Western Asset Management, the leading global fixed income manager wholly-owned by Legg Mason, Inc., said it is essential for long-term investors to look past the current panic and remain committed to spread-sensitive sectors.
“Rather than fixate on near-term economic prospects, investors should focus on developments over the medium- and long-term,” said Mike Zelouf, Product Specialist at Western Asset. “Assuming that central bank and government policies succeed in sustaining some level of financial market and economic function, trust in the financial system will eventually recover. At that point, the deep liquidity discounts apparent across spread sectors should disappear, leaving prices that once again reflect the underlying probability of default.”
“We continue to focus on mortgage-backed securities and the financial sector, two areas where we believe risk-adjusted returns look particularly promising over the next few years. Clearly, firms are susceptible to both a credit crunch and an economic downturn, but we believe investors are more than adequately compensated for bearing these risks,” said Zelouf.
Zelouf noted that bank deleveraging has triggered a negative feedback loop in financial markets which has driven bond market pricing far from fundamental value.
“This type of dynamic is restricted to fractional-reserve banking systems. The underlying global economy is not a fractional-reserve system. It will not experience such a negative feedback loop itself. It is vulnerable to the effects of such loops in the financial market, but only when monetary and fiscal policies fail to counter those effects. Policy-makers learned a lot from the mistakes made during the Great Depression and have been working hard to avoid repeating those mistakes during the current crisis,” continued Zelouf.
Western Asset notes that while the magnitude of the current financial crisis is unprecedented, so too is the policy response. The U.S. Federal Reserve reduced policy rates by amounts unparalleled this early in the business cycle, and the real Fed funds rate has been negative for nearly a year. The Fed has also willingly expanded its balance sheet and provided short-term financing en masse to commercial banks, investment banks, and insurance companies alike. U.S. Treasury conservatorship has allowed Fannie Mae and Freddie Mac to continue their mortgage securitization operations, sustaining the flow of credit to the housing market at a time when the private-label mortgage securitization business has ceased to exist. This has helped reduce yields on conventional 30-year mortgages to pre-crisis levels, an important development that directly addresses problems in the U.S. housing market, the ultimate source of current ailments.
The European Central Bank (ECB) and the Bank of England have implemented similar liquidity measures. While EU-wide fiscal initiatives have been slow, individual member states are aggressively taking independent counteractive action to the extent that they can, including deposit guarantees and coordinated government loans to troubled institutions.
“We continue to believe that these and any forthcoming actions should be sufficient to prevent deep dislocations in the underlying economy, though we do expect a mild recession across much of Europe and the U.K.”
“In seeking price stability, the ECB has intentionally been restrictive enough to induce a mild economic contraction. We now think the ECB has enough cover to begin its easing cycle and expect initial rate cuts before year-end. As such, we have increased duration in Europe to a slight long position to match our long position in sterling markets. We will also maintain short currency positions to the euro and pound sterling relative to the U.S. dollar as support erodes along with rate cuts,” Mike Zelouf concluded.
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by Investment Asia. The author was not remunerated for this article.
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