Navigating Uncharted Territory and Market Volatility


Navigating Uncharted Territory and Market Volatility

March 13, 2020

Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: a look at possible near-term and long-term impacts, following the coronavirus outbreak and other market shocks. Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income, and Michael Hasenstab, Chief Investment Officer, Templeton Global Macro, share their views, starting with global growth.

Transcript

Michael Hasenstab: I think there’s a couple of issues of global growth. Generally, it’s obviously not going to be great. But I think it’s both the landscape that we went into this crisis with, which we just saw so many vulnerabilities, whether it’s geopolitical, whether it’s political within countries, experimentation of policies that we have never tried before, Modern Monetary Theory or massive fiscal deficits, issuance of a lot of debt, that is less liquid and is lower rated, where we are late in the business cycle, that was the landscape and then the shocks came in.

And I think it’s not just the medical shock and the virus, it’s the reaction to that, it’s the extreme panic. It’s the shutdown of demand. It’s the lockdown of countries, and just the panic. And the lack of a coordinated and assertive policy response between governments, across all agencies. And I think that, to us, means that the growth outlook for this year is not going to be particularly good.

Sonal Desai: I agree with you on, certainly, on the preconditions in terms of what we came in with, with the amount of froth in the markets, if I’m looking at equity markets, from October of last year when the Fed decided to re-expand its balance sheet and you had equity markets get super frothy. I think what really strikes me, as you noted, is the fragility of what we have got right now. And, the scale of the sell-off across markets, I think there is testament to that. It would be crazy to think that there isn’t going to be a negative impact on growth.

Perhaps, I would say that I see a difference between different parts of the world. I think they’re going to be countries like Italy, always on the verge of recession, not clearly in recession. I think China without a doubt, that was a massive shock and you know, they are going to have extreme downdrafts there. In the US, I think we get a downdraft, but I feel like I am not yet prepared to say that this is going to be the real shock that will push the US off its uninspiring growth path, let’s put it that way. So I see a downturn, but it feels not yet the point that I would be willing to call a global recession.

Michael Hasenstab: I think the worry I have is that if it was just the viral shock 10 years ago, eight years ago, it would be different. If it was just the viral shock without the oil shock. If it was just the viral shock without a very uncertain political environment, it might be different. But I fear we are getting these combined shocks at the same time.

Sonal Desai: What has been really eye opening to me has been the role that has been played by social media and to some extent existing media in terms of transmitting, what I would say in many cases, is a pretty strong panicked reaction. And that, I think, has the ability to really drive things much further than they should go. What I would say is so far, it is not my baseline that we are going to go all the way because, yes, we have got this combination of shocks and if I take several steps back, I recognize that it’s two very negative demand shocks—the coronavirus and all these shale oil producers who might get knock-on effects. But I also have to recognize that if gas prices dropped—almost 50% down—and this is something which mitigates in terms of severity. Actually, consumers sit in a pretty good position from the perspective, you know, their savings rate goes up to around 8-9%, so, they have a buffer for all those fragilities which I accept are within the system. The politics, absolutely, that is something which is a wild card. And, I do agree that that’s something which we are watching very closely.

Michael Hasenstab: The only worry on the consumer I would agree is that, you know, we’ve got full employment, everyone, a lot of people have jobs, wages are starting to grow. My worry is this demand shock and, you know, the shutdown of the service sector, we already had CapEx weak and going lower. If you combine the financial market shock, which we are seeing unfold and you start to see layoffs and a more permanent spike in savings, then you have the industrial recession combined with weakness in consumer, you could have that toxic mix. Now, it’s possible that that doesn’t occur, and we just have to watch it.

Sonal Desai: Exactly the scenario you’re describing to me is a high probability risk, so it’s a very fact risk scenario for me. At this stage, I think I’m not yet prepared to make it my baseline, but fully acknowledge that that exactly is the risk scenario that we need to be prepared for …

Michael Hasenstab: The feedback loop.

Sonal Desai: … the feedback loop. And indeed, that is why, we started this year invested in a variety of different asset classes, under-risked in the sense of at the lower edge of our tolerance band for asset classes like high yield. And I do think that what we are seeing right now bears that out.

Michael Hasenstab: What we saw in the last week was the stress tests that people can look at their portfolio and say, you know, I looked at these past correlations, but this is a real live test. No one can predict the life of the virus, the severities, all the dislocations, but what we do know is we can prepare a portfolio for those uncertainties. And I think that’s where, you know, hopefully investors can take this volatile period and say, let me stress, you know, we have got a real-life stress test. You know, what worked, what held up, what had a low correlation, was I over risked? Was I under risked? And I think use that. And you know, and then there’s the other side of it, which, you know, I think we’re all doing is if there’s a panic and it goes on for a protracted period of time and there’s big dislocations, there will be good assets that become valuable. We are nowhere near that point yet, but we need to be thinking about that.

Sonal Desai: I completely agree. I think that looking for those opportunities when there is panic like this is very important. Are we looking at overshoots? I keep getting asked, you know, has the Fed run out of its tool kit and the point is, yeah, we are approaching, again, the whole ZIRP [Zero Interest-Rate Policy] idea, but again, a part of me takes a step back and says that when we went to zero interest rates in the US previously, 70% of households had their primary source of savings essentially in distressed situations, because it was a housing crisis. Depending on how protracted the current panic is, we could see something approaching that. But once again, I tend to feel that, potentially, as we go through one quarter, maybe a quarter and a half, we will be coming out of this, against a background whereby then this very dovish Fed would have reestablished very dovish policy across the board. Currently we have a dysfunctional political system, but both Democrats and Republicans are in the mode of trying to do something, it’s a political season, you know, which would be some more fiscal stimulus, which if this passes would be coming again to an economy, which perhaps doesn’t need quite as much.

Michael Hasenstab: I think your point about the tools is one that’s important globally. I mean, I think the two aspects that I sort of look at there is one, we as a world, rely on central banks to solve everything. And I think it’s a lot to ask and they have done, I think as good as job as possible about trying to achieve so many objectives with very limited tools and at some point, are we asking too much of them? And I think, you know, as we approach zero bounds or negative bounds, the number of tools available I think is going to be called into question. And as an investor looking at ways to diversify, you know, long US Treasuries gave you that diversification as rates approached zero but once they’re at zero going lower, is that tool really useful? And I think at that point, investors need to look at other asset classes or other spaces that can potentially do that. For us, we have been looking in the currency markets to get that risk hedge.

And then the other concern, though, about tools would be—and the IMF and Bank of International Settlements have been warning about this—that governments have been running up massive deficits in good times. So as we head into a bad time, how much more can we spend and at what point, if you have populous regimes in different parts of the world, do they adopt this idea if we have deficits that are too big and we can’t pay for it, we just print it to pay for it. And that, I think, takes you in a whole other realm.

Sonal Desai: And in terms of what central banks are being asked to do, I think to some extent they politicize themselves, you know, I don’t think it’s the central banks business, I think a variety of questions like climate change, etc., are very important. It’s just not a central bank’s problem. It’s a policymaker who is a fiscal policymaker or a politician’s issue and they should take control of it. I’m just noting from the monetary perspective, I think rate cuts, QE, these are very heavy-handed tools to try and address what we are seeing right now.

In the near term though, I think it is likely that we would see something like we did post 9/11 or post 2008, where you look at a specific sector which is effectively bailed out. There is no other word for it, whether it’s the airline sector or I see some talk about elements of the energy sector because the US was self-sufficient. If you take out tight oil, it will not be self-sufficient any longer, I don’t suggest for a moment it’s the right policy, it’s the wrong policy, but the fact is I think it will be used and again over the medium term, it leads us as investors into truly uncharted territories. Because I keep seeing that analogy to Japan or Japan could do it for 30 years; two things: one, nobody else was doing it and two, Japan actually had positive real rates as you and I know for most of that time and the rest of the world has negative real rates…

Michael Hasenstab: And they had a saving surplus…

Sonal Desai: I mean, there’s just so many differences that this whole notion, which immediately as we saw this dramatic collapse in US Treasuries where people said, “Oh, the US is becoming Japan,” I found that it doesn’t work for me.

Michael Hasenstab: We kind of came into the year, you know, we thought all these vulnerabilities, we needed to look for safe haven assets and the currency dynamics really sort of set themselves apart. Of course, you know, some Treasury assets provide that safe haven, but if we’re at zero or negative, it’s questionable. But really, things like the Japanese yen, the Swiss Franc, really they have the political stability, they have the savings surplus. The weakness had been, in Japan’s case because of these huge capital outflows, when there’s a panic that capital tends to return, throughout history it’s been a very clean story. History doesn’t always repeat itself. So far during this crisis, it has started to repeat itself a bit. So, I think the currency space is useful because we still need to be able to generate a positive yield, while we wait and see how this plays out.

Sonal Desai: From a broader sectoral perspective, if I look at areas like high yield and IG, I think, we have shared before our discomfort, if you will, with the amount of debt which has been issued and the quality of the issuers. And I think that yeah, the shakeout which we’re seeing now is something which was probably a time coming. Having said that, as always, it’s rare that an entire asset class only has bad apples in it. I think it may be quite a prolonged issue for energy, because clearly Russia and Saudi Arabia have viewed this as a good time to try and truly squeeze out US shale production, which has acted very much as a lid to global energy prices over the last decade now.

So I think that that is something we are monitoring very, very closely because definitely I think that sector is going to be under stress. Needless to say, sectors such as airlines, tourism, I mean it doesn’t even bear repeating because it’s so clear that these areas will be under stress.

Having said that, there will be other sectors everything from home building onwards could show some signs of decent developments. If this were not too protracted, I repeat, and we don’t see this basically spiral into the depths of a protracted global slow down, this type of easy policy will end up having some beneficiaries, as well. So we are observing this very carefully. I think it’s premature at this stage. This is not the time to be jumping in or jumping out. You know, it is a good time to take a deep breath and wait for some of this volatility to subside. It’s not normal to see 20 standard deviation moves. It’s completely abnormal.

Michael Hasenstab: Yes, I think, similar taking the view that we need to be thinking about paradigm shifts and a new world and it’s a challenge. And so similar to yourself, we are taking a step back and thinking, you know, what does this mean going forward and we are seeing political paradigm shifts, we are seeing medical health paradigm shift, a lot of these issues and market moves that haven’t been seen. So, I think it is an important time to think about a world that’s entering a very different period, and how do we position for that?

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