Being a contrarian-minded investor isn’t easy at times—it’s difficult to stay fixed to one’s long-term convictions when the markets may not be cooperating in the short term. Dr. Michael Hasenstab, CIO of Templeton Global Macro, certainly has strong convictions about many aspects of the global economy and markets—and is not afraid to act on them. Speaking at the Morningstar conference in June, Hasenstab outlined the Global Macro team’s strategy and potential opportunities they see within three tiers: developed-market currencies, US Treasuries and emerging markets.
Michael Hasenstab, Ph.D.
Executive Vice President, Portfolio Manager
Chief Investment Officer
Templeton Global Macro
We are currently focused on directional valuation opportunities in three primary areas of the global bond markets: developed-market currencies, US Treasuries and local-currency exposures in emerging markets. These areas offer some profound opportunities, in our view—perhaps the best in decades in some cases.
Our view on the major currency pairs (US dollar/euro, US dollar/yen, US dollar/Australian dollar) boils down to divergences in global monetary policies. The US Federal Reserve (Fed) has already stopped its post-2008-2009 financial-crisis quantitative easing (QE) program and was the first major central bank to tighten policy. By contrast, the Bank of Japan (BOJ) and the European Central Bank (ECB) have been deploying additional QE and expanding their balance sheets. In our view, these central banks are nowhere near a position to do anything other than continue to print money and provide ultra-accommodative policy. Ultimately, these divergences represent the cornerstone of our thesis; the US dollar should re-exert itself against both the euro and yen.
The Fed: Facing a Credibility Problem?
At the beginning of the year, most market observers thought the Fed was going to raise interest rates 100 basis points over the course of 2016; then that expectation quickly collapsed when the Fed reduced its targeted pace of hikes for the year from four to two. In response, the market began pricing in one rate hike or even no rate hikes for 2016. There were even fears that the United States would be experiencing deflation or recession. We do not see deflationary conditions in the United States; in fact, we see more risks of inflation moving higher than lower.
When we evaluate the Fed’s dual mandate of maximizing employment and stabilizing inflation, we see a pretty healthy labor market, one that is getting back to pre-2008-2009 crisis levels, or even getting back to levels not seen since the 1970s. Even wage growth (which operates with a lag) is starting to move higher while underlying inflation pressures remain persistent. From a labor market perspective, we think it is hard to justify maintaining interest rates at zero or to pursue a negative-interest rate policy in the United States. We would argue the Fed should be raising rates sooner rather than later to avoid losing credibility.
By contrast, Europe’s financial crisis trailed the financial crisis in the United States by a couple of years, and Europe’s growth cycle and policy response have likewise been lagging; it makes sense that inflation in Europe has lagged the United States as well. These differences in inflation dynamics should put the Fed in position to tighten before either Europe or Japan, but it appears the markets do not seem to agree with us and do not believe the Fed will raise rates as we believe it should.
Throughout history, central bankers have typically stated their rationale for raising interest rates well before inflation has actually flared up. It seems like the Fed is operating differently today; it is waiting until after it sees inflation. We could then see the long end of the yield curve become somewhat unhinged despite all the financial suppression factors that have been holding it down. The central scenario is a rate-normalization (upward adjustment) will occur, but the more extreme scenario is that maybe that normalization comes in the more distant future. Thus, our strategy has been focused on a short Treasury posture to help protect against that potential risk of higher rates.
China: Why We Do Not See a Hard Landing
A discussion about emerging markets generally requires some view on China. We still believe China is experiencing a soft landing (not a hard landing); there is a structural adjustment taking place that is causing a deceleration in growth but not an implosion. Certainly, areas of the old industrial-based economy are in recession, but counterbalancing support is coming from domestic consumption. These changes in the domestic dynamics are a result of demographic shifts that occurred as the population began to age. When the supply of labor started to drop, wages were pushed up, and that in turn pushed up consumption. People are not consuming more because of a policy-directed stimulus such as tax rebates, for example; they are consuming more because they have more to spend. This has caused some huge relocations in the Chinese economy; it is no longer going to be a huge manufacturing base, but there are positive dynamics from the shifts to the service sectors.
Some analysts believe that China is already experiencing a hard landing and say that official economic numbers showing otherwise are inaccurate. However, wages would not be increasing if the country were experiencing a widespread recession with major job losses, yet wages continue to rise. Additionally, if China’s economy were only growing in the low single-digits (say 3%), we would see greater social unrest. We are not seeing that; rather, we see a thriving service sector, productivity innovations and a growing middle class.
In sum, despite the overcapacity on the manufacturing side in China, which has been contracting, we see a soft landing for the overall economy. China may not be experiencing off-to-the races growth, but it certainly is not experiencing a collapse, as many people often conclude by only looking at the manufacturing side of the economy.
The other pocket of strength in China has been the housing market. This resurgence has raised some questions about a potential bubble forming. If the government overstimulates the housing market on a national level, we would be on the lookout for a correction. However, at this point we think China’s housing market is still in an appropriate acceleratory phase—in the tier-two or tier-three cities—and consumption should be supportive for at least the next year or two.
Emerging Markets: Multi-Decade Opportunities
Emerging markets have probably been the most-hated asset class for the last two years. The J.P. Morgan Emerging Market Currency Index plunged not only through its lows during the global financial crisis, but also through the lows it reached during the Asian financial crisis in the 1990s.1 Part of this was tied to the markets pricing in future Fed rate hikes and part of it was tied to specific crises in some countries. Certainly, Brazil has experienced a severe economic slowdown amid a toxic policy mix that caused the economy to implode. That type of situation coupled with concerns about China caused people to pull their money out of the emerging market asset class as a whole, but in our view, the markets overshot on the downside.
Last year and early this year, I spent a lot of time visiting countries in Asia to see if market valuations