Possible Investment Opportunities Presented by Differentiation Among Regions and Countries

Michael Hasenstab
Senior Vice President, Portfolio Manager
Co-Director of International Bonds
Franklin Templeton Fixed Income Group

KEY POINTS: The global economy is recovering but at different paces-with emerging economies, especially those in Asia, experiencing stronger growth, while developed economies continue to face difficulties. The U.S. economy is improving, and though it continues to face challenges, we believe it has better growth prospects compared with the eurozone or Japan. We believe global financial markets in 2010 will be marked by economic delineation between overleveraged developed economies versus emerging markets, particularly in Asia, that have stronger underlying fundamentals. Successful monetary and fiscal policy stimulus to stave off a global depression has created future risks of excess liquidity, inflation, higher taxes and other negative consequences. The timing of reversing stimulus will present a challenge for policymakers worldwide.

Stronger Growth in Emerging Economies Compared with Developed Economies

The global economy appears to us poised for recovery. Although we believe the rebound in the developed world will be modest, we expect emerging markets to generally exhibit stronger growth in 2010. We believe the longer-term costs of policy measures taken during the crisis (in particular massive fiscal expansion) are likely to manifest in lower future trend growth in developed economies. Conversely, growth in many non-G7 economies such as China, Brazil, Indonesia, South Korea and India may return to trend levels similar to those prevailing before the crisis.

Many emerging economies, particularly those in Asia, were adversely affected by the global financial crisis through a contraction in the demand for their exports combined with a freeze in global credit markets. The impact was particularly severe in small, export-dependent economies. In the larger emerging economies, however, domestic demand remained resilient and could accelerate going forward as a consequence of aggressive monetary and fiscal stimulus policies. The credit channel impairment has eased and emerging markets have generally started to see renewed, large foreign inflows of capital. This should lower the cost of investment and further stimulate growth in the near future. Additionally, as financial inflows translate into an increased capital stock, these countries' labor forces may become more productive. Higher productivity could then lead to higher incomes, which could possibly shift these economies from being heavily export driven toward being more demand driven-an important structural change. Moreover, even if exports to the developed world do not rebound strongly and are no longer the dominant driver of growth, we believe exports are unlikely to be a drag on growth due to the incipient recovery in the U.S. and Europe and the low level they are starting from.

We think robust economic performance in emerging economies will have important implications for financial markets globally. A high growth environment that offers strong returns on investment should attract needed capital. Such capital inflows could potentially favor the assets and currencies of rapidly growing emerging markets. Recent developments have deepened our conviction that Asian and other select emerging economies such as Brazil could likely be among the first to recover due to strong domestic demand momentum. We believe closing output gaps and reduced vulnerabilities may lead these countries' policymakers to tighten monetary policies well ahead of the developed world. However, domestic political pressures create the risk that policymakers may delay necessary tightening measures. Even with delays, policy responses in emerging economies will likely be in advance of what we expect to see in core developed economies. Higher growth could also favor the currencies of emerging economies versus the U.S. dollar, euro and yen as many emerging market policymakers become more comfortable with some degree of currency appreciation to stem inflationary pressure and help rebalance the structure of their economies.

Strong Fundamentals Appear to Underpin Emerging Market Assets

While the faster return to trend growth, the lack of leverage overhang, and new capital inflows have contributed to a meaningful appreciation of asset prices in many emerging markets in recent months, we believe fear of asset price bubbles at present valuations (whether in equity markets, spreads or currency values) are overblown. There are fundamental reasons behind these strong capital inflows; the 2009 rebound in asset prices started from what we consider to be excessively depressed levels, and more importantly, most of these economies should be able to productively absorb even this elevated pace of capital inflows for some time to come in our view. Furthermore, these emerging economies on the whole remain net creditors to the rest of the world, as their current account surpluses and net investment positions indicate. We are cognizant, however, that if emerging market policymakers continue to err on the side of caution and do not tighten policy, allowing their economies to adjust, their economies may become vulnerable to asset bubbles several years from now.

Japan Continues to Struggle

A different situation exists in many developed economies, and we believe Japan's outlook remains one of the most challenging of the large developed economies. Japan's renewed dip into deflation, as the country's consumer prices declined for the 11th straight month in January, supports this view; the Bank of Japan (BoJ) expects deflation to continue through 2010. Japan's extremely weak labor market, which has not produced enough jobs even for its shrinking labor force, keeps domestic demand weak. Indeed, the BoJ has opted for another sizable liquidity injection into the commercial banking system to counter increased risks to growth and greater deflation pressures. This suggests to us that interest rates in Japan are likely to remain at extremely low levels even after the U.S. Federal Reserve Board (Fed) and other central banks eventually begin raising policy rates. In this scenario, the interest rate differential between the U.S. and Japan would increase, and would likely lead the yen to depreciate against the U.S. dollar. Although spikes in risk aversion can potentially give the yen a temporary boost, fundamentals continue to point to significant currency underperformance over the medium term, in our view.

The U.S. Recovery Gets Underway

In contrast, we have seen continuing signs of stabilization in both the labor and housing markets in the U.S. These signs support our view that the U.S. recovery might well surprise on the upside in the first half of 2010 relative to that of Japan or the eurozone economies. Other factors that we think could contribute to higher-than-expected growth rates in the U.S. include the rebuilding of inventories, which should have a positive impact on investment spending with the inventory cycle just beginning; a substantial portion of fiscal stimulus still feeding through the system; and the slowing down of deleveraging by corporations and households, which may generate a positive credit impulse. Moreover, as the pace of job cutting has been extremely aggressive by historical standards-helping push productivity to record high levels-it appears to us quite possible that employment may stabilize. A healthier employment picture could in turn give precious support to consumption. Additionally, while the credit channel remains clogged in the formal banking sector, the nonbank (or shadow banking) credit channel appears to be in better shape as evidenced by growing equity and bond issuance. However, uncertainty remains elevated, and with the U.S. labor market still weak, we believe economic growth may lose steam in the latter part of the year as the push from fiscal policy and the inventory cycle begin to wane.

European Nations Face Difficulties Ahead

The opposite seems true of Europe, where the labor market weakened much less than in the U.S. as many European governments pushed various schemes of partial employment and shorter work weeks to limit job-shedding. Although this may have helped to cushion the blow of the recession, it has helped increase unit labor costs, lower productivity and decrease corporate profitability, leaving little potential for a recovery in employment in the near term. Moreover, we believe the banking sector still poses a risk to the eurozone as writedowns and recapitalization have generally lagged those of the U.S. This led the European Central Bank to reiterate concerns that the supply of credit could prove insufficient as demand recovers. A bank credit squeeze in Europe, which currently lacks a significant nonbank credit sector, would more significantly impede an economic recovery because the European corporate sector has historically depended more on bank lending than corporations in the U.S. Recent developments in Greece have highlighted that internal imbalances are a further risk factor for the eurozone.

Greece has one of the most challenging outlooks in the eurozone. We have generally avoided exposure to this credit thus far because of Greece's weak fundamentals, though we do recognize there is a possibility of a bailout. Greece has been plagued by a persistent lack of fiscal discipline as it has run large deficits over the last decade and failed to meet the criteria established in the Stability and Growth Pact nearly every year since it joined the eurozone. Indeed, the nation has virtually never met all the Maastricht entry criteria for eurozone members. Moreover, Greek statistics have proven to be very unreliable, exacerbating their credibility issue. In addition to wide fiscal deficits, Greece has persistently run large current account deficits. These issues suggest the increasingly unbalanced structure of the economy, and indicate that with extremely high public debt levels, Greece needs to rely heavily on foreign financing. Greece's ability to service its growing debt burden is currently at the forefront of investors' fears. We believe the nation will ultimately have to bring its public finances back on a sustainable path by running a significant fiscal surplus to reduce its debt. Complicating this effort is the challenging political environment in which the government must try to raise revenue and cut spending, even as the economy remains in the midst of recession. It is a hard challenge, and the government's actions so far do not look sufficient to us. Nonetheless, we think it is highly unlikely that the current crisis will result in an exit from the eurozone. While concerns about Greece and other vulnerable sovereigns in the region are likely to weigh on the euro, we think they are not likely to cause a global or even pan-European crisis. Contagion induced selloffs could potentially present what we consider attractive investment opportunities as differentiation among regional credits is high.

Economic Delineation Will Likely Be the Norm in 2010

We believe the contrast between emerging and developed markets will lead to an important theme, economic delineation, in global financial markets in 2010. Decoupling was a popular thesis heading into the global financial crisis, and it was debunked by the violent recoupling of all risky assets during late 2008 and early 2009. During the initial stages of the recovery, the high correlation between risk exposures persisted. Moving forward, however, we believe it will be increasingly important to differentiate between economies with strong underlying fundamentals and those that are still vulnerable to their difficult economic positions. Overleveraged credits such as Dubai World and Greece are early stage examples of this differentiation trend. In contrast, better balanced economic conditions have allowed developed markets such as Australia, Norway and Israel to already begin to tighten monetary conditions, while emerging markets such as China have exhibited double-digit growth in the fourth quarter of 2009. Assessing individual countries' fundamental growth and inflation outlooks will therefore provide important guidance toward our positioning in global interest rates and currencies. In particular, we would expect Asian currencies to be supported over the medium term against the G3 (the U.S., eurozone and Japan), in light of the Asian region's far stronger economic recovery in 2009 and early 2010.

While the U.S. currently faces a worsened and difficult fiscal situation, its growth prospects compared with the eurozone and Japan look better to us and are likely an important asset. We believe this should help the U.S. dollar reverse its 2009 weakness against a variety of other major currencies. The potential recovery of the U.S. dollar against other major currencies, generally driven by stronger confidence in the sustainability of a U.S. recovery, would be consistent with healthy levels of risk appetite in the global financial markets. In other words, we see a breakdown in the inverse correlation between the dollar and risky asset prices, which has dominated much of the crisis period. We believe that once the global economy stabilizes, the U.S.'s recovery appears more advanced than in Europe or Japan, and the Fed nears the stage where it will be able to raise interest rates, the U.S. dollar should no longer be seen as a safe haven in times of stress and a funding currency in times of optimism.

Indeed, we continue to believe that healthy levels of risk appetite are justified by the general growth outlook in emerging markets described above, particularly in Asia. China has continued to lead the way, as its sufficiently buoyant growth momentum has led policymakers to implement some measures to cool the economy. Even as a few countries' policymakers have recently started to temper the massive expansion of credit, the staggered nature of this credit expansion implies its impact will likely continue well into 2010 and 2011. More importantly, strong productivity growth has historically driven the great majority of economic activity. While at the margin, nonproductive investments and speculation do occur, such activity has remained well in the minority. We believe if global policymakers can pull back excess liquidity in a measured but consistent manner throughout 2010, it should help limit the creation of future bubbles.

The Risks Created by Unprecedented Worldwide Monetary Policy Easing

Although global growth prospects look positive in aggregate to us-better-than-expected economic performance in emerging markets balanced by subtrend growth in G3 economies-we see risks to future global economic activity. Many policymakers deserve a great deal of credit for timely and significant monetary and fiscal stimulus that avoided a repeat of the Great Depression. However, the massive easing of monetary policy has created a glut of liquidity. Current comments by central bankers that this liquidity does not create inflation given that bank credit channel remains impaired are correct, in our analysis, if in aggregate the money multiplier (i.e., the total amount of loans commercial banks extend expressed as a multiple of reserves) remains low. However, if this massive amount of liquidity remains in the system until the point when the credit channel fully opens, we believe inflation will be inevitable. This risk could remain prevalent well into the future, and we think it must be closely monitored. Historically, when actual growth exceeds potential growth it creates inflation; thus, if the developed world's potential growth rate has structurally shifted lower, the threshold for inflation may arrive sooner than in past cycles.

Fiscal policy also presents a significant risk, in our opinion. While countercyclical fiscal spending was necessary at the height of the crisis, a permanent expansion of record deficit spending will have seriously negative economic consequences. The higher tax rates necessary to fund all this spending will likely inhibit growth and distort economic activity. Additionally, consumer and corporate concerns over unsustainable deficits and the likelihood of a higher future tax burden could cause a pullback in spending and suppress economic activity.

The Potential Challenges of Timing Monetary Policy Easing

In our view, the timing of reversing monetary stimulus remains one of the largest challenges for policymakers globally. Many political interests are lobbying for the delay of such monetary tightening, and in many countries, central bank independence has come under great strain.

We observe this challenge most pervasively in emerging markets. If policymakers remain committed to monetary independence, open capital accounts and exchange rate flexibility, the large capital inflows of 2010 could present significant policy challenges. If policymakers delay raising interest rates due to a fear that this will lead to currency appreciation, then we believe goods and asset price inflation can become a serious risk. If policymakers raise interest rates consistent with stronger economic activity, exchange rates are likely to appreciate. If policymakers attempt to stem capital inflows by imposing capital controls, we believe much of the progress of economic liberalization and reform of the past decade will be lost.

However, given the largely undervalued exchange rates in many emerging markets coupled with strong productivity-led economic activity, we think policymakers have a nice cushion. Gradual exchange rate appreciation can help fight imported inflation as moderate monetary conditions help stem the risk of asset bubbles. This could, in turn, prevent capital from being misallocated to exporters who lack fundamental competitiveness and only remain in business due to an undervalued exchange rate. A simultaneous pullback in extraordinary fiscal expansion can also help sound debt conditions remain intact and serve to temper inflationary risks, in our view.

Key Themes for Our 2010 Global Bond Strategy

All the conditions discussed above combine to provide those fixed income investors willing to look globally with several of what we consider to be attractive investment opportunities. Thus, our global bond strategy has us invested generally along the following broad themes as of 19 March 2010:

• No exposure to U.S. Treasuries, Japanese government bonds or UK gilts
• Exposure to many emerging market currencies and those of certain lower-deficit developed markets
• Exposure to some spread sectors that we believe are positioned to potentially benefit from healthy economic global activity in 2010
• Exposure to some commodity-based currencies as long-term inflation hedges
• Negative exposure to the Japanese yen and euro to position for relatively weaker conditions in these two economies versus that of the U.S.

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