Navigating the Fog: Geopolitics and the Global Bond Market
Dan Fuss, CFA, vice chair of Loomis Sayles, has always encouraged analysts and portfolio managers to think broadly about their approach to investment analysis. At the 2015 CFA Institute Fixed-Income Management Conference, Fuss provided a global analytical framework through his four Ps — peace (or lack thereof), people, politics, and prosperity, while adding perhaps a fifth P for policy and the evolving role of central banks.
Defense Spending on the Rise
“Peace or lack thereof has been essential in dealing with markets in my lifetime and it controls the environment we’re in,” he said. Today, Fuss keeps a close eye on three geopolitical hot spots — Syria, Russia and Eastern Europe, and the South China Sea — when considering investments.
With regard to Syria, Fuss noted, “If you’re in the Middle East, you’re concerned about the welfare of people coming across your borders and how they will blend in your society. If you’re further away, in Europe or the US, you may need to directly or indirectly provide support, or, in a worse case, defense,” said Fuss.
Though Eastern Europe is relatively quiet, Pentagon officials recently proposed sending more forces to Europe to build up the US presence. In the South China Sea, a dispute between China and the United States over the Spratly Islands has evolved into a direct contest, though Fuss is hopeful that any serious rivalry between China and the United States will be avoided.
Fuss believes the United States may be entering a period of gradual acceleration in defense spending, expecting overall government spending to go up 1%–2% or possibly 3% in defense spending. Fuss referred to Defense Secretary Ashton Carter’s statement in the Wall Street Journal that it’s time to take the uncertainty out of the military budgeting process and separately noted that there are many in the active military who say the current defense budget is too low to deal with evolving situations around the world.
“A major issue relating to defense is how much we spend and the freedom we allocate to the US Treasury to borrow money when not enough revenues are coming in,” Fuss said. Therefore, he believes higher taxes in the United State are inevitable, but that they do have favorable implications for municipal bonds (versus corporate bonds and Treasuries). Investors should also look for companies in the industrial sector that will benefit from greater defense spending. And Fuss said if you have the risk appetite (he doesn’t), you can invest tactically in the debt of Poland, Ukraine, or even Russia.
In terms of people, Fuss sees slower population growth in developed economies as a positive for fixed-income markets. He expects aging baby boomers to move to fixed-income investments and corporate pension funds to continue to match liabilities (less so for public pensions), selling stocks and buying long bonds, at least for the intermediate term. “Everyone in this room knows the trigger points for the next allocation, and these flows have important implications for valuation,” said Fuss.
A Third US Political Party in the Center?
On politics in the United States, Fuss said, “Pressures are growing in the way we handle our democracy and there are serious papers coming out of think tanks and academia favoring a third political party in the middle along with discussions of how it should be organized, because it will be difficult.
Fuss compared the current period to the mid-to-late 1930s when markets clashed with the political process and there was great disagreement in Congress combined with very low interest rates (though not as low as today’s). Ultimately, an accord between the US Federal Reserve and the US Treasury was formalized in 1951.
What would trigger that necessity again? “If our forecasts for inflation are too low and rates go up as they did in the second half of the 1960s, then the federal government has a big problem with the cost of carry on debt escalating at the same time that federal spending is going up. Then you have a catch-up period for revenues (think much higher taxes).”
Global Economic Prosperity
Looking at the major economies around the world, Fuss said he has no idea what’s happening with China. “Whose numbers do you believe? None of them,” he said. “You will be able to measure it when demand for iron ore or copper goes up.” On the geopolitical side, Fuss is concerned about the consolidation of power in China around a much smaller committee. “They are pursuing a program of change whose stated purpose could be very, very good. But history has not been kind when it comes to centralized power.” Fuss questioned the outflow of money from China for safety purposes. “Why is money flowing out of China through Taiwan to dollar-based mutual funds in Luxembourg?” he asked.
In the United States, Fuss is looking for 2%-plus economic growth in 2015, even with the recent slowdown. “Europe is a slight plus given Draghi’s next round of QE,” he said, which should give its economy a boost and the ability to deal with immigration pressures at their borders.
Policy and the Evolving Role of Central Banking
Fuss said investment patterns in emerging markets have changed dramatically since the days of Citicorp lending to build manufacturing plants. The changing nature of flows to and from emerging markets through open-ended investment vehicles (despite assurances that exchange-traded fund (ETF) liquidity is not a problem) will now be the responsibility of the central banks. The Fed included these new policy actions under its domestic purview because of possible implications for US corporations from an export/import perspective. “Ingenious!” said Fuss.
What’s Next for Bond Markets?
“I haven’t the foggiest,” Fuss said. “The Fed is caught between a rock and about four hard places.” There are strong arguments on both sides to either get rates up because they’re not economically feasible, or keep them low because the economy cannot withstand it. “And the underlying trend that involves the military is not good,” he said.
But even as investors navigate bond markets through the fog, Fuss provides insights to light the way and find opportunities across fixed-income sectors. He recommends investors look closely at relative values and base security selection on maturities, spread, and other things, including a focus on the underlying fundamentals and especially taking into consideration the political or geopolitical parameters.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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