It’s tough to be patient in an age of instantaneous communications and instant gratification. We all want immediate answers to our questions and quick fixes to our problems. When it comes to real world tangles like the global economy, though, Chris Molumphy, CIO of Franklin Templeton Fixed Income Group®, reminds us that patience, not a magic pill, is the order of the day when it comes to European and U.S. struggles to cure their economic ailments. He’s realistic about these problems—but isn’t waiting to act where he does spot investment opportunities.
The European Central Bank (ECB) and the U.S. Federal Reserve have been firing a number of monetary policy bullets to jolt their respective economies, but investors seem to have grown impatient with what is widely regarded as sluggish economic recovery. Molumphy puts the challenges both the U.S. and Eurozone have been facing in perspective. [php function = 1]
His key opinions, in brief:
- We’re very concerned that the inability of the U.S. to deal with its debt problems could negatively impact the markets sooner rather than later.
- Monetary policy is important and can be effective in the short term, but is not designed to work over an extended period of time.
- Growth in Europe is anemic at best; it’s flat to slightly negative currently, and we don’t see much growth at all in Europe over the next couple of years.
- Broadly speaking we currently see opportunities in the fixed income marketplace in three areas: corporate debt securities, municipal bonds and global fixed income.
U.S. Obstacles and Progress
“The U.S. went through a very severe recession coupled with a financial markets crisis, so expectations for growth both today and even going forward should be muted a bit, but there are some positives. It appears the housing market has finally bottomed and is gradually improving, and the consumer has done a reasonably good job in deleveraging over the past several years and is showing signs of better health. So our expectation is that the U.S. economy should in fact continue to improve, but likely at a below-trend rate.”
Having said that, Molumphy is very concerned about the debt situation in the U.S., which is on track to record its fourth $1 trillion-plus deficit in the fiscal year ending in September.
“We don’t see any end in sight. There is simply no credible plan right now to reduce this deficit on a go forward basis. So, while we don’t necessarily see this as being an immediate issue, we are very much concerned that this lack of ability to deal with a very serious debt problem will negatively impact the markets, and it could be sooner rather than later.”
Can the Fed save the U.S. economy? Molumphy says the Fed has been providing some life support, but monetary policy actions taken over extended periods of time tend to have diminishing returns. And, there’s s a price to pay when these policies are eventually retracted.
“As monetary policy gets extended, we increasingly run the risk of a negative impact when it has to eventually be retracted from the economy. At some point we will have to pull back this $2-$3 trillion in accommodation and unless it is pulled back in effectively and efficiently—which history would tell us it’s not easy to do—then we run the risk of having negative consequences both on economic growth in the U.S. and likely in the form of higher interest rates long term. Monetary policy is important and can be effective in the short term, but is not designed to work over an extended period of time.”
Europe’s Obstacles and Progress
Europe faces some similar problems. The ECB’s recent announcement of an unlimited bond buying program has provided support for the survival of the euro. At least Europe seems to be addressing its debt issues, although perhaps not as fast as many investors might like.
“Growth in Europe is anemic at best; it’s flat to slightly negative currently, and we don’t see too much growth in Europe over the next couple of years. In many ways, the European situation appears to be broadly mirroring what we see in the U.S. but lagging by a few years. That doesn’t mean there aren’t investment opportunities there in some areas, but investors need to do their homework.
On the debt situation, Europe is really still in triage mode, if you will, with the ECB coming in and effectively announcing a backstop for sovereign debt. We think it’s probably a necessary evil and that things are generally going in the right direction, but we certainly don’t see a good deal of debt reduction in the foreseeable future in Europe.”
Fixed Income Investment Opportunities
That all being said, Molumphy currently sees potential opportunities in three key areas of the credit spectrum: corporate debt securities, municipal bonds and global fixed income.
“Broadly speaking we see plenty of opportunity in the fixed income marketplace, one area being corporate debt securities, including investment-grade, high-yield and even leveraged bank loans. We like the fundamentals with respect to corporate credit. By and large we are finding that companies are reasonably lean in terms of their operations, have built cash on their balance sheets, and have taken advantage of the low-rate environment, refinancing and extending debt maturities out into the future.
“We are also favorable on the fundamentals for municipal bonds, despite some of the dire headlines that individual cities garner because that’s what makes news. As we see it, the vast majority of states, cities and local municipalities have done a pretty good job over the past several years in dealing with budget issues. They’ve made the hard decisions–cutting expenses, looking where they can reduce overall expenditures and even tackling some of the thorny pension issues. It’s somewhat ironic that we’ve been doing this at the local level, but really haven’t made any progress at the federal level in the United States.
The third category would be global fixed income. We talk about low growth and low interest rates, and while that’s the case in much of the developed world, when we look outside of that, we see regions and countries including Asia, Eastern Europe and Latin America where we’re finding higher yields, better economic growth prospects, financial houses more in order, and the potential for currency appreciation. We think global fixed income continues to provide potential for one’s overall portfolio, but particularly in this environment.”
Overall, the picture Molumphy paints isn’t bad as long as you’re not looking for a quick fix.
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What are the Risks?
All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. When interest rates rise, bond prices fall, and the converse is true. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.
Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. In general, an investor is paid a higher yield to assume a greater degree of credit risk.
Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.