Hasenstab: Time to Rope Up

This analyst blog is part of our coverage of the 2016 Morningstar Investment Conference.

Franklin Templeton's Michael Hasenstab kicked off the 2016 Morningstar Investment Conference on Monday by laying out the case for some emerging market debt and warning against dangers in the U.S. Treasury market.

The first major theme that Hasenstab pointed to is the U.S. dollar looks set to appreciate against the euro and yen. The major driver of this will be divergent monetary policy across the globe. He sees the Bank of Japan continuing to push quantitative easing as inflation remains well below 2%, and in order for Abenomics to fully take hold, the bank needs to continue to push to encourage more risk-taking.

He doesn't see the ECB moving to tighten rates anytime soon. The central bank's goal of expanding credit still hasn't been reached and Hasenstab thinks the bank also has an implicit goal of keeping the euro low to support exports. The entire institution of the eurozone is also under pressure. Hasenstab thinks the support for Brexit is a warning sign of waning political support for the European project and that political support is what has helped paper over the weaknesses of the shared currency, and that signals that the EU is weakening could lead to the market re-evaluating the value of the euro.

On the other hand, he sees plenty of reasons that the Fed is going to have to move rates higher. There are signs of labor market tightness, higher wages, and the unemployment rate is likely close to its natural level. And once the impact of low energy prices finishes flowing through the data, inflation could start to look higher, too. He sees rates as just being too low right now.

His second major theme was U.S. Treasuries do not look attractive today. Given that U.S. rates are unnaturally low, he thinks there will either be a market-driven or Fed-driven response that will bring rates higher. Technical factors, like foreign demand for bonds, could keep things from getting ugly in the short-term. He doesn’t feel comfortable investing in something whose valuation rests solely on technical versus fundamental factors.

He likened not investing in Treasuries today as making sure you are roped up when you go rock climbing. The probability of falling is low but the consequences are very high. So it is worth protecting yourself.

So if U.S. securities aren’t the place to be--where should investors be looking? Hasenstab says local currency emerging market debt is one of the most attractive asset classes around. It isn't that there aren’t risks or the potential for large disruptions in the market, it is just that these have already been priced into the debt giving investors a cushion.

One of the big risk investors need to get comfortable with is from China. He sees the possibility of a so-called hard landing as being overblown. The central government still has policy tools at its disposal to stimulate the economy, and there are promising signs in the services sector. Manufacturing may decline but it won’t be a cataclysmic event.

Still it is important to pick your spots. Not all emerging markets are equally attractive and some still look quite overvalued (Hasenstab noted Turkey as one example). But there are some, like Mexico, that have strong fundamentals, good yields, and very undervalued currencies. The market is pricing in a scenario worse than the Tequila crisis and worse than the global financial crisis for Mexico today despite low inflation, large amounts of reserves, and decent growth.

Not all opportunities are that straightforward though. Hasenstab is investing in Brazil despite the economic crisis there. He’s willing to take the risk because he sees an exit path for the country due to political change and the fact that some steps, like higher rates, have already been taken. He contrasted this to Venezuela where he does not see a path from default.

Overall Hasesntab was quite bullish on the opportunity in select emerging markets while sounding the caution bell in the U.S.