Finding fixed income opportunities in new paradigm

Glenn Freeman  |  02/08/2017Text size  Decrease  Increase  |  

Vincent Reinhart: The big picture, just stepping back, that just about everyone should appreciate about the economic landscape is, in advanced economies potential output growth is slowing.

We are older populations; we are growing less quickly; we are participating less in the organised labour market and we are not adding as much extra output for each extra hour worked. That's slowing.

We are also slowing not just over time but relative to emerging market economies. There is growth out there. It's in China; it's in India. The relative footprint of emerging market economies is growing relative to advanced economies. 30 years ago, we were talking closer to under 40 per cent. Now, we are talking about 60 per cent of world real GDP takes place in the places we call emerging markets.

So, there's a couple of aspects of that major force potential output growth slowing. One of it is as EM gets bigger, they need us less. And so, in the 2000s, emerging market economies were running very large current account surpluses, i.e., they were buying the securities of advanced economies. That's allowed us to run current account deficits, i.e., bringing in more goods and services than sending out, means you have to be increasing IOUs.

What's happened over the last couple of years is, emerging market economies current account surplus has moved into deficit. They are funding themselves, not us and that's a problem for advanced economies over time because we still have large levels of government debt, we still have deficits. Advanced economies as a total are running budget deficits of 2 per cent to 3 per cent, relative to their gross domestic product. That means they got to sell those securities to somebody, less so to emerging markets than before.

So, obviously, it's a losing proposition to make forecasts about currencies, but there are some basic forces at work that may at least give you a sense over the medium and longer-term where currencies should go.

And again, it goes back to that feature – advanced economies growing more slowly than emerging market economies. If your potential output growth is slower, real rates are lower, too, because how fast your potential output growth is, determines the profile of how fast households think their future income will grow.

If you expect your income to increase less, you should save more. Firms, profile of expected future earnings, if they expect less earnings in the future, they should invest less. Market outcome, more savings, less investment, lower real rates. So, that's lower real interest rates in advanced economies, higher real interest rates in emerging market economies.

That's a recipe for secular appreciation in the exchange rate of the emerging markets relative to advanced economies. We think in terms of the US dollar, mostly the depreciation, we've seen in the last couple of months against the centers, Europe, Japan are behind us. We move sideways. There's still a little scope for the dollar to depreciate against emerging market economies. It's where real rates are higher and it's where there's more scope for delivering better policy.

When you're talking about credit, you are also talking about careful. You have to be selective. And that's importantly, because a lot of the opportunities have already been eroded away.

Risk spreads whether for high-grade corporate or high-yield corporate, have shrunk a lot. Risk spreads in emerging market sovereigns have shrunk a lot. And so, there are still some spreads out there but you have to be really careful.

You have to be selective. We think looking at current valuation, there's probably better values relatively in US high-yield than in corporate. When you're talking about high-yield, you have to be selective.

I always go back to this same point. Potential output growth is slowing? How come? Advanced economies had aging populations, participating less and less in work. That means that those people as investors have to appreciate that they need a more secure set of returns. And so, fixed income should be an increasing proportion of a portfolio as you get older, because you want to be able to have a more predictable stream of future income.

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