Desai Sees Bright Spots in the Economy

Karin Anderson: Hi. I'm Karin Anderson. I'm a director on the manager research team at Morningstar. I'm here with Sonal Desai, who is CIO of fixed income at Franklin Templeton.

Sonal, thank you so much for being here today.

Sonal Desai: Thank you, Karin.

Anderson: Sonal gave a wonderful keynote speech today and spoke a lot about the bright spots in the U.S. economy and the fact that you're not really seeing any of the typical recession signs that people might think are a problem. What are some of those signs, and why do you think they aren't appearing right now?

Desai: More than even signs, I think about them as recession triggers. Different factors which could trigger a recession. One of those factors certainly would be an overaggressive Fed. We don't have that. We don't have an overaggressive Fed. I think we can put that one to rest. Even though the Fed raised rates, we have a massive Fed balance sheet out there, and we have great pools of liquidity in the economy. We don't have overtight monetary policy. Then if I think about other things which could trigger a recession, on occasion, it's been oil-price shocks. Oil-price shocks ever since we've started producing shale and, globally, advanced economies have become much more energy-efficient. That seems to be less of a potential source for a recession if you will.

Another item which could potentially trigger a recession is overinvestment. Now, that would mean that firms--you know, it's traditional: Firms invest, overinvest, eventually inventories build up. We aren't seeing that. Investment during the cycle started quite late, and we still have runway room over there to get to the stage of overinvestment.

The last trigger, if you will, for a recession, and indeed the trigger in both the early 2000s and '07, '08, was the bursting of financial asset price bubble. Now, I think, without a doubt, easy monetary policy is contributing to distortions amongst different asset prices. I'm not yet seeing those bubbles, which are on the verge of bursting, but definitely an area to keep a very close eye on.

Anderson: This is very topical given what's going on this week, but you've done a lot of research on trade wars, or trade skirmishes, I think you like to call them. Why are fears of trade wars overblown?

Desai: Two main reasons. One is trade wars, like you said, we haven't had wars. We haven't. We've had tensions, at times elevated, at times less elevated. I think about trade as the dog that didn't bark after that famous Sherlock Holmes story. We keep waiting for the other shoe to drop. We went back and looked at some numbers. Now if I look at earlier periods, so if I look at the period between '92 and the mid-2000s, around that period of time, you will see that we had trade growth at the rate of something like 7% per annum. And you had global GDP growth around 3.7 or so. If I look at a similar period from 2011 to 2018 or so, so I look at a period post-GFC, trade growth was only 2.8%. It dropped by more than half. But global GDP is still kind of chugging along at broadly similar levels.

So, what has happened? One is, potentially, causality is not as strong today as it was then. China's been fully integrated. The second issue I think is that a lot of supply chains have changed. There's been a lot of evolution. Essentially we're seeing different patterns emerge in global trade. It's not telling us as much about global growth. Separately, there's the actual question about what is going on with tariffs. We hear a lot about tariffs, about imposing tariffs. And indeed when we did our research, I was fully convinced that what we were going to find is that tariffs create a massive burden. They're very inefficient. I still believe that, by the way. However, what the data will show you, if you look at WTO data, you will find that, in fact, we've never really had free trade. What we're looking at is the U.S., which has the lowest tariffs.

This isn't to argue that the U.S. should raise tariff, but certainly it's a strong argument for other countries to lower their tariffs. Average tariffs in the U.S., 3.4%. Average tariffs in Korea--by any stretch of the imagination, not your average emerging market; this is a developed country in everything but name--tariffs are 13.8%, which is the same level that you see in some countries in sub-Saharan Africa. There's a huge degree to which Korea can make concessions and lower its tariff barriers. What I find fascinating about trade and the current round of trade tensions is ironically it might ultimately lead to lower tariffs rather than higher tariffs, freer trade because other countries lower their tariffs as opposed to the U.S. raising its.

Anderson: It's fascinating. Since I have you, I also want to talk to you about your view on the U.S. dollar. The U.S. dollar had, I think, its first good quarter against both the euro and the yen in Q1. Where do you see things going for the rest of this year?

Desai: I would say that with respect to the euro, I do see interest-rate differentials playing a kind of traditional role. And it's not just interest-rate differentials. It's growth differentials. The euro area--growth is slowing. I'm not one of those who is panicked about growth in the euro area. But undoubtedly we have more resilience and more likelihood of upside surprises from the U.S. than the euro area.

Now my view with respect to the Japanese yen: similarly, interest-rate differentials are going to carry the day. But I have to also be aware that the yen has a traditional role to play as a safe haven during periods of risk aversion. And that's just something to keep in the back of your mind if you are running a strategy which is not able to take that type of volatility because, unlike the euro, you can predict that, in periods when markets panic or volatility occurs, the yen is likely to strengthen. And I don't think that relationship is going away. Fundamentally, the dollar should probably strengthen against both, keeping in mind that I anticipate greater volatility in the periods ahead. I'm a little bit more cautious on the yen than the euro.

Anderson: Great. Sonal, thanks so much for being with us today.

Desai: Thank you so much, Karin. It was a pleasure. Thanks.