International Fixed Income | October 2011
Smaller economies around the world continue to show promise while older, developed nations languishBy Tony Norris, Peter Wilson, Alex Perrin, and Michael Lee—Portfolio Managers, International Bond Fund
By now, most investors are very familiar with the challenges of reduced economic growth and large sovereign deficits in the United States and across Europe. But while these major economies have mostly languished in 2011, opportunities for fixed-income value from the smaller economies have quietly flourished. For several quarters we have maintained the opinion that the smaller, more dynamic economies of the world are likely to outperform the larger, more mature economies that have been weighed down by low growth, housing downturns, and massive deficits. That thesis has largely proved correct in 2011, and we see little reason for it to change in the upcoming quarters.
In fact, those trends that we observed a year ago have only deepened in the second half of 2011. Sovereign bond yields that were already extraordinarily low in the United States, Germany, and the United Kingdom declined sharply further in the third quarter of 2011. Real interest rates (central bank lending rates minus inflation) have been negative in the major economic regions since 2009, implying an environment of low compensation for fixed-income investments and a potential depreciation in currency over the long run. Of additional concern is the fact that real yields (average bond yields minus inflation) in the major economic regions of the United States, the eurozone, and the United Kingdom have now turned negative in 2011.
By contrast, the smaller economic regions, with healthier fiscal balance sheets and better growth prospects, have continued to offer positive real yields in 2011. Brazil notably has significantly higher real yields compared with most global economies, offering the potential for greater levels of investment value. Other smaller economies such as Mexico, Australia, and South Korea have also offered investors positive real yields in 2011 while simultaneously sustaining currency appreciation for much of the year.
Strategies for investing in the current global bond markets are best served, in our view, by continuing to underweight the bond markets of the older economies (U.S., U.K., eurozone, and Japan) in favor of overweight exposures to the smaller, healthier economies with lower deficits. Among the better-valued markets that we favor are Brazil, Australia, Poland, Mexico, Chile, New Zealand, the Czech Republic, and Norway.
Foreign currency management should also follow a similar thesis, as we believe massive structural deficits in the largest economies will eventually necessitate a decline in currency valuations over the long term. In our view, the U.S. dollar continues to demonstrate a long-term structural decline, while British sterling looks equally vulnerable. The currencies of the smaller, more dynamic economies with trade surpluses, healthier growth, higher yields, and higher interest rates are positioned to appreciate against the U.S. dollar, the euro, and British sterling, in our view.
Concluding observationsWhile economic conditions in the largest economies continue to languish, growth expectations and fixed-income valuations from several smaller economies continue to show promise. For several quarters we have maintained the opinion that the smaller, more dynamic economies of the world are likely to outperform the larger, more mature economies that have been weighed down by low growth and massive deficits. Those themes have continued in 2011, and we see little reason for them to change in the upcoming quarters. In our view, investors can continue to find the best opportunities to add value from a diversified overweight in the bond markets and currencies of the smaller economies, while underweighting exposures to the four major economies—the U.S., the U.K., Japan, and the eurozone.
Bond fund values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. In general, when interest rates rise, bond fund values fall and investors may lose principal value. Foreign investments are especially volatile and can rise or fall dramatically due to differences in the political and economic conditions of the host country. These risks are generally intensified in emerging markets. The use of derivatives may reduce returns and/or increase volatility. Certain investment strategies tend to increase the total risk of an investment (relative to the broader market). This fund is exposed to active trading risk, high-yield securities risk, mortgage- and asset-backed securities risk, and regional risk. Consult the fund's prospectus for additional information on these and other risks.