Credit crunch hasn't upturned bigger FX trends
Franklin Templeton's international fixed-income director says the underlying trends of strong non-US dollar currencies mean more than subprime liquidity problems.
Michael Hasenstab is senior vice president and co-director of international bonds at Franklin Templeton in San Mateo, California. He runs around $14.5 billion in unconstrained mandates in global fixed income, including a 'global bond-plus' fund for sovereign securities and a multi-sector fund that can invest in any bond instrument, as well as a dedicated Asia fixed income portfolio. He met with AsianInvestor on a recent trip to Hong Kong.
Has the recent credit market turmoil caused you to change your portfolios' allocations?
Hasenstab: Not much. Going into June, our global multi-sector fund has less than 4% in high yield and about 4% in investment-grade corporate bonds. Asset-backed securities would have been less than 1% of our portfolio because the valuations weren't attractive.
What then has been your focus?
Non-dollar currencies. We still have zero weighting to the US dollar. About 40% is weighted toward Asian currencies, and another 30% to non-euro European markets such as Sweden, Norway and Poland. We've got bits in local-currency bonds in Latin America.
Currency is the big theme but we've also cut back on duration to under three-and-a-half years for the multi-sector fund and under three years for the global bond-plus fund. We're long a few countries with high interest rates, like Mexico and New Zealand, as well as local-currency bonds in Brazil and Indonesia.
But overall the same trends that were in place six months ago are still in place today.
How would you summarize the key trends?
Non-US economies face short-term liquidity issues but long-term duration risk. Asia's economic growth is creating inflation, which suggests central banks will look to raise interest rates over the medium term - but they have short-term liquidity fears. Norway is a good example. Its central bank has recently both raised interest rates as well as injected a lot of liquidity by issuing short-term paper.
What, in your view, is behind the liquidity crunch today?
Two things. One is the US subprime mortgage markets, which were mis-priced. Second, an overhang of supply of debt in the LBO pipeline. We knew this supply would have to be absorbed.
While these problems are real, we're also experiencing global economic growth rates of around 5%. Balance sheets are in good shape, as many countries and companies have de-leveraged over the past five years. That's the big difference between now and 1998. So this mis-pricing in mortgages spilled over into the corporate bond market and then into emerging-market debt only because the dealing community was reducing risk and investors were deleveraging.
Hence the pain spreading to other markets.
It was fear that led to contagion in places like Brazil, which has capital account and fiscal surpluses. This contagion issue is night and day from the re-pricing of subprime mortgages. We have invested where fundamentals remain good.
So have you adjusted the portfolio to take advantage of wider spreads?
We do have to consider issues around liquidity risk, and whether this has led to any structural changes. So far the Federal Reserve is providing short-term liquidity, and the US subprime market is not systemic to the banking sector, particularly in Asia, where financial institutions have the least exposure. And Asia is now a leading source of global growth.
In the long run, I don't see this leading to changes in the portfolio. In the short run we have stress-tested many sovereign issuers to see which ones can ride out a few months without liquidity, and we've added some high yield, bank loans and some sub-investment grade government bonds. It's very company-specific but in some cases there's more value out there now. We remain cognizant the markets could get worse before they get better, so we're not trying to pick the bottom. We're taking a one-to-three year horizon on credit quality.
Will this turmoil hurt your annualised returns for 2007 or create opportunities to make more money?
Net/net, our funds this year are positive for returns. As of June 30, we were up 4% for the past quarter, although we gave back a little bit in August when contagion spread to Brazil. But we're not in a big hole. Our portfolio is diversified across 30 countries and we're benefiting from the appreciating yen.
Is the low-volatility (and hence low-return) period of 2002-2006 over?
I think so. We're not going to see the VIX index at 30, but volatility will be more normal. Low volatility hasn't been a problem for us in terms of generating returns because new countries continued to open their capital markets, which has been an opportunity for us. We expect China to be the next big one.
Will Asian currencies continue to appreciate against the dollar?
Yes. Asia is the growth engine of the world now, and China is the growth engine of Asia. Domestic demand and intra-regional trade will support Asian currencies, while the US faces deteriorating conditions that will keep the dollar weak. I believe that even if the US enters a recession, Asian currencies would remain strong.
What parts of the Asian fixed-income universe do you favour?
Sub-investment grade such as Indonesia's government bond market is attractive. Indonesia has gotten inflation under control and foreign direct investment has risen. The government's anti-corruption drive has a way to go but so far has helped attract more foreign capital, including a lot from China.
We have exposure to the Indian rupee, which has good value on a fundamental basis. Malaysia is one of our biggest holdings: it has a 15% current account surplus and the ringgit, which has been suppressed for a long time, has even stronger fundamentals than the renminbi.
What about non-sovereign issues?
The credit market in Asia is small. It's more for the future.
Is Asian fixed income a legitimate asset class unto itself?
I think it is. We launched our Asia strategy two years ago, which I co-manage with Kim Dong-il in Korea and Santosh Kamath in India. As a region its issuers are looking to diversify out of US dollars, so they must develop their own local-currency vehicles for fixed-income investments. Monetary policy and interest-rate dynamics in the region differ from those in the US and Europe, so for global portfolios, adding Asia is a good way to diversify - it has low correlation and high returns. This will be a big growth area. We believe the Asian bond universe will double or even triple over the next 10 years.
Has the recent credit market turmoil caused you to change your portfolios' allocations?
Hasenstab: Not much. Going into June, our global multi-sector fund has less than 4% in high yield and about 4% in investment-grade corporate bonds. Asset-backed securities would have been less than 1% of our portfolio because the valuations weren't attractive.
What then has been your focus?
Non-dollar currencies. We still have zero weighting to the US dollar. About 40% is weighted toward Asian currencies, and another 30% to non-euro European markets such as Sweden, Norway and Poland. We've got bits in local-currency bonds in Latin America.
Currency is the big theme but we've also cut back on duration to under three-and-a-half years for the multi-sector fund and under three years for the global bond-plus fund. We're long a few countries with high interest rates, like Mexico and New Zealand, as well as local-currency bonds in Brazil and Indonesia.
But overall the same trends that were in place six months ago are still in place today.
How would you summarize the key trends?
Non-US economies face short-term liquidity issues but long-term duration risk. Asia's economic growth is creating inflation, which suggests central banks will look to raise interest rates over the medium term - but they have short-term liquidity fears. Norway is a good example. Its central bank has recently both raised interest rates as well as injected a lot of liquidity by issuing short-term paper.
What, in your view, is behind the liquidity crunch today?
Two things. One is the US subprime mortgage markets, which were mis-priced. Second, an overhang of supply of debt in the LBO pipeline. We knew this supply would have to be absorbed.
While these problems are real, we're also experiencing global economic growth rates of around 5%. Balance sheets are in good shape, as many countries and companies have de-leveraged over the past five years. That's the big difference between now and 1998. So this mis-pricing in mortgages spilled over into the corporate bond market and then into emerging-market debt only because the dealing community was reducing risk and investors were deleveraging.
Hence the pain spreading to other markets.
It was fear that led to contagion in places like Brazil, which has capital account and fiscal surpluses. This contagion issue is night and day from the re-pricing of subprime mortgages. We have invested where fundamentals remain good.
So have you adjusted the portfolio to take advantage of wider spreads?
We do have to consider issues around liquidity risk, and whether this has led to any structural changes. So far the Federal Reserve is providing short-term liquidity, and the US subprime market is not systemic to the banking sector, particularly in Asia, where financial institutions have the least exposure. And Asia is now a leading source of global growth.
In the long run, I don't see this leading to changes in the portfolio. In the short run we have stress-tested many sovereign issuers to see which ones can ride out a few months without liquidity, and we've added some high yield, bank loans and some sub-investment grade government bonds. It's very company-specific but in some cases there's more value out there now. We remain cognizant the markets could get worse before they get better, so we're not trying to pick the bottom. We're taking a one-to-three year horizon on credit quality.
Will this turmoil hurt your annualised returns for 2007 or create opportunities to make more money?
Net/net, our funds this year are positive for returns. As of June 30, we were up 4% for the past quarter, although we gave back a little bit in August when contagion spread to Brazil. But we're not in a big hole. Our portfolio is diversified across 30 countries and we're benefiting from the appreciating yen.
Is the low-volatility (and hence low-return) period of 2002-2006 over?
I think so. We're not going to see the VIX index at 30, but volatility will be more normal. Low volatility hasn't been a problem for us in terms of generating returns because new countries continued to open their capital markets, which has been an opportunity for us. We expect China to be the next big one.
Will Asian currencies continue to appreciate against the dollar?
Yes. Asia is the growth engine of the world now, and China is the growth engine of Asia. Domestic demand and intra-regional trade will support Asian currencies, while the US faces deteriorating conditions that will keep the dollar weak. I believe that even if the US enters a recession, Asian currencies would remain strong.
What parts of the Asian fixed-income universe do you favour?
Sub-investment grade such as Indonesia's government bond market is attractive. Indonesia has gotten inflation under control and foreign direct investment has risen. The government's anti-corruption drive has a way to go but so far has helped attract more foreign capital, including a lot from China.
We have exposure to the Indian rupee, which has good value on a fundamental basis. Malaysia is one of our biggest holdings: it has a 15% current account surplus and the ringgit, which has been suppressed for a long time, has even stronger fundamentals than the renminbi.
What about non-sovereign issues?
The credit market in Asia is small. It's more for the future.
Is Asian fixed income a legitimate asset class unto itself?
I think it is. We launched our Asia strategy two years ago, which I co-manage with Kim Dong-il in Korea and Santosh Kamath in India. As a region its issuers are looking to diversify out of US dollars, so they must develop their own local-currency vehicles for fixed-income investments. Monetary policy and interest-rate dynamics in the region differ from those in the US and Europe, so for global portfolios, adding Asia is a good way to diversify - it has low correlation and high returns. This will be a big growth area. We believe the Asian bond universe will double or even triple over the next 10 years.
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