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Dan Vrabac
Mark Beischel, CFA
Co-Portfolio Managers
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Waddell & Reed Advisors Global Bond Fund – August 2011
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The Global Financial Crisis bequeathed to us a complex, volatile investment environment that could continue for quite some time (if you don’t believe us, check your Reinhart and Rogoff 2). It is incumbent upon portfolio managers to properly assess this environment and structure their portfolios in such a way as to minimize the risk of permanent capital loss while still providing a decent return to the investors who trust the managers with their hard-earned funds.
So, as portfolio managers of the Waddell & Reed Advisors Global Bond Fund — and also as investors in the Waddell & Reed Advisors Global Bond Fund — what is it that we are paying closest attention to this summer?
Things That Go Bump in the Night
Here is our list of some of the more important issues facing investors today — not in any particular order. Not only are all of these issues important, they also tend to be intertwined. Although you could write a book (or perhaps a short story) about each of these, in the interest of time and space we will do our best to get these points across as briefly as possible. We also promise to end on a somewhat more upbeat note.
- Europe and the Euro
- Low economic growth in the U.S.
- The U.S. debt situation and AAA rating
- The U.S. dollar and its reserve currency status
- The U.S. inflation outlook
- China’s growth outlook and problem loans
Europe and the Euro
The European crisis started in Greece, and then spread to Ireland, Portugal, and Spain. Now even Italy is under threat. The crux of the crisis is debt sustainability. The headlines all seem to focus on what European leaders will do to bail Greece (et al) out of the crisis. To us, this focus on bailouts is wrong-headed. A bailout implies that there is a liquidity crisis. In a liquidity crisis, the solution is to provide enough temporary funding to a country so that it can make its debt payments until it gets back on its feet. This is what European leaders have been trying to do for Greece for well over a year now— not only to no avail, but also causing the crisis to spread to other countries. What we believe Greece and some of the other so-called peripheral European countries are suffering from is a solvency crisis — they owe so much debt that there is no way out short of a default or bankruptcy. In other words, their economies cannot grow enough or generate enough revenue to sustain the current levels of debt. Furthermore, the onset of fiscal austerity programs in all of these peripheral countries will have an additional negative impact on growth. Therefore, the level of debt keeps growing at an alarming pace.
We think there are two feasible solutions.3 The first is a default. This would likely involve a dramatic writedown of Greece’s (and perhaps other peripheral countries’) debt load. To us, this is the most logical and likely end result to the situation. That means the lenders — primarily the European Central Bank, European governments and European commercial banks — will likely take an immense hit to their capital. The more peripheral countries this spreads to, the bigger the impact. Unfortunately, the longer Europe’s leaders take to realize this the worse the situation gets.
As an aside, it is also possible that one or more peripheral countries may be forced out of the Euro currency due to their debt problems. Significantly reducing debt loads is typically one part of the road to recovery; another part is a significant depreciation or devaluation of the currency. As long as the peripheral European nations cling to the Euro, the depreciation/devaluation route is not open to them, and their growth prospects will be significantly reduced. It should also be said that regaining stability in a defaulting country with a big currency write-down doesn’t guarantee immediate success — we think it will take years and involve a lot of pain. However, that is the ultimate conclusion to the end of a debt binge.
The second solution is what some are calling a “Eurobond”; essentially— instead of having Greek government bonds, German government bonds, Italian government bonds — there would be one Eurobond guaranteed jointly and severally by all of the European nations. This is the ultimate bailout of the peripheral nations by the strongest nations in Europe. It also puts the German and French taxpayers on the hook for all of the peripheral country debt. Without true debt restructuring in the periphery, we believe the creditworthiness of the core (Germany and France) will eventually be called into question. We believe the political roadblocks to this type of fiscal union are too large to allow this solution to occur before the extreme economic circumstances in one or more of the peripheral countries create a default situation.4
WADDELL & REED ADVISORS GLOBAL BOND FUND POSITION: We have no government bond investments in peripheral Europe. Our total Western European bond exposure is about 1% of the portfolio, and this is in corporate bonds denominated in U.S. dollars. Finally, we have a “short” position on the euro given our belief that it should decline versus the U.S. dollar as the crisis unfolds.
Poor Growth Prospects in the U.S. — Lowered Potential Growth
Potential Gross Domestic Product (GDP) growth is the rate at which the economy can theoretically grow based on its expected labor and capital inputs.5 If the actual GDP growth rate is faster than potential, then the economy risks overheating and a rise in inflation. If the actual GDP growth rate is slower than potential, it’s typically recessionary and disinflationary as productive resources aren’t efficiently utilized. The U.S. economy is currently very much in the latter area.
Real potential GDP growth has declined sharply in recent years. Before the Global Financial Crisis, potential GDP growth was fueled by excessive borrowing and was estimated to be between 3% and 3.5% on an annual basis. However, the Congressional Budget Office (CBO), the official arbiter of the country’s potential growth rate, now sees potential growth over the next decade at 2%.6 Our own calculations show potential GDP growth to be 2% or below.
Why is this important? The GDP of the economy today is approximately $15 trillion. Growing at 2% instead of 3.5% results in approximately $225 billion less in real GDP annually; after a decade, with compounding that would grow to a nearly $3 trillion difference!
Poor Growth Prospects in the U.S. — Lousy Employment Situation
Prior to the Global Financial Crisis, there were approximately 138 million employed Americans. The level of employment today is closer to 131 million. But that’s not the full story. Employment drops during every recession; however, in the typical post-World War II recovery, employment is back to its pre-recession level within two years. Three years after the recession began we would typically have employment three percentage points higher than it was at the start of the recession. The situation today? Three years after the onset of the recession (and global financial crisis), the number of Americans employed is five percentage points lower than at the onset of the recession!
Now consider the numbers. As we mentioned, there were 138 million employed at the onset of the recession. In a typical recovery, where three years down the road we would have 3 percent more workers than at the beginning of the recession, we would have approximately 142 million employed today. Because 131 million are actually employed today, a case could be made that we are actually short 11 million jobs and not 7 million. Let’s take this one more step. The Social Security Administration calculated the national average wage income at $40,711 for 2009 (the latest available data). If you multiply that by 11 million, the annual amount of lost income is nearly $450 BILLION dollars. Assuming the majority of that amount would be spent, it represents a huge drag on GDP growth.
WADDELL & REED ADVISORS GLOBAL BOND POSITION: With such a low potential growth rate and lack of job creation (not to mention the ongoing housing crisis — a huge negative wealth effect for the consumer), interest rates should remain low on average. However, as we have seen over the past few years, the volatility of the economy has increased markedly. Some have described this as a “low Sharpe ratio” environment — low returns with a lot of risk. The Waddell & Reed Advisors Global Bond Fund addresses this by having a low duration in an attempt to mitigate the volatility, and investing in corporate bonds in an attempt to gain additional yield in a low rate environment.
The U.S. Debt Situation and the AAA Rating
We covered the U.S. debt situation in-depth a year ago in our July 2010 Portfolio Perspectives, and our comments are still relevant today. The debt topics du jour are the debt ceiling and the credit rating of the U.S. The U.S., of course, is in no danger of not having enough resources to meet its debt obligations. As of the time of this writing, Congress and the President have arrived at a temporary solution to the debt ceiling problem. They have kicked the can far enough down the road to avoid a technical default for now; unfortunately, the real problems have not been dealt with.
Today the public debate is centered on how the government is going to deal with a large budget deficit and an already high federal debt-to-GDP ratio. The focus of this debate has led the U.S. government (and many governments around the world) to prematurely embrace fiscal austerity— primarily by cutting government spending. However, this is putting the cart before the horse. The real underlying danger today is poor economic growth, high unemployment, and reduced competitiveness of the U.S. economy. The proximate cause of our problems today was the private sector borrowing binge over the last nearly three decades prior to the onset of the global financial crisis in 2007. The high government deficits and debt are merely symptoms of this problem. We absolutely must deal with spending over the medium-term and long-term, but fiscal austerity in the face of a flagging economy has been demonstrated to be not only an inappropriate response, but a dangerous one — a response that can exacerbate the poor economic situation.7
Some investors and politicians are concerned that if we don’t deal with the deficits and debt right now, then the U.S. is going to suffer a downgrade in its credit rating. While further downgrades could have an immediate adverse market reaction, we would argue that the market has had ample time to digest this possibility, and therefore such a negative reaction would be short-lived.8 We believe the U.S. was not downgraded by Standard & Poor’s because of the debt ceiling or the size of the deficit. We think the real reason for a downgrade was the fact that the government has not yet adequately dealt with the medium-to long-term problems of health care, social security, and defense spending. As an aside, we think the rating downgrade of the U.S. could have more negative implications in Europe than in this country. Now that the U.S. AAA rating is being called into question, the market is (rightfully) wondering why France would remain AAA. Should France lose its AAA status, then the entire bailout structure put into place in Europe for the peripheral countries gets called into question.
The lack of action on these big spending issues weighs heavily on the minds of all investors — particularly the foreigners who own over 40 percent of our federal debt. But we don’t think that spending control is the most pressing issue today. We believe the first item on the government’s agenda should be to get the economy growing again— and this may require more deficit spending in the near-term, and not less. We think the U.S. government should focus on offsetting lackluster economic growth now while forming a credible fiscal plan to deal with the longer-term problems — especially in health care expenditures.
The U.S. is recognized throughout the world as always providing liquid and open markets; we have been the “go-to” country in times of global distress. We risk sacrificing this credibility not because of the debt ceiling or a rating downgrade, but because we have not forcefully dealt with the more problematic longer-term issues facing us. The longer-term implications of a loss of trust in the U.S. could be severe. We should follow the wisdom of Alexander Hamilton, first secretary of the United States Treasury, who remarked:
“But who would lend to a government that prefaced its overtures for borrowing by an act which demonstrated that no reliance could be placed on the steadiness of its measures for paying? The loans it might be able to procure would be as limited in their extent as burdensome in their conditions. They would be made upon the same principles that usurers commonly lend to bankrupt and fraudulent debtors, with a sparing hand and at enormous premiums.”9
WADDELL & REED ADVISORS GLOBAL BOND FUND POSITION: Our primary concern is with insufficient growth, and fiscal and monetary tightening now will only make the near-term situation that much worse. Issues such as the debt ceiling and the U.S.’s debt rating only increase market uncertainty and volatility. The Waddell & Reed Advisors Global Bond Fund has ample liquidity on hand to help steady the ship and to take potential advantage of any mispricing opportunities which may occur.
The U.S. Dollar and its Reserve Currency Status
Investors have shown a lot of concern over the U.S. dollar’s status as the world’s primary reserve currency. The following factors are usually cited for the concern:
- The impact of the debt ceiling debate;
- The rapid increase in government debt;
- The huge expansion of the Federal Reserve’s balance sheet;
- The rise of China;
- The downgrade of the U.S.’s “AAA” rating.
There is a lot of misinformation and misunderstanding regarding exactly what it means to have reserve currency status. Briefly, a reserve currency must be very liquid; it must be supported by a large and liquid domestic bond market; it cannot be subject to capital controls; the country underlying the currency must be trustworthy (i.e. not having a history of default, runaway inflation, or other forms of confiscation); it will be widely held by central banks around the world; the reserve currency country must be willing to supply all the currency the rest of the world needs; and, it will be used for business and financial transactions globally. The
U.S. dollar became the world’s de facto reserve currency following World War II under the Bretton Woods agreement; even though this agreement fell apart in the early 1970s, the U.S. dollar remains the primary reserve currency today, constituting over 60% on average of global central bank foreign exchange reserves.
Quick question: Can you name another currency that meets the qualifications stated above? We can’t. Sure, there are a few currencies out there that can supplement the U.S. dollar in central bank holdings, e.g. the Euro, the Japanese yen, and to a lesser extent the British pound. But none of those currencies could replace the U.S. dollar as the primary reserve currency because no country meets all of the necessary qualifications. What about China? Although in the next several years we fully expect the Chinese currency to become more important and gradually be added to the list of currencies used for reserve status, we think we are several years away from that happening — again, consider all of the qualifications and ask if China meets those today.
We fully expect the U.S. dollar to decline in importance over the next decade as central banks continue to move toward a multi-currency approach with respect to their reserves. Other currencies will start to be utilized in business and financial transactions as well. But — in spite of the current debt ceiling shenanigans going on in Washington, the loss of AAA status, and the rising debt — we believe the U.S. dollar will remain the primary reserve currency for years to come.
WADDELL & REED ADVISORS GLOBAL BOIND FUND POSITION: Unlike a lot of global bond funds which depend on currency movements for their return, the Waddell & Reed Advisors Global Bond Fund considers itself U.S. dollar-based and seeks return first through income on its investments. If we don’t believe there are sound fundamental reasons to invest away from the dollar, we will maintain a large U.S. dollar orientation in the Fund. We expect to gradually increase our exposure to emerging market currencies, but the high risk environment in the aftermath of the Global Financial Crisis warrants caution and slow progress toward that objective. We won’t trade every wiggle in either currencies or interest rates, because we believe that is detrimental to the long-term capital preservation of our investors.
The U.S. Inflation Outlook
At the current time, we are not concerned with the potential of a sustained rise in inflation in the U.S. Lower potential growth and the poor employment situation discussed above are the primary reasons. Without wage growth, we think it is highly unlikely that inflation expectations (a key variable watched closely by the Federal Reserve) get out of control. True, commodity prices and imported inflation have been on the rise. However, these have tended to have only a temporary influence on the price level. Furthermore, the higher commodity prices go, the greater the negative impact on growth. Lower growth tempers demand, which keeps inflation under control.
In the medium-term, what could cause us to change our inflation outlook would be a sustained rise in commodity prices (over several years). This would have to be accompanied by a sustained increase in import prices other than commodities. How could this happen? The high rates of growth in China and India are causing continued strong demand for commodities; that demand will not only increase commodity prices, but lead to higher generalized inflation in their economies. Higher inflation leads to higher wages. Higher wages will require their companies to charge higher prices for their products — resulting in higher import prices in the U.S. For nearly a decade the U.S. has benefitted from China exporting deflation; in the years ahead, the emerging world — as their domestic economies grow — could begin exporting inflation to the U.S. and the rest of the developed world.
The scariest development occurs if the U.S. hasn’t gone far enough down the road in terms of improving its competitiveness at the same time the inflation in emerging markets gets passed along to developed countries. The ugly possibility of stagflation in the U.S. then becomes the grim reality. We do not see this in the near future, but it is a concern in the medium-term.
WADDELL & REED ADVISORS GLOBAL BOND FUND POSITION: The short duration of the Fund and the extra liquidity are designed to make the Fund much more maneuverable. Should inflation become a problem, the Fund can quickly attempt to take advantage of higher yields as interest rates rise and spreads widen.
Chinese Growth (in particular), Global Growth (in general)
The real questions in China are whether or not its underlying growth rate is peaking, and whether its inflation is cyclical or structural. The answers are crucial for the performance of the global economy and the markets, as everyone knows that on the margin China is perhaps the most important player globally. Let’s deal with growth first. China continues to print good numbers, but the quality of that growth is increasingly being called into question. The concern is that China’s debt levels are growing faster than the economy, and the economy is requiring more and more debt to continue those high levels of growth. If you’ve lived in the U.S. for the last 10 or 20 years, you know how that ends up working out. Furthermore, the main concern of China’s leaders (and Western investors) is the unbalanced nature of that growth. Investment spending as a percent of GDP in China is higher than it has ever been for any other country; conversely, its consumer spending as a percent of GDP is very low. The authorities have taken several steps to curtail the growth of debt, but they have been unable to control unofficial sources of credit. As China continues to raise interest rates and reserve requirements on banks to slow loan growth, the impact on the economy will likely be further softening. At a time when the developed countries of the world are slowing once again (and those same countries are entering a period of fiscal and monetary austerity), it does not bode well for global growth overall. Finally, developed countries that have done well, e.g. Germany, are highly dependent on continued growth in China.
Now let’s consider Chinese inflation. The higher interest rate and reserve requirements mentioned above are not only an attempt to fight credit growth but also inflation. Where is the inflation coming from? Some economists believe it is temporary, a result of higher pork prices (pork being a significant portion of consumer spending). The pork-based inflation has occurred numerous times in the past and has always proved temporary. However, there is strong evidence that the current higher level of inflation is structural, and China will need continued tight policies and lower growth to battle it. The evidence here is rising wages. By allowing recent wage hikes to stick, the authorities appear to be acknowledging that inflation expectations among the population have risen. Without wage hikes, there would be social unrest, which is an anathema to the authorities. Finally, there is an economic concept known as the Lewis Turning Point. Expect to hear more about this with regard to China. Essentially, a Lewis Turning Point is reached when, in a developing economy, the rural-to-urban migration has peaked. The economy moves from a situation where wages are low and stable to one where wages begin rising as the new supply of labor is not enough to meet the demand. This would mean China has a structural, and not a temporary inflation problem.
WADDELL & REED ADVISORS GLOBAL BOND FUND POSITION: We believe that these intense internal pressures in China warrant continued appreciation of the currency, so we have positions that benefit from a rise in the Chinese renminbi versus the U.S. dollar. A higher value of the currency will give consumers greater purchasing power, and reduce the need for the government to offset the money supply increase resulting from high trade surpluses. Finally, a higher currency is a key tool in fighting inflation.
Ok, enough “Things That Go Bump in the Night”; Where are the opportunities?
Like others, we believe there are good opportunities ahead in several emerging market countries. There are also opportunities in companies in developed countries that do business in emerging markets. However, one cannot emphasize strongly enough that in spite of all the improvements, these are still emerging markets — they operate under different rules of law, they have mostly immature and/or small local markets, and their per capita incomes are very low by developed country standards. Therefore, investors must make sure they are being sufficiently rewarded for investing in emerging markets.
Although emerging markets have the potential to continue to grow as a percentage of the Waddell & Reed Advisors Global Bond Fund, it isn’t the only place where opportunity may be found. We will continue our search for the best companies in the world, whether in emerging or developed countries — and we will do our best to preserve capital while providing a reasonable flow of income to the investor. In this Perspectives, we just wanted to let you know that not only are we aware of the risks facing investors, we are doing our best to mitigate those risks.
The opinions expressed are those of the Fund managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 10, 2011, and are subject to change due to market conditions or other factors.
Consider all factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. International investing involves additional risks including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. Fixed income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.
1. Our apologies to George Gershwin.
2. “This Time Is Different: Eight Centuries of Financial Folly,” Carmen Reinhart and Kenneth Rogoff.
3. Emphasis on “feasible.” There are plenty of so-called solutions being offered that really do nothing to address the debt sustainability problems.
4. On July 21, 2011, European leaders came up with a plan that contains elements of both of the solutions described above. However, we think the plan doesn’t go far enough in either direction. We expect further pressure on Europe and European bond prices until the debt sustain ability issue is properly addressed.
5. Potential GDP growth is basically determined by growth in the labor force and growth in productivity. Both of these have trended lower over the past decade.
6. CBO’s 2011 Long-Term Budget Outlook, June 2011.
7. Expansionary Austerity: New International Evidence; IMF Working Paper July 2011 (WP/11/158).
8. On Friday, August 5th, Standard & Poor’s downgraded the U.S. debt rating from AAA to AA+. The other two rating agencies, Moody’s and Fitch, have not indicated any downgrade in the very near-term.
9. The Federalist Papers, number 30.