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US growth moderate yet steady as global growth, inflation downshift

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US growth moderate yet steady as global growth, inflation downshift

Market conditions continue to favor fixed income spread products.

Western Asset Management’s Chief Investment Officer Ken Leech expects continued U.S. economic growth that will be solid if unspectacular; struggles and deflationary pressures for Europe and Asia; and emerging markets challenged by falling commodity prices, particularly oil.

That global economic outlook – along with a strengthening dollar, continued prospects for accommodative U.S. Federal Reserve policies and the S&P 500 having reached all-time highs – have combined to create a favorable environment for investors in fixed-income spread products.

"We believe combining spread products with the opportunistic use of duration remains compelling."

"We believe combining spread products with the opportunistic use of duration remains compelling," Mr. Leech advises.

Mr. Leech and the Western Asset team have been steadfast in their contention that the path of the U.S. and global recovery would be a long one.  Thus the firm's diversified investment strategies have performed well in 2014.  Mr. Leech believes they are likely to continue to be appropriate in 2015, as the U.S. recovery retains its moderate pace of roughly 2-2.5 percent growth.

"A constructive investment environment needs elements of attractive valuations, economic growth and supportive liquidity conditions," Mr. Leech writes.  "Our view is that the U.S. now enjoys all three elements."

"Valuations are attractive as spreads remain somewhat elevated.  The U.S. economy should continue to grow at a moderate pace.  The Fed, while moving away from the emergency policy engendered by the crisis, intends only to inch the funds rate slowly above zero, a process not expected to begin until the middle of next year.  The combination of all these factors strongly suggests spread sectors should outperform U.S. Treasuries."

As for the international outlook, Mr. Leech writes, "The global economy has moved a long way since the crisis.  While the recovery has only been one of moderate growth, it is still nearly six years old, and the systemic risks have been severely reduced.  Monetary policy continues to be very accommodative ... Some estimates suggest an improvement of as much as 0.5 percent."

Other key points include: 

  • U.S. spread products have not kept pace with equities.  Yield spreads have widened moderately since late June, and are now roughly back to where they started the year.
  • Western Asset continues to lean on the benefits of opportunistically using additional U.S. duration in conjunction with spread assets to provide crucial portfolio ballast.
  • Global crosscurrents have cut into spread products even as the economic storylines remain favorable.
  • Global inflation is shifting downward and the U.S. dollar is gaining, which is producing a favorable backdrop for U.S. Treasuries.
  • For the developed world, the decline in energy prices should provide a boost to growth.
  • The low interest rate backdrop is favorable: rates have declined meaningfully worldwide.  These factors could form the base for a more positive growth backdrop next year.
  • Mr. Leech believes the risk to the Western Asset outlook can come from one of two directions, and one important reason for today's elevated spreads is that both are at play:
    • Stronger economic growth, which is traditionally beneficial for spreads sectors, may accelerate the path of Fed interest rate increases. 
    • Weaker economic growth, perhaps caused by a more pronounced global downturn, might undermine the recovery picture and cause spread sectors to widen sharply.


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