MARKET REVIEW: THE DOG THAT DIDN T BARK

Transcription

1 Legg Mason Thought Leadership MARKET REVIEW: THE DOG THAT DIDN T BARK Ken Leech Co-Chief Investment Officer Low and falling inflation is a worrisome global phenomenon. It is a potential warning sign for both corporate and top line revenues, and economic growth. We believe it will increase, but very slowly Global central banks will need to stay exceptionally accom modative. This is a crucial component of the outlook for risk markets We expect global growth to improve at a moderate pace in Even with the substantial compression in credit and sector spreads, we continue to maintain our overweight position We think the continuation of spread compression toward longterm averages is very likely, and needs to be monitored closely. Past performance is no guarantee of future results. All investments involve risk, including possible loss of principal. This material is not for public distribution outside the United States of America. Please refer to the disclosure information on the final page. NOV 2013 IN THE U.S. INVESTMENT PRODUCTS: NOT FDIC INSURED NO BANK GUARANTEE MAY LOSE VALUE

2 KEN LEECH Market Commentary NOVEMBER 2013 The dog that didn t bark. ~Literary allusion ascribed to Sir Arthur Conan Doyle Executive Summary Low and falling inflation is a worrisome global phenomenon. It is a potential warning sign for both corporate and top line revenues, and economic growth. We believe it will increase, but very slowly. Global central banks will need to stay exceptionally accommodative. This is a crucial component of the outlook for risk markets. We expect global growth to improve at a moderate pace in Even with the substantial compression in credit and sector spreads, we continue to maintain our overweight position. We think the continuation of spread compression toward long-term averages is very likely, and needs to be monitored closely. Our position has generally emphasized overweights to credit and spread 1 products, based on the view that a moderate US and global recovery combined with low inflation will lift these markets while keeping sovereign yields anchored. We expect growth to improve modestly next year, but we think the recent decline in inflation will keep monetary policy on a very accommodative footing. Even with the substantial compression in credit and sector spreads 2, we continue to maintain our overweight position. After more than four years of recovery, arguably the most notable aspect of the expansion has been the absence of inflation. Monetary policy experimentation and accommodation have been attempted across the developed world on a scale never seen before. Pundits, policymakers and investors have predicted the seemingly inevitable inflationary fallout. Still, despite ongoing recovery and more quantitative easing (QE) 3 programs and their equivalents than anyone can remember, core global inflation in 2013 will record its lowest level since the crisis year of 2009, and headline inflation, while more volatile, is not really any higher. What s more, the softness in commodity prices and continued tepid wage growth suggest that this low-inflation trend will continue. Just as important, inflation remains below central bank targets across the developed market economies. (Exhibit 1) Exhibit Central Bank Target Month SAAR 4 DM Source: JP Morgan. As of 30 Sep 13. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 1 Spread refers to non-treasury parts of the bond market, such as the corporate and mortgage-backed sectors. 2 A sector spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in the characteristics of the sectors, such as creditworthiness. 3 Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities. 4 The seasonally-adjusted annual rate (SAAR) refers to the annual rate, adjusted for seasonal factors. 5 The developed markets (DM) refers to countries with well-established financial markets and economies.

3 Market Commentary Early this year there was concern that the Federal Reserve (Fed) might tolerate an inflation overshoot. Now the low level on headline and core inflation has led to discussion of the Fed adopting an inflation floor. In Europe the ECB 6 has eased policy further as anxiety has risen over whether sharply falling inflation is masking evidence of declining demand. (Exhibit 2) Exhibit US Headline Inflation 7 2 EU Headline Inflation Jan 11 Apr 11 Jul 11 Oct 11 Jan 12 Apr 12 Jul 12 Oct 12 Jan 13 Apr 13 Jul 13 Oct 13 Source: BLS 9, EuroStat, Bloomberg. As of 31 Oct 13. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment. 6 The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency. 7 Headline inflation is an inflation rate not adjusted for volatile components such as fuel and food. 8 The European Union (EU) is an economic and political union established in 1993 after the ratification of the Maastricht Treaty by members of the European Community and since expanded to include numerous Central and Eastern European nations. 9 The Department of Labor Bureau of Labor Statistics is one of the agencies tracking inflation in the US. 10 Tapering refers to the Fed s announced approach to reduce the pace of its current $85 billion in monthly asset purchases gradually instead of ending the purchases all at once. 11 Gross Domestic Product ( GDP ) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time. Continued low inflation is a profoundly important fact for fixed-income investors. Fear of an imminent inflation breakout has kept many on the bond market sidelines in recent years, despite the brutal 0% alternatives available on short-term investments. Fixed-income markets have rallied over the past two months, following summer fears of Fed tapering 10. The Fed s pronouncement that it would be able to unwind its QE program as soon as the middle of 2014 was based on its expectation of GDP 11 growth of just under 3% through the end of next year. Such a growth rate would bring the unemployment rate down, leading the unwinding of the asset purchase program implemented to achieve that goal. The markets fear of such outcomes led to tightening projections in the forward markets, which we believed were unlikely to be realized. In response to this market action, the Fed walked its projections of tapering back, to some extent, and it also emphasized its commitment to continued low rates even after its balance sheet expansion ends. Similarly, market and Fed expectations of growth have moderated on softer than expected economic data. These changes have brought yields somewhat lower and rewarded our extension of maturities. We would emphasize, however, that beneath the favorable recent swings in Fed talk and economic growth data, the continued softness in inflation has been an ongoing support for the bond markets. One of the key questions is how and when the Fed might react with respect to the inflation rate. We have always believed in the sincerity of Fed Chairman Ben Bernanke s concern over the potential consequences of deflation and the necessity to truncate that risk. That is one of the reasons the markets were caught so off guard this spring when he argued that the low level of inflation was transitory. After rates rose substantially in response, Chairman Bernanke reversed himself and re-emphasized the twin objectives of the Fed: that

4 Market Commentary even if growth becomes more satisfactory, inflation remain below target. This was meant to reassure markets that even after QE ends, monetary policy will stay very accommodative. The Fed s forecast is for growth just under 3% for 2014 and for inflation to move back toward the 2% target. But what if the Fed misses its growth target? After all, it has consistently overestimated growth in recent years, with an average error of 1.5% over the last five years 12. Similarly, what if inflation fails to move back up to target? Former Fed Chairman Alan Greenspan confronted this problem in He was so startled by the inability of the Japanese to extricate themselves from deflation, he called for an asymmetric risk monetary policy: explicitly keeping the federal funds rate too low. His legacy may have been heavily tarnished by the housing boom which followed, but at the time, his concern was real and understandable. Chairman Bernanke has shared these types of concerns during his tenure, and the crisis has led him to extravagant monetary policy initiatives to forestall downside risks. Fed Vice Chair Janet Yellen has been the Fed s most successful forecaster during this period, and she more than anyone else at the Fed has been focused on downside risks to growth and inflation. Low inflation is a global phenomenon. It is worrisome. We believe it will turn up, but very slowly. Global central banks policies will need to stay exceptionally accommodative. This is a crucial component of the outlook for risk markets. While growth has been modest and inflation low, the enormity of the policy accommodation has restored optimism that economic growth is on a more assured path to normalization. This combined with falling default rates across virtually all fixed-income spread sectors has lifted returns. This landscape should continue to favor spread sectors. As value investors, we have tracked the rising prices for spread product and considered paring our positions, but we remain overweight. We think the continuation of spread compression toward long-term averages is very likely. Our view is that the US and global recoveries will continue to improve, but at a moderate pace, and needs to be monitored closely. Low and falling inflation is a potential warning sign for both corporate top line revenues and economic growth. We intend to follow carefully both its path and that of policymakers responses. 12 Federal Open Market Committee as of November 18, 2013.

5 Market Commentary All investments involve risk, including loss of principal. Past performance is no guarantee of future results. The opinions and views expressed herein are those of the portfolio managers and may differ from those of other managers and are not intended to be relied upon as a prediction or forecast of actual future events or performance, or a guarantee of future results, or investment advice. Fixed income securities are subject to interest rate and credit risk, which is a possibility that the issuer of a security will be unable to make interest payments and repay the principal on its debt. As interest rates rise, the price of fixed income securities falls. Foreign securities are subject to the additional risks of fluctuations in foreign exchange rates, changes in political and economic conditions, foreign taxation, and differences in auditing and financial standards. These risks are magnified in the case of investment in emerging markets. U.S. Treasuries are direct debt obligations issued and backed by the full faith and credit of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasury securities, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities. Commodities contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors. Yields represent past performance and there is no guarantee they will continue to be paid.

6 Batterymarch Brandywine Global ClearBridge Investments Legg Mason Global Asset Allocation Permal Royce & Associates Western Asset Management INDEPENDENT EXPERTISE. SINGULAR FOCUS. Legg Mason is a leading global investment company committed to helping clients reach their financial goals through long term, actively managed investment strategies. Over $670 billion* in assets invested worldwide in a broad mix of equities, fixed income, alternatives and cash strategies A diverse family of specialized investment managers, each with its own independent approach to research and analysis Over a century of experience in identifying opportunities and delivering astute investment solutions to clients IMPORTANT INFORMATION: This document is for information only and does not constitute an invitation to the public to invest. You should be aware that the investment opportunities described should normally be regarded as longer term investments and they may not be suitable for everyone. The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Past performance is no guide to future returns and may not be repeated. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested. Please note that an investor cannot invest directly in an index. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed and is not a complete summary or statement of all available data. Individual securities mentioned are intended as examples of portfolio holdings and are not intended as buy or sell recommendations. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors. The information in this document is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason nor any officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this document or its contents. This document may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this document may be restricted in certain jurisdictions. Any persons coming into possession of this document should seek advice for details of, and observe such restrictions (if any). This document may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. This material is only for distribution in the jurisdictions listed. INVESTORS IN EUROPE: Issued and approved by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No Authorized and regulated by the Financial Conduct Authority. Client Services +44 (0) This document is for use by Professional Clients and Eligible Counterparties in EU and EEA countries. In Switzerland this document is only for use by Qualified Investors. It is not aimed at, or for use by, Retail Clients in any European jurisdictions. INVESTORS IN HONG KONG, KOREA, TAIWAN AND SINGAPORE: This document is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Korea, Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): R) in Singapore and Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) ) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently. It is intended for distributors use only in respectively Hong Kong, Korea, Singapore and Taiwan. It is not intended for, nor should it be distributed to, any member of the public in Hong Kong, Korea, Singapore and Taiwan. INVESTORS IN THE AMERICAS: This document is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which may include Legg Mason International Americas Offshore. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc. INVESTORS IN CANADA: This document is provided by Legg Mason Canada Inc. Address: 220 Bay Street, 4th Floor, Toronto, ON M5J 2W4. Legg Mason Canada Inc. is affiliated with the Legg Mason companies mentioned above through common control and ownership by Legg Mason, Inc. INVESTORS IN AUSTRALIA: This document is issued by Legg Mason Asset Management Australia Limited (ABN , AFSL ) ( Legg Mason ). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client s professional advisers. This material is not for public distribution outside the United States of America. * As of October 31, Western Asset Management Company and Legg Mason Investor Services, LLC, are subsidiaries of Legg Mason, Inc. Legg Mason Perspectives is a registered trademark of Legg Mason Investor Services, LLC 2013 Legg Mason Investor Services, LLC, member FINRA, SIPC MIPX /13 FN