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Hasenstab: Flexibility Key in Global Bonds

Jeremy Glaser

Note: This video is part of Morningstar's May 2015 International Investing Week special report.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm speaking today with Franklin Templeton's Michael Hasenstab. We're going to look at some of the recent turmoil in the bond markets and also how he thinks investors should think about international bonds as part of their portfolio.

Michael, thanks for joining me today.

Michael Hasenstab: Yes, my pleasure.

Glaser: Let's first talk about the European bond market. It's been a tumultuous couple of weeks there. We've seen some pretty significant moves in a very short period of time. What do you think is driving that move in European sovereign debt?

Hasenstab: I think there are a couple of factors: One, it had become definitely the consensus trade, and everyone was getting a bit complacent, given where the actual levels were. But then, this month, in one of the rare exceptions, you had more issuance than they were actually buying back--although on net, the ECB will be taking out more from the market over the course of their program than governments will be issuing. So, the ECB, I think, still will have an important role there.

The other factor, though, that came out--and this is something we'd been looking for earlier this year--was that [quantitative easing's] effect on euro depreciation has a pretty meaningful impact on the growth of German exports, which has a very meaningful impact on European growth in a pretty short order. We're talking months, not quarters. And so you've seen growth come out a little bit better than I think people expected. You had a crowded market, a little bit better growth, and these types of moves get extreme.

Glaser: So, what's you outlook for Europe, then? Is this just a temporary move and we're going to see yields come back in again? Or is this more of a durable move?

Hasenstab: We have very minimal exposures. We have a little bit of exposure, for example, to Ireland, but nothing to places like France or Italy or Germany--the kind of core markets--because we just didn't see value there. And so, at this point, even despite this move, we're not being enticed to change our view. Ultimately, our view globally is for rates to go higher over the long term. Europe will probably take longer than the U.S. will; but nevertheless, we're not seeing a lot of value there.

Glaser: I want to dig a bit deeper into your comments about currency and how that's impacting growth there. Generally speaking, even though the dollar rally has slowed a bit, what impact is the stronger dollar having on global bond markets. What impacts will that have?

Hasenstab: I think there are a couple of separate factors happening. I think what's happening in the currency market is quite interesting. We would expect that--despite this pickup in European growth and despite the temporary slowdown in U.S. growth on the back of decreased oil production--over the course of 2015, U.S. growth will outperform European growth. U.S. monetary policy will move to more of a tightening bias than European policy. Similarly, for Japan, we expect their policy to remain a lot looser than the U.S. and growth in the U.S. to outperform. Under that environment, the dollar should appreciate against the euro and should appreciate against the yen.

That being said, it's not going to be uniform against the rest of the world; in fact, places like Mexico have already priced in basically a significant Fed tightening. The market has, in our view, got massively oversold. Mexico's peso is trading at some of the weakest levels on record. We think there's a lot of upside room in places in select emerging markets to actually appreciate against the dollar, even though the dollar will be appreciating against some of the other majors.

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Glaser: So, there is some value there, potentially, in some emerging markets. Does the fall in oil prices and low commodity prices make you worried about some of those economies?

Hasenstab: It varies. The oil exporters, places like Russia and Venezuela--yes. It is putting a lot of pressure on their balance of payments, on their fiscal accounts. However, most of the emerging world is actually a net oil importer. And even for countries that do have a slight net oil export, such as Mexico, it's very minimal. In fact, what's going to drive Mexico more than a change in the oil price is their own domestic policy, which is on a good path and their linkages to the U.S. economy as a large exporter into the U.S. Korea, a net oil importer, India, China--all of these countries are going to be huge beneficiaries of declining oil prices. So, there are a lot of reasons that emerging markets will be diverse in their return profile--some doing well, some doing poorly. Oil is certainly one of those reasons.

Glaser: So, what impacts do you think the Fed's policy will have on these emerging markets, then? We saw with the "taper tantrum" that emerging markets really got hammered. Would you expect to see something like that happen again?

Hasenstab: Well, certainly, our expectation is for U.S. rates to go higher; that's why we moved our strategies to have a negative duration in the U.S. So, we're actually quite pleased with this backup in yields. However, there could be a temporary knock-on effect in some emerging markets. Our assessment, though, is that that will be temporary in countries with good fundamentals and positive economic linkages to the U.S.--like a Korea or like a Mexico. Additionally, I would note, though, unlike back in the taper tantrum, the markets have already priced in a really bearish scenario for places like Mexico and Korea.

So, certainly, you could see some temporary weakness in those countries on a Fed move or on additionally higher rates. However, over the medium term, the market has already priced in the worst news, and rates in those countries are also likely to increase. So, you've seen, for example, in Mexico, as U.S. long rates have gone higher, so have Mexican long rates. So, the interest differential in favor of emerging markets is likely to persist, and that should be supportive of any medium-term currency moves.

Glaser: Taking a bit of a step back: When you look at the current environment, what do you see as the real benefit of holding international bonds right now as part of a broader asset allocation?

Hasenstab: It really depends what kinds of international bonds you hold. If they are bonds with long duration, if they are bonds with a lot of yen and euro, I'd be very skeptical. However, if there is flexibility to have a very active currency management--some short dollars; some long dollars; on the interest-rate side, the ability to go short duration as well as long duration--I think what that type of portfolio can do for investors is provide or at least target a positive return in a negative-bond-market environment. That's really what we're shooting for--providing something that moves in a very different fashion than other asset classes.

But I would caution that the index approach to international-bond investing that worked when you just had a broad-based decline in yields and a broad-based decline in the dollar [may not work now]. That approach had some value from total return and diversification over the last number of years, but that's not going to work going forward. The type of international investing that investors need to look toward is very different. It has to be very active, very dynamic, and have both long and short biases.

Glaser: Mike, I certainly appreciate you taking the time to share your thoughts with us today.

Hasenstab: It was my pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.