Bonding with emerging markets

Michael Hasenstab Istanbul - Arabstoday     He is one of the biggest bond and currency players in the world, managing more than $120 billion of assets spread across several funds of Franklin Templeton Investments. Michael Hasenstab's distinguishable strategy of investing outside the benchmark and into the emerging markets, eschewing governments of developed markets such as the US and Japan with minimal exposure to Euro zone governments, has made him one of the topmost bond managers in the world.
The Templeton Global Fund, one of the ten funds he manages, has had a stellar run over the past decade, consistently outperforming its peers. It achieved a 10-year annualised return of 11.7 per cent, which is nearly double the average of its category. A 12.7 percent return in 2010 brought Templeton Global Bond to the best quartile of its world-bond category, which is the eighth time in the past 10 calendar years, according to US fund data specialist Morningstar. The fund witnessed more than $16 billion of net inflows in 2010.
Among the other superior performing funds he manages include Global Total Return Fund and Emerging Markets Bond Fund. He was named the fixed income manager of the year for 2010 by Morningstar in January this year.
"By shying away from overleveraged developed economies, the fund's profile differs from traditional benchmarks and much of the competition," said Karen Dolan, director of mutual fund analysis, Morningstar in a statement in January. "Hasenstab instead focuses on the bonds and currencies of countries with low debt levels and positive growth prospects. He has proved to be one of the few managers who can execute a global bond strategy this well and this consistently."
In a chat with a group of journalists in Istanbul last month during Franklin Templeton's "East meets West" conference and a subsequent email exchange, the 37-year old, Hasenstab, who has a Ph.D. in economics from the Australian National University, spoke about his strategy in depth, opportunities that lie ahead, outlook on the dollar and emerging market currencies and how to go about diversifying a bond portfolio.

Your funds generate returns not only from the fixed income securities but also from the currency overlays that you use that you use which distinguishes you from most of other bond managers. Could you give us a very brief description of your strategy specifically the way you use currencies in your portfolio?
Michael Hasenstab: It all starts with really the country and the macro research. We have two kinds of direction that we take -that is, teams that are set up. One [consists of] country analysts and one [of] global macro analysts. What we are looking for is when a global theme and a country theme intersect, that gives us the confidence that there is an investment opportunity in a given country.

When we look at a country—any given country has really three levers that we can pull—currency, interest rate or credit. So it's a function of what our macro analysis, what our country analysis says. Sometimes in a country it is a purely currency play and some times it is an interest rate play, sometimes it is both.
So it really has to do with what is our call on a country and from that we position accordingly. In terms of some of our currency views right now, the biggest overweight would be non-Japan Asia. So that's Korea, Malaysia, Australia, Indonesia, Philippines, kind of broadly across the region. Second would be Scandinavia and Central Europe. And then lastly would be some spots in Latin America.
We spend a lot of time doing the due diligence, going out to the countries meeting with policy makers, politicians, academics, business people, journalists—try to get a picture of what's really going on. Same way you would want to meet with, if you were investing in a company, the CEO, CFO, some of the business people. We kind of take that same approach on the country side as well.

 

Do you have any exposure to the US Treasuries right now in your portfolio?
Zero. There is no value there. Yields are so low. Fiscal policy is so bad. Rates have to normalise and have to go higher.

So what's your outlook of the US dollar against other currencies?
Our general outlook is US dollar would weaken against most emerging markets and will weaken against the more better-run developed markets, like a Sweden or Australia. But the dollar could actually do well against the yen and it's unclear against the Euro. So we don't have any Euro-dollar positions on. Even though dollar is going to weaken against almost everyone, Japan is even in worse situation than the US and so, that would be the one place we think the dollar could actually do well.

What about when interest rates rise and dollar gains strength?
It is not guaranteed that dollar will rise. This will however be true if the economic growth is sustainable. And secondly one has to keep in mind that with higher interest rates inflation is higher and so there is negative real interest rate that leads to exchange rate decline.
We expect the global recovery to lead to rising bond yields in most economies. Even in the US, where we expect the recovery to be only moderate, historically low bond yields are likely to rise as improving economic activity combines with the historically large financing needs of the public sector.
Over the medium term, concerns regarding an eventual end to quantitative easing measures and the Fed's ability to reduce its balance sheet in a timely manner to avoid inflationary pressure should put further upward pressure on US Treasury yields, in our view.
While the prospect of higher interest rates is a challenge for many fixed income investors, our strategies are currently cushioned from rising yields, with an average duration of less than half that of the benchmark, no exposure to US Treasuries or Japanese government bonds, and minimal exposure to Eurozone government bonds.
Additionally, while we do not have unmatched exposure to the US dollar, we are looking to potentially capitalise on rising yields in the US by positioning long the dollar against the Japanese yen, a strategy that we believe should benefit from an increase in interest rate differentials between the US and Japan.
Historically, there has been a strong correlation between the bilateral exchange rate and the difference between yields in the US and Japan, and we expect this relationship to continue given the very large portfolio and other investment flows.

How far is your bond portfolio insulated from what happens to the dollar?
We try to diversify away from having everything just be ‘dollar up dollar down'. A lot of our positions in Europe actually have nothing to do with the dollar. They are euro versus Scandinavia; they are euro versus Eastern Europe. So good third of the portfolio, its current exposure has nothing to do with the dollar. So we try to manage that by diversifying out some of that.

When you talk about the currencies appreciating, what sort of time frame are you looking at?
We take a long horizon in terms of currencies. I think it's very hard to predict a currency move in a month, a quarter or even a year. There's just lot of white noise, random movements. But if you look out three years, currencies reflect macro-economic balances, trade flows, capital flows, growth, and interest rate differentials. So we take that view what do we think the Korean won is going to be two or three years from now, not next month. That's where people get in a lot of trouble in investing in currencies. If you have a short time horizon it's just so much volatility. But if you extend that horizon and you can be patient, there's some money to be made.

How do you think of the yield curve when you think of investments? Is there particular preference that you have at the moment?
Right now, we are heavily skewed towards the short end of the yield curve in most countries we are investing in. So the average duration of the fund is under two years right now—about 1.9. Right now our preference is to be very defensive buying short-dated funds, rolling them over as rates go higher; so in effect creating a floating rate strategy.
 
What's the proportion of sovereign versus corporate in the mixed bond funds?
Global Bond Fund does just governments, but Global Total Return Fund does governments and corporates. We have about 15 per cent exposure to corporates, most of it is in high yield. And there we take a sector view that we think high yields are attractive and we have a corporate credit team that mostly do a bottom up work. So it is taking a top down view on the sector and then bond selection is done from a bottom up perspective of the credit team.

What are the risks that might affect the emerging market currencies?
We continue to see the greatest risk to emerging markets over the next several years as insufficient tightening. It is important for local authorities to continue to normalise policy in economies where activity has returned to its long-term potential.
This can be a politically sensitive issue, but it is crucial in order to avoid overheating economies, inflationary pressure and asset price bubbles over the next several years. Economic policy must remain forward looking, and policymakers must not become complacent due to temporarily contained price pressures. In developed economies, the consequences for maintaining excessively stimulative policy for too long are more likely to be raising yields and a limited capacity to counter future adverse shocks. In both cases, leaving policy too loose can have dire consequences for long-term, sustainable growth.
A related risk exacerbated by extraordinarily loose monetary policy in the largest developed economies and ongoing uncertainty in the Middle East is the potential for higher commodity prices and fears of increasing inflation pressure in many emerging economies.
While high commodity prices may present an opportunity for investors in commodity currencies and credits, to policymakers they pose a challenge that often favours allowing for some currency appreciation to lower imported inflation. Such supply-driven inflation can be a major concern for policymakers in economies where commodity prices are a large part of consumption baskets—generally emerging markets—because it is more likely to be passed through to inflation expectations and wages.
This tends to further support interest rate hikes and lead to greater acceptance of currency appreciation in order to limit the impact of higher international prices on the domestic economy. This has supported our strategy of maintaining currency exposure in rapidly growing economies with favourable external balances and tightening policy.

In terms of emerging markets bonds—is liquidity an issue for you? And how do you determine the timing of your exit?
We definitely look at liquidity. For some countries, yes, the size is too small and it is not appropriate. But what has changed in the last decade, really in the last five years is the liquidity in the emerging markets has really grown. There has been tremendous amount of local issuance, development of the local bond market. Korea, you know, is one of the most liquid markets in Asia.
Ten years ago it wasn't at all. And not only has the underlying cash market improved, the swaps market is actually in Korea's case more liquid than the underlying cash market. In cases, when we wanted to add interest rate exposure in Chile or in New Zealand during the crisis we did it actually by swaps because they were more liquid than the underlying cash market. So, we look at the liquidity opportunities, look at the cash market, look at the derivatives market and then play it accordingly.
[On the exit question], if we feel like we can get out without moving the market, we feel like it's a country where if we exit we are sort of going to shoot ourselves in the foot, then we won't go in the first place. So before we invest we make sure we are comfortable that we can get out.
The other thing that has improved in the emerging markets is: it used to be the investors in the debt markets were mostly all foreign. And so foreigners would buy or sell and it would be pretty volatile. But you now see a lot of pension funds, locally developed mutual funds, banks—so the investor base locally is a lot more diverse and it helps us. Because if foreigners are selling, there is a local agent that is actually buying and that helps.
The asset allocation between currencies, between bonds or other fixed income instruments—who takes the call?
That's myself. But it's actually apparent. We take our fiduciary responsibility quite seriously. We have more than 40 investment professionals in the global bond space analysing different markets in various locations around the world.
Once we go through the research process, of say we are looking at Indonesia, or Sweden, we go through the due diligence of understanding what's going on in the country, go to the country, the analysts digging apart the macro situation, the political situation, it becomes pretty clear which of the lever you want to pull—the currency trade or is it an interest rate trade?
And so then it's just a collection of all of those trades that we then start to build the portfolio, to try to maximize the highest total return we can get subject to the volatility parameters that we want for each individual fund. So volatility is the way we manage risk as opposed to a tracking error or other risk matrix. To me the risk is the chance you lose money. Not the chance you deviate from an index—that doesn't tell you anything about risk. It just tells you ya, nothing.
Bond are conisdered safer than equities and given that you have generated on some of your bond funds almost equity like returns with lower volatility, how would you advise an investor in terms of a balance in the portfolio?

I think you need a balance. I think one should never have 100 per cent bonds, 100 per cent equities. I guess the one common advice is to have diversification in their bond portfolio as well as in their equity portfolio. So, whether you have a split of 70/30, 30/70, 50/50, it is up to each individual's situation. Within that, I think the important thing is to not have such a home country bias.
A lot of investors in their bond portfolio just buy the bonds of their own country and they are highly exposed to one risk and I think it is really important to diversify out to a lot of the markets. The danger there is when people start to go global, the first thing they do is buy, if you are in South Africa or you are in Germany, US Treasuries or German bunds—they buy some of the big markets.
And those may not be the best opportunities. So people need to go global. But if they go global they need to go really global-emerging markets, developed markets, a blend of that. That's I think the one message that we try to get out to clients is it is up to them about assets between fixed income and equities, but of the fixed income make sure it is diversified.

What are your thoughts on quantitative easing and the spiralling budget deficit in the US—how do you think things will play out?
I think the fiscal situation is pretty embarrassing. I mean the government almost shut down over a fight over $50 billion and we have a $1-1/2 trillion deficit. And even more recently the deficit hawks are starting to disagree amongst themselves. Not only the Democrats and Republicans can't agree, but even within the Republican Party you are seeing no vision in terms of what they want to do.
We are getting clearly into the election mode of 2012 and it's going to be very hard for them to tackle the issues that need to be tackled. I am quite bearish on the outlook of our fiscal accounts and fairly pessimistic on the outlook that policy makers can actually make it fix that's meaningful. There can be short term fix, but a real substantive reform that the UK did is pretty unlikely which makes me fairly negative on US Treasuries because of that. And then you have all sorts of excessive liquidity from quantitative easing and very low rates and you get those two together and that fuels some serious risks.

Almost a perfect storm in terms of a crisis over US sovereign debt?
It's hard to know what triggers it. As you were earlier pointing out that US has this exorbitant privilege of a reserve currency so people are forced buyers of its asset. So if you were to take the US fiscal and monetary policies and put it in any other country the yields would be so much higher and currency would be even weaker. And US can get away with it. So I don't think we are in a dire default scenario or anything like that. But I think there is upward pressure on rates. I am not talking double digit yields I am just saying couple hundred basis points seems fairly reasonable to expect.
From / gulfnews .