Opportunities in Currencies and Sovereign Credit

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

Almost five months into 2009, it is becoming increasingly clear that many economies are going to suffer a long and protracted slump. The International Monetary Fund (IMF) has recently predicted that the world economy will contract 1.3% this year, marking the first shrinkage in world growth in 60 years. Although the news is not the best, the major dislocations we currently see are offering important opportunities for active investors such as ourselves.

One area of activity we have been following is currencies, particularly the U.S. dollar. There has been a rush by many banks and companies to repay U.S. dollar-denominated debts. The result has been a temporary boost in the value of the U.S. dollar. However, we are not convinced that the dollar's rise in recent months represents a classic flight of quality. In fact, in January, even as the dollar was rising against the currencies of the U.S.'s main trading partners, foreigners were actually net sellers of U.S. assets and U.S. Treasury bond yields rose.

There are a number of factors that traditionally would be negative for the U.S. dollar. These include the massive expansion of the Federal Reserve's balance sheet, the highest level of fiscal spending since World War II, and the nationalization of many financial institutions.

Simply put, the large-scale deleveraging that is taking place has delayed the dollar's decline, although we believe that this scramble for dollars is coming close to an end.

In the current circumstances, we think there is a strong argument for a weaker dollar.

Policy decisions dealing with the financial and economic crises have not necessarily been wrong-but they could potentially pose long-term challenges for the U.S. economy and dollar, including long-term inflation issues.

Middle-income economies have seen their currencies decline against the U.S. dollar to a degree not justified by fundamentals, among them the South Korean won and Mexican peso. But circumstances have changed since crisis struck emerging markets in the late 1990s.

Back then, the ratio of currency reserves to external debt was minimal. Now, countries like Mexico and South Korea have strong reserves relative to short-term liabilities. Yes, these countries are facing stresses, but we believe the markets are confusing stresses with the risk of default. As a consequence, in the past couple of months, we have begun to un-hedge our currency positions in these countries as part of our global fixed income strategy.

Similarly, we believe the widening of sovereign credit spreads is not justified by fundamentals. Many countries are facing important challenges, but their sovereign credit issues are being priced at distressed levels, while countries' balance sheets appear to us to be quite healthy.

For example, Indonesia is expected to record a decent rate of growth this year (perhaps 3% to 4% according to Indonesia's central bank), because it has minimal external debt and has built up a decent level of foreign reserves-yet its sovereign debt is trading at distressed levels.

Please click for more information on the following funds:

FTIF - Templeton Emerging Markets Bond Fund
FTIF - Templeton Global Balanced Fund
FTIF - Templeton Global Bond (Euro) Fund
FTIF - Templeton Global Bond Fund
FTIF - Templeton Global Income Fund
FTIF - Templeton Global Total Return Fund