CONTRIBUTORS
Michael Buchanan, CFA
Chief Investment Officer
Western Asset
Preview
Today’s global financial environment is shaped by the following major themes: heightened geopolitical tensions, concerns around public debt sustainability and loose fiscal policies, investor sentiment on asset allocation in USD-denominated assets, and uncertainty about the short- and medium-term impacts of tariffs on inflation. In this quarterly report, Western Asset CIO Michael Buchanan examines the broader macroeconomic implications of these developments with the Firm’s key macro decisionmakers and offers insights into how investors might best approach portfolio construction given this backdrop.
Key takeaways:
- Diversification away from the US dollar and US assets is not a new phenomenon. The reallocation to non-US assets has intensified since “Liberation Day.”
- As central banks have gradually increased reserves in gold and other non-USD currencies, the euro, Swiss franc and Chinese renminbi are emerging as key beneficiaries.
- The persistent relative strength of the US economy over the last several years has led investors to overweight US holdings relative to their long-term asset allocation strategies. However, the potential improvement in eurozone growth, the rise of China as one of the world’s largest economies and opportunities in emerging markets (EM) have prompted investors to seek opportunities for diversification away from a heavy US bias.
- The trend of diversifying away from US assets reflects, among other factors, growing concerns over the impact of US trade and defense policies on the future valuations of US assets; however, the US fixed-income and equity markets remain the largest and most liquid worldwide.
- Global inflation rates fell dramatically as Covid-induced supply chain disruptions dissipated and short-term energy price volatility moderated. Despite higher tariffs having some impact on goods prices, longer-term inflation expectations remain well-anchored. Policymakers generally expect inflation to trend toward central banks’ respective targets within their forecast horizon. As a result, we expect volatility in short-term government bond yields to wane.
Conclusion
US government policy has caused severe volatility in fixed-income markets over the last several months. Global growth is expected to slow given heightened unpredictability but should remain positive. US growth is downshifting due to a myriad of factors including tariff uncertainty, waning benefits from immigration and reduced government spending in recent years. A significant fiscal boost from European defense and German infrastructure spending should support eurozone growth and provide relief from tariff-related uncertainty. Deflationary pressures in China persist and confidence is weak amid property market concerns, but sentiment is improving with fiscal stimulus and policy easing. Overall monetary policy remains restrictive, and we believe that central banks will continue to cut rates. The Fed remains well positioned to provide support if the US economy falters. Public debt levels continue to rise and yield curves may steepen further given concerns over fiscal policies. While we retain a modest overweight to interest-rate duration, we are concentrated in shorter maturities and biased to select countries and regions such as core Europe and the UK. While fundamentals remain positive, spreads are at the tight end of historical ranges in some sectors and warrant caution. We will continue to look for further periods of volatility to add to spread risk.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Municipal income may be subject to state and local taxes. Some income may be subject to the federal alternative minimum tax for certain investors. Capital gains, if any, are taxable.
Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically. The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries. There are special risks associated with investments in China, Hong Kong and Taiwan, including less liquidity, expropriation, confiscatory taxation, international trade tensions, nationalization, and exchange control regulations and rapid inflation, all of which can negatively impact the fund. Investments in Taiwan could be adversely affected by its political and economic relationship with China.
WF: 5939232