Need to Navigate Rising Rates

The core of our strategy for 2015 remains positioning ourselves to navigate what we think is a rising-rate environment.
Michael Hasenstab        Print Edition: January 2015

A strengthening economy in the United States, along with the potential for higher US interest rates, may increasingly magnify the fundamental differences between healthy and vulnerable economies around the world.

In recent months, global financial markets have been broadly influenced by pick-up in growth in the United States, economic stabilisation in China, and abundance of global liquidity from the Bank of Japan (BOJ) and the European Central Bank (ECB). We continued to see differentiation among specific emerging-market economies in 2014; some had healthy current account and fiscal balances with strong export-driven economies, while others struggled with deficits and economic imbalances. Looking ahead to 2015, we believe investors should not view the emerging-market asset class as a whole but instead distinguish between variant individual economies. In our assessment, economies that have healthier balances and stronger growth prospects should continue to see currency appreciation over the long term, while those with imbalances are more likely to face strains.

Throughout much of 2014, the US dollar strengthened against the euro, the Japanese yen and a vast number of developed- and emerging-market currencies. However, some specific currencies from stronger economies fared better. We believe this is the type of differentiation among emerging-market regions that we are likely to continue seeing over the coming year.

In late October 2014, the BoJ introduced a sizable quantitative easing (QE) with an indefinite time horizon. The annual level of asset-purchasing was raised to 80 trillion yen-a level that basically equates to the most recent Federal Reserve QE programme. This massive amount of liquidity has significant implications for global markets in 2015-money printed in Japan is not likely to stay in Japan; we believe it will spread globally. Though Japan's QE is positive for global risk assets, in our view, it will likely contribute to further depreciation of the yen.

Elsewhere in Asia, China's growth rate moderated in 2014 but did not face a "hard landing." Looking forward, we continue to see indications of a healthy shift in the composition of the country's economic growth to stronger, more sustainable consumer growth. It is important to note that China's economy is much larger today than it was years ago. Even a 7% growth rate today creates a much larger global aggregate demand effect than China's higher growth rates from 10 years ago did.

The core of our strategy for 2015 remains positioning ourselves to navigate what we think is a rising-rate environment. We have continued to prefer short portfolio duration while aiming at a negative correlation with US Treasury returns. We also actively seek opportunities that can offer positive real yields without taking undue interest-rate risk. We continue to maintain our conviction in a strengthening US dollar against the yen and euro and continue to look for investment value in currency and bond markets of select emerging-market economies.

 Michael Hasenstab is the chief investment officer, Global Bonds, Franklin Templeton Fixed Income Group.

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