OREANDA-NEWS. January 18, 2016. While the U.S. Federal Reserve has moved its funds rate off zero for the first time in eight years, the path toward normalization will be full of fits and starts thanks to dovish Fed policy, low inflation and slower than expected U.S. economic growth.

That was a big theme of Western Asset Management Chief Investment Officer Kenneth Leech's quarterly market update webcast, but he pointed in another direction for investor opportunity.

"Ultimately with markets beaten up as much as they have, the real opportunity, the real thrust of our risk budget system, is spread product sectors," Leech said. "We really think that earning the higher yield in spread products instead of governments is going to be the best and most fruitful strategy. It gives us the best opportunity set and continues to be our strongest theme."

"Hopefully the picture we've painted of moderate but sustainable growth suggests monetary policy is going to be very accommodative across the globe. That is crucial for the ongoing global recovery. We expect to see Europe, Japan, China continuing to be extremely accommodative."

"In the United States we expect the Fed to be very thoughtful and cautious before raising rates, to the extent that they wait for actual inflation as opposed to expected inflation," Leech said. "This new downshift means that interest rate normalization, in this 'two steps forward, one step back' process we have been living with over the last five years … interest rates will eventually normalize, and move up. Unfortunately this is going to take more time than we thought."

Leech predicted the Fed is unlikely to raise rates as steadily as some market watchers expect.

"The data will not be moving sufficiently far from the Fed's forecasting to get them to change policy over the first quarter," he said. "But if our forecast plays out, the possibility that we see something like only one or two hikes this year instead of four is much more likely."

The Fed's decisions will rely upon U.S. and global economic data, according to Leech.

"The Fed's forecast is that inflation will slowly but surely move up as growth comes in above trend – roughly 2.5 percent," Leech said. "The Fed expects to raise rates slowly but surely. We heard Stan Fischer yesterday talking about a base case of more tightenings over the next 12 months. It's a possibility the market is a little bit skeptical will play out the way the Fed thinks."

"The other possibility is that lower oil prices, a strong U.S. dollar and weak global growth will keep that inflation rate under pressure. Then the pace of Fed tightening might be less."

"We expected the Fed to go in December," Leech reinforced. "We expect the Fed to stay on pace until data show they might need to change. We do expect them to move in March because we don't think U.S. data will have changed that much, and they've been very clear that they are going to be primarily focused on the U.S. But our forecast for growth in the U.S. is more on the order of 1.5 percent, rather than 2.5 percent. We think inflation is going to stay pretty subdued."

"Inflation is driven by excessive growth in nominal GDP," Leech said. "We just don't see that. Inflation is not only not moving up, but it's actually been moving modestly down. While we see that the Fed, in conjunction with a stronger labor market, wants to move … We think they will be very cautious in moving the funds rate. They should be very cautious."

"I would be pretty optimistic about the way that the Fed is managing things."

The environment has caused the Western Asset Management team to be careful in its strategies.

"Downside risks are very much in the fore," Leech said. "That means that when we look at our portfolio, even as we see the Fed about to tighten, we need extra risk management against the possibility that the global picture will actually spill back into the U.S. and cause challenges."

"So our portfolio, which is overweight spread product, also has extra government duration. We are not hedging our below-investment-grade high yield."

Western Asset Management has adopted more defensive strategies to manage its investors' risks.

"We needed to have some macro strategies, particularly long-duration positions, to manage the portfolio if in fact our base case – which continues to be that moderate growth both in the U.S. and globally will be sustainable – in which case non-Treasury, non-sovereign bond sectors can outperform very meaningfully," Leech detailed. "Should that not happen or should downside risks accelerate, we need to have some portfolio ballast."

"The good news for us and our broad accounts was that we basically took out this kind of insurance. The bad news is we needed it."

The uncertainty is likely to persist as long as fears of inflation continue to roil global markets.

"When people talk about interest rates being in a bubble or being too low, what they're really saying is that inflation is too low," Leech observed. "That in fact might be right. We've actually had a meaningful downshift in inflation. With uncertainty coming out of China this week and certainly weaker oil prices, the risk of inflation going lower have actually increased."

"We all know the story of the drivers from the commodity side," he said. "It's not just oil, it's very widespread. This suggests a continuation of the story we've been seeing, that global demand is just not robust enough in the face of an oversupply of commodities."

Leech also discussed "the elephant in the room, which is Chinese growth."

"China has let their currency fall against the developed market currencies, particularly the U.S. dollar. We'd like to have certainty and clarity. The growth rate is going to continue to slow; this process, given the amount of stimulus that is going to be used by the Chinese government, it's going to be manageable. Growth is going to come in somewhere in the 6-to-6.5 percent range that they have been expecting, but this is going to be part of a very long transition process away from a manufacturing investment-led economy to one that is more consumption-based. That has pretty broad implications for other emerging markets, in particular commodities."

"Given the fact that the Chinese government has basically signaled very strongly that they will let the currency move, I think that does increase uncertainty," Leech emphasized. "The opacity of data there and trying to understand the Chinese economy means that at a minimum, we have to be open to the possibility that growth could be even weaker than we suspect."

"That concern is part of the reason why spread product and equity markets around the world are much weaker over the last couple of days," he said. "You can see the very tight correlation with commodity prices and emerging-market currency regime. So the possibility that China's slowing and that their currency may be weakening is obviously going to put quite a tremendous amount of pressure on those areas. That again leads to the reevaluation of the possibility that global growth will be even weaker. So this downshift in global growth, the possibly it is downshifting again, I think that uncertainty is really what's roiling the markets at the moment."

Turning his attention to Europe, Leech said, "This is a positive story. You'll remember we had a tremendous fear of Europe last January. The story has kind of gotten out of the front page, but the growth rate in Europe, in our view, is going to be close to 2 percent this year."

"You've finally gotten traction in terms of the financial – the loans, the household and non-financial corporations. You can use money supply and other credit metrics but … the contraction in credit late in 2013 and early 2014 that got [European Central Bank ("ECB") President Mario] Draghi to be aggressive in getting the European community to back a very ambitious Quantitative Easing ("QE") program has started to bear fruit. We think the ECB will continue to be very accommodative. Obviously the ECB has an inflation mandate, which gives them a very strong incentive to maintain a very accommodative policy."

Transitioning to emerging markets (EM), Leech announced, "This is an area that has been extraordinarily challenged. When we look at the emerging markets outlook we see moderate or weakening global growth. We see weak commodity prices, the possibility of a Fed hiking and we can obviously build a very negative outlook. We are very cautious on emerging markets."

"However, the challenge is that markets always are very good at pricing in the forward case," Leech commented. "So markets have been under unbelievable pressure. The spread between local currency and sovereign yields, the developed market and EM yields, are back to a crisis high. That's in conjunction with currency developments of just horrendous pounding last year on the orders of something like negative 15 percent across the board."

"Obviously, this is a heterogeneous asset class. You have to be very selective about countries to invest in. Even though the outlook has weakened and the downshifting in the growth outlook in the summer challenged us to reduce our EM exposure and put in some hedges, over long periods of time, I want it to be very clear that the demographic thrust of stronger growth rates, lower debt loads and better demographics suggest this is an area you do not want to abandon."

"I think that with these kinds of valuations, the opportunity set here is pretty pronounced," Leech advocated. "Two areas we've liked most is Mexico, which has performed pretty poorly in line with some of the fears we've seen, and the other being India. Neither of those are as exposed to oil prices, specifically, as some other countries, but you have to be very cautious in the EM space. Obviously, we have position sizes that are appropriately small. With valuations this challenged, our suspicion is that valuations have overshot, as many spread markets have."

Leech went on to say that U.S. credit markets have been in a bear market since mid-2014.

"This has been an ongoing headwind that's been pretty pronounced, and obviously accelerated last year pretty meaningfully in the credit space," he said. "U.S. investment-grade credit, but particularly U.S. high-yield – really, really beaten up as the fears of downward global growth, but particularly the energy and commodity-related spaces have picked up pretty significantly."

"We think investment-grade corporate bonds are really attractive. We're not looking for huge spread compression, but pricing is very fair. Corporate bond spreads – especially long corporate bond spreads – have gotten near the 2002 and 2011 peaks, a recession in the first case and fear of a meaningful recession in the second. Pricing in the corporate bond space certainly has been way in front of challenges in the equity market. Historically investment-grade corporate defaults have been, over long periods of time, a reasonably constrained number, pretty de minimus."

"Liquidity is meaningfully challenged in today's market, much more meaningful than a year ago," Leech observed. "But when you look at the actual amount of defaults you'd have to have if you were a buy-and-hold investor of investment-grade, versus holding Treasury bonds, that number is north of 9 percent. It's way north of any reasonable expectation of defaults."

"I think we all understand, in the world we're living in, with risk aversion being very high, why government bonds are so sought globally. But from our perspective, corporate bond spreads are pretty comfortable. The most important thing about investment-grade is not the overall spread; it's really where you position yourself in the market. We haven't seen this kind of spectacular dispersion between sectors in an awful long time. It's much more important what sectors you're in, what securities you're in, than the overall outlook."

Those who have listened to Leech's market updates in the past know that the number one focus of the Western Asset Management team in this area has been the re-rating of banks.

"The unintended consequence of very zealous regulation – some would say overzealous – is that the beneficiaries are fixed-income holders," Leech underscored. "We continue to think Tier 1 banks will move, in terms of spread, towards the lower end of the investment-grade range."

"When you look at high-yield, you've got a story that's different. In investment-grade, while you take a lot of volatility in the spread, historically, defaults have been very low. In high-yield you have to be very thoughtful about your issue selection, and subsector selection. But high-yield has really run into kind of a perfect storm. Spreads have moved way in front of fundamentals."

"The expected default rate as implied by the spread has just outpaced any reasonable, even aggressive, estimate of where defaults may come in. A lot has been led by commodities, especially energy. But even in the non-energy component, we've seen the fourth worst non-commodity-related high-yield returns. That's in an environment where the U.S. economy is in recovery and the Fed expects it's going to increase. The possibilities of lower global growth and sustained weakness in commodity prices, in conjunction with the Fed tightening – all are negatives from a top-down perspective. But when you look at yields relative to other parts of the capital markets, this is going to be one of the most attractive areas to invest in in 2016."

The viewpoint on energy and other commodities is quite different.

"In the energy space, you've seen a tremendous contraction in capital spending, in rig count, a movement by management to try and shore up balance sheets, to protect cash flow," Leech reported. "Rig counts over the last 12 months are basically down 44 percent globally and down 60 percent in the U.S. Our theme has been that you need to buy companies that are going to be able to withstand a sustained period of low energy and oil prices, but companies that have the wherewithal to do that are going to provide spectacular returns. The key is issue selection."

In the non-government credit space, Leech also sees opportunity in the commercial mortgage-backed securities ("CMBS") sector.

"When you look at the consumer and real estate fundamentals, they're very positive," he said. "While these markets have not widened as much as we've seen in high yields, the fundamentals are very solid. Consumer leverage is the lowest level in 35 years. That speaks very well for the investment-grade components of the mortgage market. CMBS has been beaten up a little bit more lately, but given the nature of the crisis, given the enormous shutdown of building that we saw – when you look at retail growth or office growth relative to the actual supply, new issue CMBS should be some of the biggest beneficiaries. So while spreads are not as compelling as some of the high-yield, we certainly think fundamentals here are much less controversial."

About Kenneth Leech

Ken Leech is Chief Investment Officer of Western Asset Management Company. He joined the firm in 1990. From 1991–2014, assets under management grew from just over \\$5 billion to \\$466 billion. Mr. Leech leads the Global Portfolio, US Broad Portfolio, and Macro Opportunity teams. From 2002–2004, he served as a member of the Treasury Borrowing Advisory Committee. In 2014, Mr. Leech and the Western Asset team were named Morningstar's US Fixed-Income Fund Manager of the Year for the Western Asset Core and Western Asset Core Plus Funds. He was inducted into the Fixed-Income Analyst Society Hall of Fame in 2007. Mr. Leech is a graduate of the University of Pennsylvania's Wharton School, where in four years he received three degrees, graduating summa cum laude.

About Western Asset Management

Western Asset Management is one of the world's leading fixed-income managers with \\$446.1 billion in assets under management as of September 30, 2015. The firm is a wholly owned, independently operated subsidiary of Legg Mason, Inc. From offices in Pasadena, Hong Kong, London, Melbourne, New York, S?o Paulo, Singapore, Tokyo and Dubai, the company provides investment services for a wide variety of global clients, across an equally wide variety of mandates. To learn more about Western Asset Management, please visit www.westernasset.com.

About Legg Mason

Legg Mason is a global asset management firm with \\$671.5 billion in assets under management as of December 31, 2015. The Company provides active asset management in many major investment centers throughout the world. Legg Mason is headquartered in Baltimore, Maryland, and its common stock is listed on the New York Stock Exchange (symbol: LM).

DEFINITIONS

Gross Domestic Product ("GDP") is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.

The Federal Reserve Board ("Fed") is responsible for the formulation of policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Investment-Grade Bonds are those rated Aaa, Aa, A and Baa by Moody's Investors Service and AAA, AA, A and BBB by Standard & Poor's Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.

All investments involve risk, including loss of principal. Past performance is no guarantee of future results.

Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation, and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed-income securities falls. Investing in asset-backed, mortgage-backed or mortgage-related securities are subject to additional risks such as prepayment and extension risks. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. Diversification does not assure a profit or protect against market loss.

Morningstar 2014 U.S. Fixed-Income Fund Manager of the Year and 2015 Nominee

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. Established in 1988, the Morningstar Fund Manager of the Year award recognizes portfolio managers who demonstrate excellent investment skill and the courage to differ from the consensus to benefit investors. To qualify for the award, managers' funds must have not only posted impressive returns for the year, but the managers also must have a record of delivering outstanding long-term risk-adjusted performance and of aligning their interests with shareholders'. Nominated funds must be Morningstar Medalists—a fund that has garnered a Morningstar Analyst Rating™ of Gold, Silver, or Bronze. The Fund Manager of the Year award winners are chosen based on Morningstar's proprietary research and in-depth qualitative evaluation by its fund analysts. For more information about Morningstar Awards, visit http://corporate1.morningstar.com/Morningstar-Awards/. 

This award does not imply positive performance for the funds being discussed.

Morningstar Awards 2015©. Morningstar, Inc. All Rights Reserved. Nominated for Western Asset Core Bond and Western Asset Core Plus Bond funds for US Fixed-Income Manager of the Year, US.

Awarded to Ken Leech, Carl Eichstaedt and Mark Lindbloom for Western Asset Core Plus Bond Fund (WAPSX) named Morningstar 2014 U.S. Fixed-Income Manager of the Year, United States of America. Morningstar Awards 2015 © Morningstar, Inc. All rights reserved.

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