Michael Hasenstab: Bet on emerging economies

Michael Hasenstab is senior vice president, portfolio manager and co-director of global fixed income at the Franklin Templeton Fixed Income Group. What is your outlook for the economy, interest rates and the bond market in the second half? Incoming data continue to support our view that as the global economic recovery gets under way, differences in growth performance across regions and countries will become more and more visible, and will play an increasing role in driving market performance. In this regard, the first key difference is between developed and emerging econo¬mies, with the latter coming out of the crisis in a much stronger relative position. These developing economies do not share the developed world's problems of a prior overreliance on leverage and challenging fiscal positions. In particular, Asia will continue to benefit from stronger macroeconomic fundamentals, translating into higher economic growth, stronger balance-of-payments positions, capital inflows and, therefore, a sustained tendency for currencies to appreciate versus the euro, yen and the U.S. dollar. Within the developed world, we expect differentiation among economies to become an increasingly important theme going forward as the differences become clearer. We have been seeing the early stages of this trend as the market has focused on the significant fiscal challenges of some eurozone countries. However, even while recognizing the fundamental problems facing Greece and the unprecedented reforms that will be needed to put its debt on a sustainable path, the market has neglected the fundamentals of other economies as the contagion-driven sell-off has spread broadly. This has created attractive valuations for adding exposure to peripheral European countries with strong fundamentals, such as Poland or Norway. In contrast to heavily indebted eurozone countries, Poland is expected to grow by close to 3% this year and has a very manageable public-debt burden; Norway's sovereign-wealth fund is four times larger than its public debt, and its economic recovery has already warranted monetary policy tightening. Contagion-induced sell-offs notwithstanding, many of the challenges faced by Europe are not shared with the U.S. Europe faces uniquely difficult growth head winds relative to the rest of the world. This has been complicated by the lack of policy coordination. Europe, of course, has a unified monetary union, but not a unified fiscal policy or structure to deal with fiscal issues. Attention has been focused on this structural weakness in light of the debt crisis in Greece as a result of the slow and varied responses from regional governments and the political backlash it created. In contrast, the aggressive policy response in the U.S. has helped stimulate the economic recovery that continues to take hold. Also differentiating the policy responses in the U.S. was the aggressive bank recapitalization. In contrast, European banks still suffer from a significant leverage overhang, which will make it difficult for them to extend credit and will weigh on the region's recovery. Finally, the labor market is in much worse shape in Europe than the U.S., in part due to labor rigidities. What worries you most about the markets and the economy over the remainder of the year? The strong recoveries of emerging markets have created a challenging environment for policymakers. In many of these economies, robust domestic demand has underpinned the economies' resilience and is increasingly making the exceptionally stimulative level policy inappropriate. However, conditions in the developed world are such that monetary policy is likely to remain loose for some time, and liquidity globally will remain high. This is having a significant impact on emerging economies as investment continues to flow to these rapidly growing and less vulnerable economies in search for higher returns. While such capital inflows are beneficial to growth and help lower the cost of much- needed infrastructure, they also create the possibility of fueling an overheating of the economy or creating asset price bubbles. Policymakers must sometimes make politically difficult decisions, such as raising interest rates to cool the economy in order to defend against increases in inflationary pressure and future asset bubbles. So far, we have been very encouraged by the responsible policies undertaken in emerging markets around the world, especially in China, India, Malaysia and Brazil. What one investment-related suggestion would you make to financial advisers? Periods of financial-market volatility and macroeconomic adjustment can make it difficult to predict inflection points precisely. However, it is important to build positions grounded in long-term fundamental analysis in advance of these inflection points. Investing based on market momentum can be profitable over the short term, but following the crowd can be quite costly when markets turn. By positioning where valuations are attractive relative to the underlying fundamentals, investors can be well-positioned to benefit from market revaluations when these inflection points are reached, and not be forced to chase falling or rallying markets. Such an approach sounds simple, but moving against market momentum is scary for investors and can be painful over the short term. But periods of panic are the best times to be adding exposure in order to maximize long-term performance.