US Election Preview: The Possibility for More US Stimulus and Sectors That Could Benefit


US Election Preview: The Possibility for More US Stimulus and Sectors That Could Benefit

October 29, 2020

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

Ahead on this episode: with the US election quickly approaching…we look at results markets may already be pricing in, and when oddsmakers are actually expecting final results. Plus, what different election results could mean for more stimulus and the sectors that could benefit…and, facing the fixed income investing challenges in a zero- and negative-rate environment.

Talking about it all is Stephen Dover, Head of Equities at Franklin Templeton, and Ken Leech, Chief Investment Officer from Western Asset Management Company – a specialist investment manager of Franklin Templeton. We hope you enjoy the conversation.

Transcript

Stephen Dover: Ken, let's jump right into it. We're just a few days away from the US election. What do you see the results of that and how does that affect your thoughts on investing?

Ken Leech: Well, I think you always have to take the election into consideration and at a big firm, like everyone knows there's different political opinions. We try and be very closely attuned to the monitoring, not only the polls but the betting markets around the world. And I think the evidence suggests to us that the likelihood of a blue sweep has grown meaningfully. That is our kind of our base case. We do think that the race is tightening a little bit and there are some possibility of a split by [Joe] Biden winning and the Republicans have a better chance of holding the Senate than perhaps the presidency. But that's our base case. I will say, interestingly, if you look at the betting sites, they have a site where you can bet on the day the loser makes their concession speech. And every day from the third through the 13th is a big payout if you catch it right, the last slot is 13th or beyond me, 10 days after the election or later that's a—you actually have to lay three to get one though. The entire world is betting that no one will know the answer to this question of who won until after the 13th. So, there's a possibility as we all know, with all the ballots and everything else that there could be quite some delay before where we have a definitive answer.

Stephen Dover: Yeah. There certainly could be so, Ken, if we have a situation where we have a blue wave, there are certainly some proposals out there in terms of stimulus, in terms of tax policy, in terms of regulations, how do you see those affecting the market or your investment decisions?

Ken Leech: Yeah. So, we think that the highest likelihood that you can count on is that the fact you're going to get a meaningful amount of stimulus. It's right on the Biden platform page. We expect it to be pretty meaningful. We would expect that that infrastructure, healthcare, and the Biden plan, which is basically his green energy initiative would all be part and parcel of a pretty big stimulus package. We actually think that there's a possibility the taxes won't be raised initially—the go-to often for the Democratic party is when you're in recession to use government spending and tax policy later, that was the exact sequencing that President Obama used when he came in in a pretty weak economy.

If that's true, then you would expect growth to be picking up in the first half of next year. If the stimulus is as meaningful as we think, it suggests to us the possibility that the dollar might be weaker, that's somewhat counterintuitive, but often when global growth, the entire growth rate of the entire globe goes up, the dollar tends to be somewhat weaker because better global growth while it's good for the US it's even better for other trading partners. So, the question of whether it takes the longer view, which may be more negative in a pro-business sense, or the positive GDP [gross domestic product] impulse from stimulus, I think it's an open question.

Stephen Dover: Yeah, on the equity side, we do too. Certainly, had reduce earnings around 10, 15%, all things being equal if the market would reduce by that much, but things aren't equal, I should mention huge stimulus. Which really brings me to the kind of second overall question, and I think probably a lot of the listeners have, is really about, we're talking about a lot of fiscal stimulus. We have a Fed [Federal Reserve], that's been very loose with money and yet we don't have inflation, which is for most of us who've looked at historically or orthodox economists think we would have had inflation. And you pretty much thought we weren't going to have inflation for quite a while. What's your thinking about the fiscal stimulus and inflation at this point?

Ken Leech: Yeah, I think when you, all of the things being equal as you, as you pointed out Stephen, if you've got a reasonable economy and the Fed is too loose and there's lots of stimulus then you would expect to have a big pickup in inflation and that's pretty reasonable, but we all know the world we live in is just, there's nothing normal about it. And it's not a standard economy. It's a very weak economy. It, in fact, was on the precipice of having almost a global collapse as we all know less than six months ago.

So one of the things you have to look at is a Fed policy against a counterfactual, if you will, which is obviously subjective, cause no one knows what would've happened had the Fed not stepped in. But when people say the Fed is loose because they've got a 0% rate, that's a fair point that 0% is low. But in fact, it's not low enough, right? That's why they are actually buying bonds. They're actually adding even more liquidity in the system to try and keep the economy going, to try and reduce the unemployment rate, to try and get us to a growth rate and back to full capacity, which depending on the path of COVID, which we all understand is, is very difficult to forecast. And certainly, wouldn’t try and say that we know, have the answer to that question, but that path of the virus, how long it's going to take to get back really is unknown and unknowable. And I think Powell [US Federal Reserve Chair Jerome Powell] is very sincere when you watch him and you may have a different view, but I think he believes his mission and the Fed's mission is to be as accommodative as possible until they can get back to regaining the lost ground in this recession and their view is that's still an awful long way. And that's our view that it’s still going to be a long, hard slog from here. Take a lot of time. Lot of people have been displaced, very difficult to get everyone back to work in a short period of time. And I think that that's why, in our view, zero interest rates are probably here to stay for a meaningful period of time. So we have a joke at Western Asset that when we use the word never, and never in our business and our firm means three years, because that's the outside of the plausible forecast. So, we think the Fed is never going to tighten. We think that is going to take a lot of time before we get back anywhere to a full capacity or the inflation rate. And I would say if you think about the global financial crisis, we had the same fears.

Stephen Dover: Yes, absolutely.

Ken Leech: And 10 years later we never got back to the 2% inflation rate—that was 10 years. So, I do think that this fear is not unwarranted, but it's not the first order concern that we're facing today.

Stephen Dover: Do you have any concerns about the reserve banks buying debt, sovereign debt and particularly corporate debt?

Ken Leech: You know, I think if you're a bond person, you always worry about inflation. And obviously that means you always worry about monetary policy being too loose or too aggressive and buying debt—monetizing debt is a real fear. And we've seen some historical examples where that's gone very, very badly. I think that in the course where you're buying debt to try and get a degree of monetary stimulus, you have to be careful to distinguish between making a distinction between the Fed buying bonds, essentially providing liquidity to the system, versus actually monetizing the debt, making the Federal Reserve, liabilities legal tender, which is further afield.

So, we think that when you think about Europe, you think about Japan—now, unfortunately you're thinking about the United States—zero interest rates, ongoing QE [quantitative easing] for a long period of time, boy, the evidence that it's straightforwardly leading to inflation is just not there. Right? You still have to get your economy to a more vibrant level where that monetary policy becomes way too stimulative. And we still, as I said, we still think that that'd be a first-class problem to have, that your economy everything's fine and you don't have to worry about these things and that would be great.

Stephen Dover: Right. Well, I think probably what investors are wondering or concerned about is how do you invest in a zero-rate environment or overseas even a negative-rate environment?

Ken Leech: Yeah. It’s a brutal question. And that's what makes fixed income investing so difficult and, you know, in January—and it's hard to even think back to pre-COVID, right? Because it seems like 10 years in COVID time, but in January, the big thrust in the global investing community, especially from fixed income perspective, was how do I get yield? How do I get safe yield? And that was when the funds rate was at 1.5% and the 10-year [US Treasury] note was at 2% and people were like, well, I just am not getting enough yield to make it work for me. And so you saw this huge push, for example, in private credit. You know what I'm going to give away all my liquidity from the public markets because if I can just get that extra premium, I'm going to lock my money up and take my chances in the private debt market. That's how thirsty people are for yield.

Now, global central banks have really made a very explicit statement, which we would take them at their word that they're going to stay at these incredibly low rates, as you point out, negative in Japan, in Europe, but zero here in the United States for years, they're making that as explicit as they possibly can. So this ability to put your money in cash in the hopes that rates are going to come back up in the short run, and you can reinvest the higher rates is a difficult one, right? It was difficult for people who tried that after the global financial crisis—it was a tough call in January, so we think that you're stuck. The yields are low, there's no getting around it. But if you think yields are low in the US, boy, it's much worse outside of the United States. And our franchise is global, we see every time rates go back up or high-quality bonds widen and spread a little bit that we get inquiries from Asia, from Japan, from Europe where they have negative policy rates. Boy, they look at US rates, you know, we think, 2% is like, “how can you invest at 2%?” They think, “oh my God, you guys get 2%? This is great” So I can see it, so that's our challenge.

Stephen Dover: Well, that begs the question of just your view on the dollar and where that might be going both from the terms of foreign investors, but also for US investors.

Ken Leech: So again, we're not believers that the monetary policy in the US is flamboyantly misplaced. I mean, we do think that Powell is extraordinarily sincere in his desire. And I think when you watch him, you see a person who believes sincerely that the mission of the Fed should be to try and get the US economy back to full capacity and low unemployment and we would be on his side that may take some time. And, obviously very dependent on the path of the COVID disease. But, with that in mind, you know, we're not massively negative on the dollar.

So, the dollar the ebbs and flows, it goes up and down—forecasting currencies in the short run is extremely difficult. The noise to signal ratio can be very high, but over time we think if the global economy starts to recover, that you would expect to see the dollar start to a weaken a little bit, which is usually what happens because the benefit of improving global trade accrues to our trading partners, even more than ourselves, but this is not a collapse of the dollar by any stretch of the imagination. So, a mildly weaker trend in the dollar would be our base case.

Stephen Dover: Great. Now within fixed income. I know that you have looked at spreads, particularly corporate debt and a little bit of high yield, but maybe you could talk a little bit about where you're looking within in the market, within the fixed income market to find value.

Ken Leech: Yeah. As I said, we all understand that the absolute levels of rates are low. Our view was that the number one goal of US economic policy has been to protect the basic corporate infrastructure of America so that we could effect a recovery. And that led to the extraordinary, unprecedented authorization of the Federal Reserve to buy investment grade corporate bonds directly, and indeed some segments of the high yield market as well. From our standpoint, when you hear Powell, he says that his goal is to get corporate investment grade spreads all the way back to where they were at the beginning of the year before COVID started. Now, we think that that's an aspirational statement, that's not something that they're going to drive heaven and earth to get to, but it does suggest strongly that every time spreads start to widen, the Fed starts to pick up their buying. And then when spread starts to do better, they pull back a little bit. So we think investment grade credit, it's not an exciting story and certainly, somebody who does equities is probably going to yawn when I talk about investment grade credit. But the idea is when you think about investment grade as an asset class, if you went to your finance professor and said, well, what should the spread be? And he would look at you and he'd want an answer, something like default risk plus liquidity premium. The default risk for corporate investment grade credit, historically for the entire asset class, not for any one name, but the asset class, is less than a half a percent, cumulative five-year defaults—that's de minimis, and that's why it was called investment grade. That was the whole idea behind it. And so, spreads in the public markets always trade wide to that, so that's always a little bit cheap to that. If you think about insurance companies, for example, what do they do? They buy nothing but corporates.

Stephen Dover: Right.

Ken Leech: Never sell them. And they just take the defaults because they've studied it forever and they know, yeah, they go up and down, but you know, that we will get more money at the end of the day than the default risk. So, from our standpoint, valuations are not too high by that stretch of the imagination since they're being priced to a six to 7% default rate over five years. After the global financial crisis, defaults peaked to 2.5%. So again, they're not as wide as you'd like them, or as wide as they used to be, but they're not—from a purely fundamental basis—they're not extraordinarily rich by any stretch. We think that the macro policy of the Fed, incredibly low interest rates until we get back to full employment, which is usually good for corporate credit, is a positive. And then of course the backstop on top of that is a positive with respect to the Fed buying, if you do get into some wobbles. And lastly, you've already asked the question previously, the bid for our high-grade debt market from global investors is just kind of ongoing.

Stephen Dover: Maybe we just turn a little bit to that to global investing. Where do you think there are the best opportunities outside of the United States?

Ken Leech: You know, when you think about kind of the sectors in fixed income, if you think about the non-government guaranteed, so mortgage pass-throughs are government guaranteed, but if you think about investment grade, high yield, kind of structured product in emerging markets is for very big buckets of credit risk, or if you will, investment grade has all the attributes that we just talked about. It it's kind of in the protective umbrella of the Fed as well. High yield has some elements of that, so we do think that there are some opportunities in high yield. We do have some reopening trades, which we call reopening trades where you buy specific credits that will really benefit if, if the path of COVID goes away sooner, and the economy can reopen sooner, we try and do best in class. We have a few names like that. So there are opportunities there.

Stephen Dover: And maybe on that note, what are your thoughts on China? Obviously, the China fixed income market is opening up. It's being included in indexes. It actually has a yield and that to some seems attractive. What are your views on the Chinese fixed income market?

Ken Leech: Well, we've been pretty meaningful investors in the Chinese fixed income market. We're very constructive as you point out. China has a yield, you're looking at, in a world where a lot of developed countries are close to zero. You can get 3% there in government bonds—that in our view is positive. There's always a question about whether China is an emerging market, or obviously, on its way to be a developed country, fair point. But we do think that their monetary policy has been pretty normal. We think that the Chinese long end that their plan is to be a very serious economic competitor with the US. It's going to take them a lot of time, but they're on that path. The reason they open up their bond market, as you point out and their equity market and trying to get it included and having their currency as part of the IMF [International Monetary Fund] basket are all part and parcel of the need to be a bigger part of the global financial community.

If you eventually, you want your currency to be globally traded, even if it's far in the future, first, you have to have it be regionally traded. And you've seen them really work hard on their Asian neighbors to make sure that a lot of the commodity transactions that are based in their currency. And that's why they've opened up their markets. Because if you really do want to be a broad-based financial participant, you have to open them up. So, from our perspective, we think you're going to see more and more investing, moving towards China. And so, so we're very constructive on that market.

Stephen Dover: Ken, what are the big risks out there that you are most concerned about?

Ken Leech: The biggest risk is COVID and the path, we think this is a long, hard slog. And that's because right now there's a lot of optimism that we're on a recovery path, and that given how much policy help there's been that path will continue, but that's not a foregone conclusion. We see that COVID doesn't go away, as soon as you reopen the economy, cases start to go up. The fiscal support that that has been fantastic is not endless, and it's not without costs down the road. And if this takes longer than we think and some of that desire or willingness to provide that kind of fiscal, and we're already seeing debates in Washington on that point, as you're seeing in other parts of the world, we are more immediately concerned with the risks of potential steps back than we are of taking too many steps forward.

Stephen Dover: Great. Ken, this has been a great conversation. It's really interesting to talk with you. I look forward to talking with you in the future. Thank you very much.

Ken Leech: Stephen, my pleasure. And I look forward to talking with you as well.

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