fact that there still is uncertainty with respect to the outlook for growth,” Leech said. “That puts the market in a challenging position. Market reaction is going to be very volatile because the Fed may go in September, it may go in December, it may not. When you start talking about that kind of uncertainly, each data point is important.”

A key concern for Leech and the Western Asset team is inflation, just as it is for the Fed.

“The Fed again has consistently overestimated inflation,” Leech said. “Inflation has been subdued. It’s actually been declining more recently because of the commodity price pass-through. The Fed expects that rate to be stable and to be moving up quite sharply.”

Unlike the Fed’s growth forecast, which was revised downward recently, its inflation forecast has remained steady, with expectations for it to return to the 2 percent level in the not too distant future.

“Our forecast has been more cautious,” Leech said. “If we’re right that the global and U.S. recovery will stay on track, we will get inflation to stabilize and eventually move up. But this process, in our view, is going to take longer than the Fed is suggesting.”

“The Fed is really walking a fine line. It really wants to get off zero and it’s struggling with how to get this lift-off in rates started. It doesn’t want to do it in any way, shape or form that would upset the recovery or upset the markets. That’s why, when confronted with uncertainty or data that are not straightforwardly suggestive of a move, the Fed has responded in a dovish fashion. We continue to believe that is going to be the case, based on the fragility of the global recovery.”

As for when the Fed will actually raise rates, Leech leaned toward a conservative view.

“We had expected that the Fed would move in September,” he said. “We still think that is better than a 50-50 shot. Our forecast is for a 2 to 2 1/2 percent growth rate. The Fed’s implicit growth rate for the second half of the year is something like 2 to 2 3/4 percent. If we’re near the top end of the range, the Fed could easily go in September.”

“But it’s going to be a close call, based on the guidance that the Fed has given.”

As for Europe, Leech believes it will experience a positive growth rate this year.

“We’re in the 1 1/2 percent growth camp,” he reported. “Lending has picked up in Europe.”

China and many emerging market economies draw concern from the Western Asset team.

“Chinese growth is slowing, deliberately on a longer term trend, but this year the data have been weak,” Leech said. “We continue to believe that China will avoid a hard landing this year. The monetary stimulus it put in place and the possibility of fiscal stimulus later in the year will allow it to avoid a hard landing and get back to its 7 percent growth target.”

“But if we’re going to be wrong on that forecast, the risks have certainly risen to the downside.”

With regard to fixed-income market positions, Leech reported that Western Asset has been underweight to the mortgage pass-through part of the market. “We did think this was going to be a sector that might not perform as well as some others,” he said. “This is the first year that mortgage pass-through performance has been negative relative to Treasuries in quite some time.”

He also discussed prospects for the corporate bond sector.

“It’s pretty attractive,” he said. “Historically, when the U.S. yield curve tends to steepen, the credit curve tends to flatten. In this case, a lot of stress and supply on the long end have provided an opportunity for investors to lock in spreads in the long end that are reasonably attractive.”

As for the high-yield markets, Leech reported, “Last year in high-yield, it really, really mattered where you were more than anything else, and energy was by far and away the worst performer. This year energy’s done a little bit better than other measures. High-yield in general has done pretty well, but energy has been the best performer. We continue to think that that’ll be the case.”

With the global economy recovering, aided by accommodative central bank policy, Leech believes oil prices will stabilize. This should only help high-yield energy prospects.

“The market’s been encouraged that oil prices have stabilized near $60 a barrel the last couple of months. If they stabilize here, or recovery abroad over the next couple of years improves, high-yield energy is going to one of the brighter spots of the fixed-income spread sector markets.”

When it comes to housing, Leech said that Western Asset believes prices have bottomed.

“We are seeing an improvement trend that is going to be sustained,” he reported. “We’re not of the view that housing prices are going to run away and hide. Additionally, we are seeing some thawing in the lending from banks, so we are seeing an improved housing tone. That’s one of the bright spots of the economy. When you look at the fundamentals of mortgage payments to income, they are still well below average. So this is a sector where we do think defaults will stay low and we continue to hold our positions on this sector.”

As for emerging markets, Leech sees a sector that has been challenged, for obvious reasons.

“Weaker commodity prices, some diminution in global growth, have led many to believe that this sector is going to be out of favor. Many people have really given up on it. There’s an argument for the degree of difficulty, but we have to compare and contrast that with prices.”

Western Asset likes the outlook for the emerging market space, particularly Mexico, India and Brazil.

“Over time these countries are going to be in an improving trend,” Leech said. “Valuations of markets have really become compelling, even though their growth rates are under pressure from a commodity-exporting basis, but also a general soft global GDP framework.”

When asked about the turmoil related to Greece, Leech said both sides have a lot to lose.

“The Greece population would be much worse off if it had to leave the euro, and the European Central Bank (ECB) is cognizant of the challenges of having a bank meltdown or a Greece economy in chaos.”

“The policy lines are tough. The ECB doesn’t want to continue to lend money indefinitely without some possibility Greece is going to take a much different tactic with respect to its economic policies, and the Greek government ran on kind of a one-issue platform that it would get a better deal without having to make meaningful adjustments. It’s a very tenuous situation. The headlines vary from day to day, and it really helps increase volatility, but we continue to think—knock wood—that a deal will be reached.”

Leech concluded by observing that downside risks persist.

“That’s why policymakers are very, very concerned, and that’s why they’re going to stay accommodative,” he said. “We believe that’s the right course. They need to stay accommodative. And accommodative monetary policy is going to be crucial for the ongoing global recovery.”

“If Fed policy moves from zero to 50 basis points, or a year from now to 100 basis points, that’s going to cause a lot of people to think, oh my gosh, this is a very tough policy. That would still be a very, very accommodative rate, and that’s what the Fed’s trying to provide clarity on: how it is going to keep the markets understanding that it intends to be very, very accommodative, even if that doesn’t mean an absolute zero rate.”

“We think this interest rate normalization path is going to proceed, but it’s going to be very, very slow. In that environment, we think spread sectors will continue to outperform government bonds.”