Western Asset: PM Exchange Highlights

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Pasadena, CA, April 29, 2024 — Western Asset hosted its latest PM Exchange webcast, sharing insights and opportunities across sectors of the fixed-income market. The webcast, titled “Positioning for Potential Outcomes in the 2024 Post-Cash Era,” covered a broad range of topics including implications of the recently published inflation numbers, upcoming global elections, potential Fed rate cuts and the various economic scenarios that might ensue in 2024. Additionally, the panel members explained why they believe we are now in the end-of-cash era, and where they see opportunities for putting cash to work, especially focusing in on Emerging Markets.

The panelists included:

  • Michael Buchanan, CFA, Co-Chief Investment Officer (CIO), who also served as the webcast’s moderator;
  • Bonnie Wongtrakool, CFA, Global Head of ESG Investments and Portfolio Manager;
  • Annabel Rudebeck, Head of Non-US Credit; and
  • Kevin Ritter, Interim Head of US-Based Emerging Markets Team.

Celebrating more than 50 years in the business, Western Asset is one of the world’s leading fixed-income managers, leveraging a consistent philosophy and process since 1971. The Firm managed $388 billion for institutions and individuals on six continents as of December 31, 2023. Western Asset is a specialist investment manager of Franklin Templeton.

Commenting on the outlook ahead for fixed-income, Michael Buchanan, Co-CIO, said:

“We recognize that much of the inflation data year-to-date has been coming in somewhat hotter than what we and the market anticipated. However, we do expect that some of the marginal drivers of these more recent inflation prints should begin to taper out over the next few months, and that should keep the potential for rate cuts alive for the balance of the year. From a broader perspective, we continue to view the inflation picture as much better today than it was 18 months ago, which ultimately should allow many developed market central banks to pivot from what we deem to be currently restrictive monetary policy to something closer to neutral, or perhaps even accommodative. Overall, we believe the current backdrop for fixed-income is still very favorable.

Recent trends in investor behavior point to overwhelming interest in cash or cash-like investments, with many measures showing cash-like investments at or near all-time highs. The sentiment is understandable considering the challenges to not just fixed-income, but all asset classes, in 2022. Given today’s market environment and fixed-income valuations, we think that cash is not always going to be king, and today may be a good opportunity to put some of that cash to work.”

Commenting on inflation, the Federal Reserve, and reasons to move out of cash, Bonnie Wongtrakool, Global Head of ESG Investments and Portfolio Manager, said:

“We have seen inflation numbers coming in somewhat higher than expected, and that’s resulted in the market pricing in less than 50 basis points of cuts this year from the Fed, with the first cut now expected in the fall. The Fed’s view has been the same as ours, which is that inflation is moderating, not in a straight line, but in the right direction. On the growth side, one factor that’s giving the Fed comfort is labor supply. Immigration into the United States has been strong, and that’s enabled the job market to be very resilient while inflation is still slowing. We have seen wage growth coming off the elevated levels that we saw post-Covid, running around 3.5% to 4%, which is close to the Fed’s comfort zone. While the Fed has made it crystal clear that they are not in any hurry, we do believe that their next move will be a cut sometime in the second half of this year.

There’s about $6 trillion in money market funds right now, and I’ll give three good reasons to move out of cash. The first reason is that it is very rare for cash to be the best-performing asset class, and it’s even more rare for cash to be the best-performing asset class multiple years in a row. More often than not, cash is actually the worst-performing asset class, and in comparing the performance of cash to other asset classes over the past two decades, cash was actually the worst or the second-worst performing asset class half of the time.

The second reason I would give is that, historically speaking, when the Fed moves into an easing cycle, fixed-income traditionally outperforms and cash significantly lags. It is possible that the Fed pauses after it cuts later this year. Looking at history in this scenario, investors have realized attractive returns on a bond portfolio that is diversified like the ones we manage at Western Asset.

The third reason I would give, which is equally important, is that fixed-income as an asset class does provide valuable diversification in an investor portfolio versus other asset classes. We did see negative correlation between equities and bonds break down in 2021 and 2022, but those were periods when inflation was surprising significantly to the upside. I would say we’re more in an environment today where inflation is below a key level of 3%, and historically speaking, that is when there have been good negative correlations between equities and bonds.”

Commenting on the European Central Bank and inflation scenarios, Annabel Rudebeck, Head of Non-US Credit, said:

“Western Asset’s base case outlook for the rest of 2024 focuses on a growth picture that is resilient but slowing—particularly in Europe—yet not recessionary. On inflation, it’s a little bit more complex, but we think we’re well away from those double-digit inflation numbers we’d experienced in the past and we’ve likely reached a peak in rates. So, the question now arises around the timing and the magnitude of rate cuts.

As we look at the challenges facing the ECB relative to those of the Fed, we’re seeing European growth at basically 0% and inflation at 2.4%. There are plenty of signs of strain and need for stimulus within the system, and a lot of the conversation at the moment is about why the US is doing so very well while productivity is seemingly failing dramatically across Europe and the UK. We and the market expect the ECB to move ahead of the Fed and almost certainly to move this year. There’s no real reason for them not to.

We consider different scenarios. We have an optimistic scenario where growth picks up in the US and China with domestic demand improving in Europe. If inflation were to come down lower at the same time as a calming of geopolitics, that would be an extremely supportive environment for fixed-income generally, and particularly for the credit parts of the market. In that environment, there would be a propensity to see tighter credit spreads. As we move to more negative scenarios, like a harder landing in the US, we’d expect to see credit tightening up across the board. That would be a good environment for much of fixed-income, but probably less so for credit products. And then there’s the scenario where inflation remains elevated or even rises with a weaker growth backdrop. That’s an environment when a lot of asset classes may struggle.

We’ve seen a very healthy and much improved corporate market, both in high-yield and in investment-grade. Corporate treasurers and CFOs are still in a very defensive mindset and have focused on liquidity, terming out debt profiles and making sure that financing needs were very well managed. That’s been a very positive development in our market. We also see companies with big capital structures recognizing that it’s very useful to keep credit ratings higher so they can access that liquidity again at times of need. It’s a similar story for the banks, as they are preparing to adhere to new regulation. I think we’ll see higher ratings there also over time.

Of course, there can always be a better entry point for corporate securities, and if investors have the patience, it may be a good idea to wait. The question is when that time is going to come. It’s not just a discussion about spreads, it’s also about yields. And today, investors are seeing 5.5% on investment-grade income and 8% or so in high-yield. That’s a very nice amount of income to get following an environment that we had before Covid.”

Commenting on the outlook for fixed-income in emerging markets, Kevin Ritter, Interim Head of US-Based Emerging Markets Team, said:

Western Asset’s medium- to longer-term view on emerging markets is that there’s a very interesting confluence of fundamentals and valuations that is creating an attractive backdrop for emerging markets broadly. Because emerging markets were first to hike and were very proactive in raising rates, inflation has come down meaningfully in a lot of the emerging market countries, and some have even started their easing cycles.

We’ve seen some attractive returns towards the back half of 2023 and into 2024, we think there’s still further room for compression for a lot of these emerging market trades. For emerging markets to perform, investors don’t necessarily need to see Fed cuts. For the better part of 2022 and in 2023, many emerging market borrowers were basically frozen or shut out of the capital markets. We think the thawing in emerging markets is an important development that will propel this trade into 2024.

Typically, the six-to-18-month period after the last Fed hike is when investors see very strong returns in the emerging market sector. We think history is going to be a good gauge here, and emerging market valuations are certainly more attractive both on a historical basis and on a relative basis, vis-à-vis other asset classes. Within emerging markets, it’s obviously a very diverse, heterogeneous type of asset class. So, the way that we approach emerging markets is that we think beyond benchmarks, and we tailor solutions for client needs and spots that we find attractive.

We find investment-grade-rated emerging markets attractive, where you can currently realize about 150 to 200 basis points over Treasuries, which is about two times that of the US investment-grade market. We’re also finding value in frontier markets, or what we call “next-generation” emerging markets. We’ve also been very active in “emerging market-currency supranationals,” where investors are able to get emerging market currency and rate exposure in the wrapper of a triple A rated security.

One region of interest is Latin America, and we see compelling opportunities in Mexico, where local Mexican Treasuries trade at 9.5% to 10.5% with an inflation rate that is currently sub 4.5%. The Mexican central bank has done an admirable job fighting inflation and started their easing cycle last month. These factors, combined with tailwinds from friend-shoring or diversification of supply chains, are going to make for a very attractive carry trade in Mexico. We think that’s quite an attractive allocation for portfolios over the course of 2024.”

This information does not constitute investment advice. Market and currency movements may cause the capital value of shares, and the income from them, to fall as well as rise and you may get back less than you invested.

The information contained in this document has been compiled with considerable care to ensure its accuracy. However, no representation or warranty, express or implied, is made to its accuracy or completeness. Franklin Templeton and Western Asset Management have procured any research or analysis contained in this document for its own use. It is provided to you only incidentally and any opinions expressed are subject to change without notice.

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security, or fund, or to adopt any investment strategy. It does not constitute legal or tax advice. The views expressed are those of the author and the comments, opinions and analysis are rendered as at publication date and may change without notice.

The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. The analysis of Environmental, Social and Governance (ESG) factors forms an important part of the investment process and helps inform investment decisions. The strategies do not necessarily target particular sustainability outcomes.