Active management of global fixed income's three primary sources of alpha — currency, duration and credit exposure — enables investors to exploit country-specific differences and position for global trends. When assessing investment opportunities, the expected return from each potential source of alpha can be isolated to ensure that only attractive risks are held. New investment opportunities play a useful role here, primarily as a risk management tool that can isolate particularly attractive risk components within securities. For example, a strategy for a given country may keep the duration element and hedge out the currency by using currency forwards. Alternatively, external sovereign bonds offer exposure to a government's credit without local currency or interest rate risk.
Before developing these positions, however, an in-depth understanding of the macroeconomic fundamentals is necessary. Top-down economic research is combined with bottom-up security-level analysis to uncover fundamental value and highlight potential catalysts that may drive a revaluation.
Two global trends that have been shaping our strategy recently are the accelerating global economic slowdown and financial market deleveraging. We have been positioning our fund to take advantage of long-term opportunities brought about by a tough global growth environment through duration exposure in countries where markets are not yet pricing in the likely monetary policy response to the slowdown.
The International Monetary Fund's most recent World Economic Outlook update, released last November, lowers the world growth forecast from 3.7% in 2008 to just 2.2% in 2009, (a rate below 3% is generally consistent with a global recession). This forecast expects outright contraction in advanced economies, and more moderate growth in emerging markets. While yields already have fallen dramatically in the U.S. in anticipation of prolonged loose monetary policy from the Federal Reserve, we are positioned for similar responses from central banks in Europe, Korea and Mexico.
These economies are quite vulnerable to the U.S. recession and global credit crunch in addition to domestic factors such as past interest rate tightening, an overvalued currency or a housing bubble. However, we believe bond prices do not yet reflect the likely interest rate cuts as the balance of risks continues to shift from inflation toward growth.
While deleveraging and slower growth in developed economies is expected to have a negative impact on growth everywhere, there is still likely to be considerable differentiation between economies that can be capitalized on. The IMF forecast highlights the growth differential of Asian economies over the rest of emerging markets and advanced economies. This growth differential should support Asian currencies over the medium term by continuing to attract capital to the region.
Up to now, we have seen currencies fall against the U.S. dollar fairly indiscriminately, but we are beginning to see some differentiation in the performance of individual currencies. We expect this differentiation to become more marked in the next couple of years. In our view, this is likely to result in the currencies of Asian countries with sound fundamentals appreciating against the U.S. dollar, but making more significant progress against the euro.
Michael Hasenstab is a senior vice president, co-director/portfolio manager of the Franklin Templeton fixed income group, based in San Mateo, Calif.