1. Global Bond Update
< GAIN FROM OUR PERSPECTIVE ® >
October 2009
Finding Value in an Uneven
Recovery
Emerging Markets versus Developed Markets
We believe there is likely to be differentiation in how various countries
recover from the crisis. These factors may provide some interesting
investment opportunities over the next couple of years. In terms of
understanding the differences and vulnerabilities of countries going
forward, we believe it’s important to understand the key drivers that are
expected to differentiate a particular country’s recovery. On the whole, this
analysis continues to point to one of the major themes in positioning our
portfolio—the emerging markets versus the developed markets story.
Michael Hasenstab, Ph.D. In our view, there are five major factors that will influence the speed and
SVP, Portfolio Manager strength of the different recovery paths:
Co-Director of International Bonds
®
Franklin Templeton Fixed Income Group
1. Domestic Economy and Export Sensitivity. Those countries that had a
very large component of domestic demand versus a reliance on exports
In a recent conference call, Dr. have been better cushioned through this crisis, and are probably better
positioned for an environment where we are likely to see weaker global
Michael Hasenstab gave an update
growth. Countries such as China, India, Indonesia or Brazil appeared to
on the global macroeconomic have remained pretty robust throughout this most recent global economic
outlook and the potential market downturn, and seem to be on a healthier path compared to some of the
opportunities. The following are economies that were more reliant upon an export engine. Most market
highlights from his discussion. observers 12 months ago would have likely predicted that if emerging
markets experienced a drop of 30% in exports, then domestic growth within
these countries/regions would collapse in tandem.
That is because the perception was that many emerging markets were reliant upon export-driven growth
models and, to varying extents, export industries have been an important driver of employment and
investment in a lot of these economies. However, what the recent global economic crisis illustrated was that
export growth is not the only thing driving many emerging market economies. Looking at the change in the
composition of final demand between the third quarter of 2008 and the second quarter of 2009, we have
1
seen a substitution from export to domestic demand of 10 percentage points. So instead of everything
getting weaker, there was a significant substitution, particularly in Asia, between the export-led economy
and the domestic economy.
It also illustrated a key difference across the various countries. Some emerging countries appeared to be far
more sensitive to the decline in exports, such as Singapore, Malaysia or Taiwan, whereas other emerging
countries, such as China, India or Indonesia, seemed far less sensitive. So the reliance upon external
markets varies, and our analysis of emerging markets is currently favoring those economies that have
strong domestic demand.
2. Policy Responses. Many countries have had to resort to extreme stimulus measures. Extraordinary
monetary and fiscal support was provided in many places including the U.S., UK and China, and while
these policies have played an important role in limiting the severity of the recession and may lead to an
earlier recovery than would have otherwise occurred, there are likely to be longer-term costs associated
with them.
1. Source: Franklin Templeton Investments, Datastream. Includes China, Indonesia, Korea and Taiwan.
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FR ANKLIN TEMPLETON FIXED INCOME GROUP
While both developed and developing economies have utilized stimulus measures, in emerging markets,
governments are in a position to begin unwinding their policies sooner than may be possible in the
developed world.
This illustrates that there is something underway in a lot of these emerging markets, more than just
cheaply priced exports because of undervalued exchange rates. There is not only a domestic consumer
that exists and provides some cushion, but now policy-makers in many of these emerging economies have
a framework and transmission mechanism in place to stimulate domestic demand through their own
respective monetary and fiscal policy. There has been a structural change in several of these economies
where policy has improved to the point that countercyclical measures are now possible and can be
effective. We are already seeing evidence of this as growth has reaccelerated and output gaps are closing
in many emerging markets.
3. Future Capital Flow Dynamics. We believe the crisis was primarily a developed world shock, particularly
stemming from the U.S., UK and Europe. While there was an initial increase in risk aversion, over the
medium term the crisis is likely to accelerate the structural reallocation of capital into other parts of the
world. Again, the data so far supports this. Even though China has faced a severe contraction in exports,
the increase in capital flows has more than offset the negative effects of the decline in exports, resulting in
higher inflows on the whole. While the decline in exports has received much of the attention, what’s being
ignored is the positive effect of huge amounts of capital coming into these countries, which in many cases
can be more important. We believe that this trend is likely to continue going forward as the relatively
stronger growth and higher interest rates in emerging markets attract increased capital. The differentiation
of recoveries (and consequently policy) is central here and we would expect that the liquidity created in the
most severely impacted countries would likely flow to not only emerging markets but also developed
economies that are in stronger positions such as Australia and Norway.
4. Overhang from Previous Excesses: Leverage and Overconsumption. Financial sector deleveraging is far
more prevalent in the UK, U.S. and eurozone than in the emerging world, which going into this recent global
economic crisis did not have a tremendous amount of leverage on their respective balance sheets. Asian
banks, in particular, used significant leverage in the boom before the financial crisis in the late nineties.
Since then, most countries within Asia have run a very low leverage ratio and, as a result, do not have the
burden of an overhang which, unfortunately, may inhibit future credit extension and therefore growth in the
U.S., eurozone and UK.
We believe the reliance on leverage is very important and may affect the pace of recovery for various
countries. Considering that this was a crisis about leverage, and that we’re now entering a world where the
use of leverage is not likely to be the same as it was in the past because of prudent regulation and risk
changes, those countries that do not need to delever are, in our view, in a better situation. While
substantial steps to repair the balance sheets of financial institutions have been taken in developed
economies, we believe this process has quite a bit further to go.
5. Consequences of High Public Spending and Debt. The U.S., Japan, and many countries in Europe are
running massive fiscal deficits, which are likely to be a burden for those countries going forward. These
deficits are unsustainable over the long term and are adding to already high public debt levels. These debt
burdens were further increased by the public sector rescues of several private institutions. Looking at the
advanced economies versus emerging market economies, we can see a vast difference in programs that
were required to shore up the banking system. In the advanced economies, there were real cash outlays,
whereas in the emerging markets, it tended to be more liquidity provisions that can be more easily unwound
if they’re no longer needed.
The International Monetary Fund (IMF) estimated that the magnitude of all this financial sector support in
the advanced economies was somewhere in excess of 25% of GDP. In the emerging G-20 economies, it
was less than 15%, and over 90% of that was simply a liquidity provision. In the advanced economies, there
was a lot of purchasing of assets, capital injection and upfront government financing, which didn’t really
occur in emerging economies. According to the IMF in their recent October ’09 outlook, advanced
economies are running roughly an 80% public debt-to-GDP ratio, whereas emerging and developing
economies are a little under 40%. They project this gap to continue to expand as the massive increase in
debt in the U.S., Japan and much of Europe contrasts sharply with more or less constant public debt levels
in developing and emerging economies, which are actually projected to decline over the next four to five
years.
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FR ANKLIN TEMPLETON FIXED INCOME GROUP
We believe that these five major factors will go a long way to explaining the different paths of the various economies
around the world during the recovery phase. In fact, the evidence of the relative strength of the recovery in emerging
markets is already clear in several recent trends.
Trends in the Recovery
Capital Flows. We have seen capital flows vastly increasing to emerging economies. They’re clearly not back to the
levels that they were in ’07 and ’08, but if we look at equity, syndicated loans and international bond issuance at the
end of the second quarter, we’re certainly back to the type of levels we saw in early ’06 and late ’05. And anyone
observing the market these days can witness the oversubscription of new deals, which is not uncommon.
Credit. Credit has not begun to expand strongly but has been growing in emerging markets despite significant
differentiation among regions. In eastern Europe, private credit has been contracting, but looking at Latin America,
private credit growth recently turned positive after contracting earlier this year. Emerging Asia actually never had a
private credit growth contraction, looking at an annualized change in three-month moving averages, and has
remained positive during the entire crisis.
Pace/Change in Employment. This is a very good indicator of where an economy stands in the recovery path.
Employment growth is a lagging indicator, but looking at emerging economies shows that emerging economies are
actually already in net job creation, whereas in advanced economies, job losses are slowing, but significantly more
2
jobs are still being lost than created. While improved corporate profitability and likely profit growth could begin to
reverse that trend over the course of the coming quarters, emerging economies are clearly well ahead in terms of
the path to a sustainable recovery.
Economic Activity Indicators. Looking at any number of other indicators—PMI data, industrial production, retail
sales—economic activity growth rates in emerging economies, particularly Asia, have already recovered to the
levels we saw pre-crisis. Clearly, the actual levels are not back to pre-crisis levels, but the growth rates are,
whereas the advanced economies have turned positive in some of those indicators, but clearly are nowhere near
the growth levels they were at going into the crisis. We believe that the net effect of this is likely to be continued
outperformance of emerging market growth rates versus developed market growth rates for the foreseeable future.
China’s Economic & Political Power Grows. The continued economic performance is contributing to the rise of
China’s economic and political power. China is clearly on a path to take on a greater role in the world economy, and
this crisis sped up that transition. We’ve seen an increased move towards the internationalization of the yuan and
an increased role of China as a political participant in global organizations, such as the IMF.
Asian Policy-Makers. In Asia, we’ve seen a structural shift away from policy-makers focused on an export model,
which is somewhat consistent with a weak exchange rate, to a domestic growth model wanting to move away from
the sensitivity and the reliance upon the U.S. consumer and external markets. That shift towards a domestically
driven economy is more consistent with a stronger exchange rate, which helps the wealth transfer to domestic
consumers.
Brazil: Net Creditor. Improving economic performance has not been limited to Asia. For example, Brazil has
rebounded quite strongly from the crisis. In fact, Brazil is now a net creditor to the IMF as of October 5, 2009. So not
only are they getting the Olympics in 2016, but they’ve also reversed their roles vis-à-vis the IMF, which has
provided support to Brazil in the past.
Interest Rates. We believe that emerging market economies are likely to see higher interest rates because they
weren’t levered and had more domestic growth drivers, which would feed back through to the exchange rates.
Consequently, we’ve generally been cutting our interest rate exposure in a number of emerging markets and
moving shorter on the yield curve to position a bit more defensively on interest rates while still positioning to take
advantage of exchange rate opportunities. However, we still think there are a number of cases where the declining
risk premium in emerging markets will actually shift yields lower structurally. Even though a central bank may have
to tighten and raise rates in a place like Indonesia, we believe significant rate hikes are already priced in. Further,
Indonesia is undergoing a big structural transformation where we think the risk premium will likely be lower. As a
result, we think government bond yields could actually stay where they are or move lower, even in the face of some
moderate interest rate hikes later this year or early next year.
In addition to opportunities stemming from the relative strength of the economic recoveries in emerging markets, we
are also focused on the following trends
2. Source: International Monetary Fund; World Economic Outlook, October 2009, Sustaining the Recovery.
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FR ANKLIN TEMPLETON FIXED INCOME GROUP
Euro and Yen Against the U.S. Dollar.
We view the recent strength of the euro and the yen against the U.S. dollar as being out of line with underlying
fundamentals. This requires us to look deeper into what’s going on in Europe and Japan versus the U.S., and
question the market pricing.
The euro and yen are strong against the dollar, reflecting market sentiment that conditions are worse in the U.S. We
believe the dollar does need to adjust weaker, but not against the euro or the yen, but more against the emerging
markets.
When we look at why people have been selling dollars and buying euros, a lot of the market points to the
extraordinary expansion of the balance sheet by the Fed, but it is important to also look at Europe, England and
Japan. Japan did not expand its balance sheet much because it already ran a massive balance sheet. The Bank of
Japan’s balance sheet has been in excess of 20% of GDP going back several years. And even with the U.S. Fed’s
expansion of its balance sheet, as a percent of GDP, it still has remained under 15%, so Japan still has remained
much higher. Europe expanded its balance sheet as well, but not to the same extent. Still, the actual level has
remained higher than that of the U.S. because they were running a much higher balance sheet going into the crisis.
In terms of Europe’s intervention into the credit markets and their form of quantitative easing, it’s fairly similar to
what happened in the U.S. Meanwhile, the Bank of England’s balance sheet changes look almost like a mirror
image of what happened to the Fed. So to say that the Fed balance sheet expansion is behind a weaker dollar may
make sense when you’re looking at it versus a country like China, Korea or Brazil, which didn’t expand their balance
sheets, but doesn’t make sense when you’re talking about the euro, the yen or the pound.
Banking Sector Conditions: Another issue is the relative banking sector conditions. Recently, the IMF incorporated
banking sector conditions into its global financial stability report, where they estimated the amount of additional
capital necessary to achieve an 8% Tier I ratio in the developed economies. It’s very interesting that, based upon
the IMF estimate, the U.S. has already met the capital requirements, and there isn’t a large of amount of additional
capital necessary. However looking at Europe, the IMF still estimates that they need about $150 billion to achieve
that Tier 1 capital ratio of 8%. So that is saying that Europe has not gone as far through the recapitalization path as
the U.S. has.
The U.S. still has further to go in terms of the likely write-down of bad loans, but Europe has even further to go. It’s
particularly a concern in Europe because the banking sector is a bigger provider of credit relative to the capital
markets than in the U.S., which relies more on the capital markets. The European bank sector still has a huge
overhang, which will likely drag on economic activity. It is probably not as bad as Japan in the late ‘80s and early
‘90s, but it is somewhat analogous, and it’s going to be very difficult to expand credit.
Labor/Unemployment: Another issue that differentiates Europe, Japan and the U.S. is relative strength of their
labor markets. Labor markets in Europe are far more rigid than in the U.S., and consequently unemployment has
not gone as high as it has in the U.S. Yet, that has meant that the unit labor costs in Europe have grown
considerably, whereas the U.S. labor costs have actually decreased. U.S. productivity has gone up, and that should
affect corporate profitability, which may lag in Europe, and certainly wouldn’t support such a strong euro. So if we
look at the relative conditions, it seems to us a little hard to envision why the euro is so strong on the back of
relative labor conditions between the U.S. and Europe.
Current Account and Fiscal Balances: The fiscal deficit in the U.S. is expected to continue to be larger than in
Europe. The current account conditions in Europe are also better than they are in the U.S., so there are some
positives, but in our view these are not enough to support the euro at the current highs. As of October 21, 2009,
we’re neutral on the euro—we have a small net-negative position paired against our other European holdings, but
we’re not really taking an active view in either direction. We don’t think there’s particularly great value there. If
anything, we would be looking to see if it becomes a position to take advantage of future euro weakness.
Japan: There’s been some optimism toward the new political party in Japan, and the hope is that it will lead to
some significant changes. However, we believe the changes are actually going to be somewhat of a negative for
the economy. The idea of the postal savings reform, which was one of the core cornerstones of Koizumi’s reform
agenda, is now completely off the table and is unlikely to move forward. We believe the absence of this policy is
likely to be a negative for Japan. It also looks likely that the policies will not be business friendly.
If we look at the labor market, which is really the core for any hope of sustainable consumption growth, their labor
market is arguably as bad as it was in the early ‘90s. If you look at the job applicant ratio, it was at about 0.4 as of
August 2009. It was in excess of 1.0 a couple of years ago, and the last time it was back at 0.4 was back in ’93, ’94,
’99 and ’02. So it would appear that Japan is not going to have a lot of strength from consumption. In addition,
Japan still suffers from multiple structural problems that have plagued their economy, and in our view it is very likely
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FR ANKLIN TEMPLETON FIXED INCOME GROUP
that the new government elected will continue the major stimulus programs in place to bolster the country’s
economy.
Positioning for a Rise in U.S. Interest Rates
Negative Exposure to the Yen: Another topic is how to use the Japanese yen’s overvaluation as a directional
investment and a hedge. What we have been doing in our portfolios is to take negative exposure to the yen, both
because we’re skeptical that over the medium term conditions in Japan will be better than in the U.S., and because
of the very high causality between relative interest rates between the U.S. and Japan, and the Japanese yen.
Looking back at the difference between U.S. and Japanese ten-year yields, there is a strong correlation between
yields and the value of the Japanese yen. As U.S. yields have come down, that has changed capital flows, with less
capital flowing into the U.S. because it’s no longer providing a higher yield relative to Japan. Further, a lot of
exporters have been hedging their future dollar receipts back to the Japanese yen.
So there are several reasons why we think this interest rate differential is important. Over time, we would expect the
interest rate differential to widen again and U.S. yields to ultimately go higher on the back of fiscal conditions,
monetary conditions, and eventually, relative growth conditions between Japan and the U.S. Although we don’t
necessarily expect the U.S. domestic growth to return to pre-crisis levels, we think that relative growth conditions in
the U.S. should be better than they are in Japan, given Japan’s structural problems.
U.S. Treasury Exposure: Some of the other ways that we have positioned for a potential rise in developed
government bond yields is by typically not holding U.S. Treasuries, gilts or Japanese government bonds, and by
holding the currencies of commodity exporters, which we ultimately think should benefit if inflation rises. Now we
don’t expect to see inflation dynamics in the short term in developed economies as we’re still on a deflationary path,
especially with the labor markets as weak as they are. However, in our view over the medium term, it’s really not a
question of if, but a question of when rates need to rise and we get a normalization.
Conclusion
In our global bond portfolios we have been focused on the likely differentiation of recovery paths between most
developed economies and the emerging world. We believe that this trend should favor the currencies of non-Japan
Asian, some of the core markets in Latin America, and peripheral Europe, particularly Scandinavia. We have
continued to be fairly diversified geographically in currency and credit exposure, but have become more selective in
duration positioning. We encourage our clients to view our global bond portfolios as a strategic, longer-term
allocation in an overall portfolio. Going forward, we see more opportunities in some of the transition and emerging
economies than there are in the core developed economies.
The following information does not reflect the audio commentary portion of the conference call.
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The information provided is not a complete analysis of every material fact regarding any market, industry, security or fund.
Holdings are subject to change. The analysis and opinions expressed are as of October 21, 2009, and can change
without notice. A manager’s assessment of a particular security, investment or strategy is not investment advice nor is it
intended as an investment recommendation; it is intended only to provide insight into a fund’s portfolio selection process.
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there can be no assurance that any forecast, projection or estimate will be realized or that any investment strategy will be
successful.
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