Western Asset Management Company

Presenter: Ken Leech

January 7, 2016
8:00 AM PT
Operator:

Welcome to Western Assets webcast. Thanks for joining us. We are kicking out the new year with a market
update and strategy insights for 2016 with Ken Leech, Western Assets Chief Investment Officer.
Kens comments will be followed by a brief question-and-answer session. Please feel free to submit question throughout the webcast by typing your questions into the Q&A section located on the left-hand side
of your screen. Ken, over to you.

Ken Leech:

Well, thanks everyone for joining. Its always unsettling when the first week of the year has quite the market volatility weve seen. So with the pun intended, obviously, we have the Chinese curse May you live in
interesting times as a key development in this webcast with the weakening of the Chinese currency and
uncertainty over the growth rate there.
Certainly, weve seen global markets roiled pretty meaningfully even over the first few days of this new
year, and hopefully well address some of those concerns as we talk about our outlook for interest rates in
the US and around the world and the best investment opportunities.
I think the right way to startand you know the themes weve hadis trying to think about the US in
conjunction with world growth, and that the US has had a pretty good picture relative to many parts of
the world. So lets start with global growth.
If we look at the upper leftupper slide, just look at the black line, you can see that global growth, while
its beenits moderate, its been downshifting. And I think thats ultimately the source of uncertainty and
the source of trepidation that you see in risk markets whenever you get a downshift.
We discussed in our last two conference calls that we thought this downshift was going to be pronounced
and take hold and that we would be moving at this new lower trajectory and that therefore downside
risks to the market and inflation had increased and we needed to have some macro strategies, particularly
long-duration positions, to protect the portfolio if in fact our base case, which continues to be that moderate growth both in the US and globally, will be sustainable, in which case non-Treasury, non-sovereign
bond sectors will outperform very meaningfully.
But should that not happen or should downside risks accelerate, we need to have some portfolio ballast,
and thats been our strategy. And I think the good news for us and our broad accounts was that this portfolio ballastyou know, that we basically took out this kind of insurance, and I think that the bad news is
that we needed it.
And you can see how that played out on the bottom. You can see that the IMF forecast for 2015 last year in
the middle of the year was downgraded pretty significantly both in the developing and emerging market
components to get a lower world growth. But when you look at that top graph, you can see that the IMF

Western Asset Management Company 2016. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients,
consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.

Western Asset

January 7, 2016

continues to persist in a belief that global growth is going to improve and while we are hopeful that that
might happen, we think it may take longer to play out than they do.
They have an increase in both developed and emerging market growth forecasts for this year, and while
we think the prospects for developed market growth improving are actually pretty good, naturally, the
reason why we continue to be optimistic that global growth is going to be sustainable, we do think the
challenges in emerging market growth are pretty significant and we are a little bit skeptical of the increase
that they have forecast.
On the next page 2, you can see the global inflation. We all know that over long periods of time the story
of interest rates is just the story of inflation. When people talk about interest rates being in a bubble or being too low, what theyre really saying is that inflation is too low, and that in fact might be right. You would
think that global growth and US growth over time, as theyas the recoveries continued, output gaps
would be filled, and eventually we would have a stabilization in inflation and then a pickup.
But on a global basis, you can see that that not only has not occurred, but weve actually had a meaningful
downshift in inflation, and with some uncertainty coming out of China this week and certainly weaker oil
prices, the risk of that inflation going lower arehave actually increased.
And when we look at the next page, we all know the story of the drivers from the commodity side, its not
just oil, its very widespread, and this suggests a continuation of the story weve been seeing, that global
demand is just not robust enough in the face of an oversupply of commodities. And that continues to be
putting downward pressure on global inflation.
And then as we look at that backdrop, a global environment of moderate or weakening growth and weakening inflation and we transpose that against the US story, I think thats really the important part of looking
at the US interest rate outlook. I think when you think about what the Fed is saying on this graph on page
4, you can see that when they look at the current inflation rate, inflation expectations have been well anchored, growth has been reasonable and the Feds forecast, as you see here, is that inflation will be slowly
but surely moving up as growth comes in above trend; their forecast is roughly 2.5%. And if thats true, the
Fed expects to raise rates slowly but surely. And in fact we heard Stan Fischer yesterday talking about a
base case of more tightenings over the next 12 months.
Thats one possibility, and its a possibility I think that the market is a little bit skeptical will play out just
quite the way the Fed thinks, and I think the reason isand you see the other possibility that weve highlighted here that lower oil prices, a strong US dollar and weak global growth will keep that inflation rate
under pressure. And if thats true, then the pace of Fed tightening might be less.
If you read our note from the last quarter, we expected the Fed to go in December, we expect the Fed to
stay on pace until data show that they might need to change, and so we do expect them to move in March
because we dont think that US data will have changed that much, and theyve been very clear that they
are going to be primarily focused on the US, but our forecast for growth in the US is more on the order of
1.5% rather than 2.5%, and we think inflation is going to stay pretty subduedtake an awful long time
to turn around. So our suspicion is that the rate of Fed hikes that they projected will turn out not to occur.
And when you see just kind of very quickly, you look at the path of nominal GDP and inflation over very
long periods of time and you think about the Fed starting a policy of hiking rates, you can see from this

Western Asset

January 7, 2016

graph that inflation is driven by excessive growth in nominal GDP, and we just dont see that and were not
completely convinced that the case that thats about to occur is imminent.
And you can see on the next page weve just taken the last 5 years to give you a clearer sense. Nominal
GDP obviously very constrained inflation is not only not moving up, but its actually been moving modestly down. And so from our perspective, while we see that the Fed, in conjunction with a stronger labor
market, wants to move the Fed as weve characterized it, we might want to inch the funds rate off zero. We
think that they will be very cautious in moving funds rate and we think that they should be very cautious.
And the hopeful spot in that, the bright spot, that we would like to highlight comes from yesterdays FOMC
minutes. You know, basically, I think the Fed is trying to be very clear that while they want to inch the
funds rate up, they do not want to have a policy mistake or upset the economy or, you know, the financial
markets in a meaningful way. And I think that the key to that is if in fact they do stick to a policy of moving
the funds rate up if and only if they see the inflation rate moving up.
I think that while that might be considered a pretty dovish path that I think is the path that the Fed is starting to migrate to, as you see from our statements that they want to carefully manage actual and expected
progress.
And I think thats important because if in fact actual inflation does move up and they tightened in behind
it, thats perfectly appropriate. But if inflation were not to move up, which is our suspicion, then they
should stay pat.
I think when you look at the statements from yesterday, theyve talked about confirming that inflation
would rise as projected as being very important and I think you also talked about the fact that it will probably take some time before inflation reaches a 2% path.
Our suspicion is that obviously the data will not be moving sufficiently far from the Feds forecasting to get
them to change policy over the first quarter.
But that if our forecast plays out, the possibility that we see something like only one or two hikes this year
instead of the four that they talked about is much more likely.
Lets quickly turn around the world. Europe. I think from our standpoint, this is a positive story. A year ago,
the risk of the markets was that Europe was fallingpotentially following the recession. Youll remember
that we had a tremendous fear of Europe last January.
The story has kind of gotten out of the front page, but the growth rate in Europe, in our view, is going to
be close to 2% this year. We think that as you see from this slide, youve finally gotten traction in terms of
the financialthe loans, the household and non-financial corporations.
You can use money supply and other credit metrics but what you see here when you look at the green line
is that the contraction in credit that we saw late in 13 and early in 14 that got Draghi to be very aggressive
in getting the European community to back a very ambitious QE program has started to bear fruit.
And I think we think this will continue and the ECB will continue to be very accommodative. Following
up on that point, obviously the ECB has an inflation mandate, which gives them a very strong incentive to
maintain a very accommodative policy.
Western Asset

January 7, 2016

You can see that inflation expectations are actually starting to slip modestly and thats because inflation
in the eurozone is very close to the zero line, and certainly falling energy and commodity prices might put
that under further pressure.
So we think that even with a little bit better growth were going to see very accommodative interest rates
and that leads us to believe that the Fed again is going to be kind of bulwark of supporting sustainable
global growth.
So lets get to the elephant in the room, which is Chinese growth. What do we do with that? And obviously, theres been a lot of discussion in just the last couple days as China has let their currency fall against
the developed market currencies, particularly the dollar.
And I think the point that we have to emphasize is that wed like to have certainty and clarity. Our view on
China has been that the growth rate is going to continue to slow, that this process, given the amount of
stimulus that is going to be used by the Chinese government, its going to be manageable.
That growth is going to come in somewhere in the 6% to 6.5% range that they have been expecting
but this is going to be part of a very long transition process away from a manufacturing investment-led
economy to one that is more consumption-based and that has pretty broad implications for other emerging markets, in particular commodities.
But the point we make is that given the fact that the Chinese government has basically signaled very
strongly that they will let the currency move, I think that does increase uncertainty.
Certainly, the opacity of data there and trying to understand the Chinese economy means that at a minimum, we have to be open to the possibility that growth could be even weaker than we suspect.
And I think that uncertaintythat concern is part of the reason why spread product and equity markets
around the world are much weaker over the last couple of days and you can see how that plays out on
page 11.
You can see that we have just the manufacturing side of the Chinese economy which has obviously been
decelerating faster than the overall growth rate of the Chinese economy.
But even still, you can see the very tight correlation with commodity prices and emerging-market currency regime. So the possibility that Chinas slowing and that their currency may be weakening is obviously
going to put quite a tremendous amount of pressure on those areas.
And that again leads to the reevaluation of the possibility that global growth will be even weaker so that
this downshift in global growth, the possibly that it is downshifting again, I think that uncertainty is really
whats roiling the markets at the moment.
And then, lets look at emerging markets. And obviously, this is an area that has been extraordinarily challenged when we look at emerging markets outlook we see moderate or weakening global growth.
We see weak commodity prices and we see the possibility of a Fed hiking and we can obviously build a
very negative outlook and I think that we are very cautious on the outlook for emerging markets.

Western Asset

January 7, 2016

However, the challenge of markets, which we all know, is that markets always are very good at pricing in
the forward case. So markets have been under unbelievable pressure.
So when you look at the slide that weve put on page 12, the spread between local currency and sovereign
yields, the developed market and emerging-market yields are back to a crisis high.
Well, put that in perspective. Thats in conjunction with the currency developments that have 3 years of
just horrendous pounding last year on the orders of something like -15% across the board. Obviously, with
emerging markets, this is a heterogeneous asset class.
You have to be very selective about what countries you are going to invest in. But I would say this. Even
though the outlook for emerging markets has weakened and the downshifting in the growth outlook in
the summer challenged us to reduce our emerging market exposure and to put in some hedges.
Over long periods of time, I would want it to be very clear that the demographic thrust of stronger growth
rates, lower debt loads and the better demographics over time suggest to us that this is an area that you
do not want to abandon.
Because I think that with these kinds of valuations, the opportunity set here is pretty pronounced. The two
areas weve liked the most is, as many of you know, Mexico, which has performed pretty poorly and in line
with some of the fears that weve seen, and the other one being India. I think neither one of those are as
exposed to the oil prices, specifically, as some of the other countries, but from our perspective, we think
you have to be very cautious in the emerging-market space.
Obviously, we have position sizes that are appropriately small. But we do think that with valuations this
challenged, our suspicion is that valuations have overshot, as many spread markets have, the actual outlook for US and global growth even though that outlook has dimmed a bit.
Now lets look at the US sectors starting on page 13. One of the points that were trying to make is that
when you think about kind of the recent developments last summer, or even this week in the equity
markets, people are starting to talk about, oh my gosh, weve had these challenges. Actually, in the credit
markets in the US, weve had a bear market since the middle of 2014. So this has been an ongoing headwind thats been pretty pronounced, and obviously accelerated last year pretty meaningfully, particularly
in the credit space.
US investment-grade credit, but particularly US high-yieldreally, really beaten up as the fears of downward global growth, but particularly the energy and commodity-related spaces have picked up pretty
significantly.
So lets talk about those, and in turn, lets start with investment-grade corporate bonds. So the investment-grade corporate bonds, from our perspective, is interesting in the following way.
We think that corporate bonds in investment-grade are really attractive. Were not looking for huge spread
compression, but we certainly think pricing is very fair.
You think about the point in the cycle where the Fed is saying that the economy is starting to improve
sufficiently enough and fast enough so that they actually need to start raising rates.

Western Asset

January 7, 2016

At the same time, corporate bond spreadsespecially, you think about long corporate bond spreads
have gotten near the 2002, 2011 peaks, which was a recession in the first case and a fear of a meaningful
recession the second case, with the Europe crisis in 2011. And yet, here, the Fed thinks that the recovery is
actually picking up speed.
So I think that there is a disconnect, and we think the pricing in the corporate bond space certainly has
been way in front of the challenges weve seen in the equity market.
Youve seen our slide. Its a very simplistic one, on the bottom panel. But this simply shows what the historical path of investment-grade corporate defaults been, over long periods of time, which we know, over
long periods of time, is a reasonably constrained number, pretty de minimus.
Liquidity is obviously meaningfully challenged in todays market, much more meaningful than we
wouldve thought a year ago, and we have actually, in our model, as you can see in the footnotes, subtracted 25 basis points from the yield on a 6-year duration index. 25 basis points is a point-and-a-half bid/
ask spread which is not quite that bad.
So we think thats not an unreasonable estimate, although you might want to push that a little bit. But the
point we make is, when you look at the actual amount ofthe realized default youd have to have if you
were a buy-and-hold investor of investment-grade, versus holding Treasury bonds, that number, north of
9%, the point being that its way north of any reasonable expectation of defaults.
I think we all understand, in the world were living in, with risk aversion being very high, why government
bonds are so sought globally. But from our perspective, corporate bond spreads are pretty comfortable.
The most important thing about investment-grade is not really the overall spread. But if you look at page
15, its really where you position yourself in the market. And we really havent seen this kind of spectacular
dispersion between sectors in an awful long time.
When you look at the numbers on the right-hand side, in terms of excess returns, you can see weve got
several positives, and yet we still got a negative of 15.5% for metals and mining. So it really made more
its much more important what sectors youre in, what securities youre in, than the overall outlook.
From our perspective, our number one focus has been, as you know, if you listened to these calls for the
last couple years, the re-rating of banks.
Weve seen that Tier-1 banks at +2.2, 172 basis points and then senior bank bonds having a plus score even
in the midst of a credit winding in a pretty pronounced fashion, we continue think that basically the unintended consequence of very zealous regulationsome would say overzealouscontinues to be that the
beneficiary of that are the fixed-income holders.
And then we continue to think that banks will move, in terms of spread, towards the lower end of the
investment-grade range.
When you look at high-yield, though, youve got a story thats a little different. One of the things about
investment-grade we all know is that, while you take a lot of volatility in the spread, historically, defaults
have been very low.

Western Asset

January 7, 2016

In high-yield you know, here, you have to be very thoughtful about your issue selection, and subsector
selection as well. But high-yield has really run into kind of a perfect storm.
When you think about thefrom a top-down perspective, which is my bailiwickand, as many of you
know, Mike Buchanan will be following up with a webcast specifically devoted to high-yield, across the
entire range of issues. So let me try and do some justice to just a quick snapshot.
We think that spreads have moved way in front of fundamentals. So just as you saw on the IG slide, we
think the expected default rate as implied by the spread has just outpaced any reasonable, or even aggressive, estimate of where defaults may come in.
Our thought is that, obviously, a lot of that has been led by commodities, especially energy, issues, which
well talk to in a second. But we think, even in the non-energy component, youve seen one of theI
think, the fourth worst non-commodity-related high-yield returns, and thats in an environment where
the US economy is in recovery and, as Ive already said, the Fed showing an expectation that its going to
increase.
So from our perspective, we think the challenge is that the possibility of lower global growth, the possibility of weak and sustained weakness in commodity prices, in conjunction with the Fed tighteningobviously those are all negatives from a top-down perspective from the fundamentals.
But when you look at the yields on these securities relative to other parts of the capital markets, we continue to think this is going to be one of the most attractive areas to invest in in 2016.
The energy story, I think is page 17. Many of you may have seen this as actually, it was a J.P. Morgan slide
that was in Barrons over the weekend.
You know, the point we try and make is that, in fact, in the energy space, youve seen a tremendous contraction in capital spending, and in rig count, a tremendous movement by management to try and shore
up balance sheets, to protect cash flow.
If you look at the bottom right-hand side, you can see that the percentage change in rig counts over the
last 12 months around the year is basically down 44% and down 60% in the US.
From our perspective, our themes have been that, in the energy space, you need to buy companies that
are going to be able to withstand a sustained period of low energy and oil prices, but that those companies that have the wherewithal to do that are going to provide just really spectacular returns, and that the
key to this is going to be issue selection.
That has been our theme, look forward to our webcast to talk about that. We continue to believe that thats
going to be the key going forward.
And then, while Im going to be accused of being Pollyannaish, which is something almost no one ever
accuses me of being, we do have a slide which shows that you have to be thoughtful about getting too
negative on high-yield.
You know, when you think about high-yield, its actually not very common to get negative numbers for
the entire asset class. As you can see from this, theres only been six, and each was followed by a very
strong return recovery the next year.
Western Asset

January 7, 2016

Our expectation of moderate US growth, moderate global growth, very accommodative Fed policy, from
our perspective, in conjunction with spreads that way, have over-discounted the possibility or the increase
in defaults suggest to us that the possibility of a pretty significant positive return from the sector is in the
offing.
Then, lastly, I talk about the other opportunities that we think we see in the non-government, the credit
space, is in the CMBS sector. We think, when you look at the consumer and real estate fundamentals,
theyre very positive. And while these markets have not widened as much as weve seen in credit highyields last couple of times, I think the reason for that is that the fundamentals are very solidconsumer
fundamentals, if you look over at your left hand side, consumer leverage is the lowest level it has been in
35 years.
You know, I think that that speaks very well for the investment-grade components of the mortgage market. On the right-hand side, I think probably, you probably get some back-and-forth. CMBS has obviously
been beaten up a little bit more lately, but again the point youre trying to make is that given the nature
of the crisis, given the enormous shutdown of building that we sawwhen you look at retail growth or
office growth relative to the actual supply, you can see that this widening has really presented the situation
where new issue CMBS and supported opportunity should be some of the biggest beneficiaries.
So, while the spreads are not as compelling as some of the high-yield, we certainly think here fundamentals are much less controversial because the solid part of the portfolio continued to hold it.
Let me just sum up before we take questions, and I know Ive gone pretty quickly, and probably havent
covered everything that everyone wanted to hear. Ive tried to focus a little bit on the global picture. I
think whats important there is that global growth and inflation have moved lower. So even though they
moved lower last year, I think the outlook now even lower again, and that means the downside risks are
very much in the fore.
And from our perspective, that means that when we look at our portfolio, even as we see the Fed about to
tighten, we need to have some extra protection against the possibility that the global picture will actually
spill back into the US and cause challenges. So, from our perspective, our portfolio, which is overweight
spread product, also has some extra duration.
So we have some extra government duration, we are not hedging our below-investment-grade highyield, so when you look at the duration of a portfolio mix, you got to understand that when you look at
a high-yield bondif it yields 10%, we all know that if you bought that for your personal account, youd
be hoping that the bondeither oil prices would go up or management would do a very good job of
managing the situation.
But the duration that you see on your printout is a very soft number, its not really interest-rate sensitive.
From our perspective, therefore, when the portfolio duration looks long, some of that is intentional in the
government space, some of it is what we would call soft duration.
Hopefully the picture that weve painted of moderate but sustainable growth suggests that we believe
monetary policy is going to be very accommodative across the globe. That is crucial for the ongoing
global recovery. We expect to see as weve talked about Europe, Japan, China continuing to be extremely
accommodative, but also in the United States we expect the Fed to be very thoughtful and very cautious
before raising rates, and to the extent that, in our view, that they wait for actual inflation as opposed to
Western Asset

January 7, 2016

expected inflation. And they continue to start to assert that as a central theme of their policy, that is going
to be taken pretty positively.
So, this new downshift means that the interest rate normalization, which we have set over long period
of time, if were right global and US recoveries are going to slowly but surely, and kind of this two step
forward, one step back process that we have all been living with over the last 5 yearsif thats going to
be the path that were going to be on, then interest rates will, in fact, eventually normalize and then move
up, but unfortunately with this downshift in both growth, and especially inflation, we think this is going to
take more time than we thought before. We think, therefore, that interest rates are going to be very slow
before they move up.
And we continue to think that as, at a minimum as a portfolio insurance asset, in conjunction with overweights to spread products, that will be an important component of strategic diversification.
But ultimately with markets having been beaten up as much as they have, the real opportunity, the real
thrust of our risk budget system is spread product sectors. We really do think that earning the higher yield
in spread products instead of the governments is going to be the best and most fruitful strategy. It gives
us the best opportunity set and that continues to be our strongest theme.
And with that, Im happy to take any questions.
Karlen Powell:

Thank you, Ken. And reflecting a bit on the end of 2015, can you share any insights from the first US interest
rate hike in almost 10 years? Was the market reaction as you expected?

Ken Leech:

I think its interesting. We obviously have an awful lot of people who work at Western Asset, I know in the
financial community who have actually never seen an interest rate hike. When I first started my career
many, many moons ago in the 70s, I can see Karlen looking at me, Im way off topic.
But you know, I mean, we had interest rate hikes were so routine, and we eventually got to 20% interest
rates. And so, the idea that this move from zero to a quarter was just so fascinating for so long. I think the
Fed did a very good job of managing that process, and I think that when you think about the way they
guided expectations, being very clear that they are going to not focus on the global growth, focus only
on the US, most people were very comfortable by the last couple of weeks before the Fed meeting. That
the Fed was going to be going, there was not a lot surprise, there wasnt a lot of undue market movement.
I think if you compare and contrast that with the ECB meeting in the same month, where there was an
enormous amount of volatility because the market you know, had completely different expectations than
what ultimately came out. I think you got give the Fed very high marks; I think theyve been in a very tough
spot, here, looking at this scenario where, from a labor market perspective, you can argue very easily that
they are not only should be moving up more rates more quickly, but they are actually behind the curve.
And at the same time, from the global inflation or global growth perspective, you can make the opposite
case. So, its a very tough challenge. We have a lot of sympathy for the Feds, kind of a conundrum if you
will. But I think they manage that process very well. I think that theyre on track to hike the next time, and
then they are going to be very data-dependent.
So, from our perspective, growth will be where it is. Well have our view, and sometimes well be right,
sometimes well be wrong.

Western Asset

January 7, 2016

But the key is from our perspective that the Fed needs, in this environment, to under-tighten the data. This
economy is very strong and inflation is moving up, then the Fed should move gradually. If its not, they
should stop.
And I think that thats exactly what theyre trying to signal, and so I would be pretty optimistic about the
way that the Fed is managing things.
Karlen Powell:

Well, thanks, Ken. One listener notes that youre concerned about the pace of inflation, but did the breakeven rates on TIPS make them attractive anyways?

Ken Leech:

We have actually increased our TIPS positions and our break-even rates for the first time in a while. Part
of that is due to valuations, the markets expectation that inflation is going to be very, very low for a long
period of time is based on, obviously, some of the commodity and growth weaknesses weve seen
As youve heard over this webcast, while we think that that is going to be true for the immediate future,
we do think over long periods of time that the Fed should be able to attain its inflation objective, and that
would make the break-evens move wider.

Karlen Powell:

What will be the catalyst for oil and commodity price stability?

Ken Leech:

Boy, I think from my perspective this is a big question. When you think about last year, I know people who
were seeing all of the news, the two big themes from last year are China and oil, and certainly, I think as a
firm we thought that from a global growth perspective in the summer that we needed to be more cautious on both.
But I think that weve been very surprised by just how deep and persistent the oil price decline has been.
This is going to be a project thats going to have to come from two ways. Obviously, weve talked about
the supply constraint challenge. Low prices tends to shut in supply, and that eventually helps to put at a
bottom, and thats one important point. Second one is that global demand has to stay on course, and
if global demand is moving further north, then over time, that dual-edged sword, if you will, of greater
global demand and reduced supply slowly but surely brings that price on.
In the short run, oil prices are very sensitive to market sentiment, and so youre going to get wild swings.
We saw that last year, we saw prices in the 30s. The first quarter we saw tremendous optimism, in the
second quarter when prices looked like they had stabilized around 60, and now we have tremendous
pessimism.
Interesting to me, and Ryan Brist who is heading our oil task force, which we are going to be looking at a
number of factors on this to really try and provide a lot more information from a variety of sources on this
is that now that prices have hit kind of their low over the last many years, now the pessimism is starting
to really grow in abundance, and we all know thats how markets are. But from our perspective now, the
pessimism is really outstripped from our position on the fundamentals.
So Id like to say that I had a clear clarion catalyst that you can say if this happens, then you know that the
all-clear had been sounded, but we think that its going to take time to clear the commodity downturn,
but we do think that its coming.

Karlen Powell:
Western Asset

Another listener notes that historically high-yield bonds have a higher correlation to equities, but you read
10

January 7, 2016

so much from other firms indicating a high correlation to interest rates. Whats Western Assets view on
this?
Ken Leech:

You know, high-yields interesting. I remember when I wasgetting myself off-topic again, but, you
know, back in the early 80s, I remember in the 87 crash, for example, high-yield bonds actually had a day
where they actually in some cases went down more than stocks that day.
The interesting thing, you know, when you think about high-yield is not all high-yield is created equal. So
the higher quality high-yield obviously is going to perform more like an investment-grade bond and those
bonds obviously tend to have more interest rate sensitivity and be more high-end and more correlated
to interest rates.
Obviously, the further you go down and the more idiosyncratic the issues, then the more correlated they
are going to be to the equity markets. So obviously, they are correlated to both interest rates and the
equity market, and I think that that is straightforward in general, given some of the widening, what we
have seen is that basically the high-yield market has performed much worse than either. And so, from our
perspective thats kind of an interesting thought.
That youve got a market thats cheap to both the interest rates and the equity markets. We think that its
very attractive relative to both and thats why we think thats really one of the bigger opportunities thats
this year.

Karlen Powell:

Another listener has asked, has increased global tension like nuclear testing in North Korea and conflicts in
the Middle East been responsible for the recent market volatility? What worries you the most?

Ken Leech:

Weve talked about Middle East tensions and the possibility for Middle East disruptions for so many years
that its extreme now that we talk about the Middle East and we talked about it in the middle of an oil or
glut where prices continue to move south.
So I think that thats very interesting by itself. Certainly, global uncertainty and global tensions continue to
be very important. I think from our perspective over time, not an immediate point, but over time as the US
withdraws from its roles as a kind of the global policeman, the possibility of having more difficult conflicts
grows and I think we have to be more and more thoughtful about how that may play out.
But I dont think that thats the immediate sense of the markets turbulence. I know others may disagree
with me on that.
I think also the nuclear testing by North Korea, while catching the news and its obviously very disheartening, that thats going on without the Chinese basically, hopefully asserting a little more parental influence
over there.
But thats a negative. But I dont think that thats really the reason why the markets are as roiled as they
have been.
I really do think its more the uncertainty thats developing possibility the Chinese growth might be weaker
than previously expected as kind of highlighted by the symbolism of the weakening currency. And I think
that in conjunction with weaker commodity prices has really got people a much more nervous than they
were a week ago.

Western Asset

11

January 7, 2016

Karlen Powell:

Ken, another listener has asked, do European peripheral government bonds still offer value?

Ken Leech:

We have reduced our position in the peripheral bonds as spreads have tightened meaningfully. We are not
all the way out though so we do think that they have some value.
We think that from the comments I made earlier, the ECB we think is going to be in a period of unbelievable accommodation. We do not see interest rates in Europe going up. Our forecast is not for the next 3
years.
Therefore, when you look at peripheral bonds that have higher yields than Germany, you look at carrying
roll down. We still believe that there are opportunities though.

Karlen Powell:

Another listener has asked, whats your best guess as to the probability of a recession in the near future?

Ken Leech:

Well, I think that thats a question that we pushed on pretty hard and given the global world we all live in
with high debt loads and high debt burden at the same time that we see the US policy makers starting to
move up.
That was why we highlighted that slide, Will the Fed Make a Policy Mistake? I think theres a lot of reasonable concern over that. Our view is that that the probability is under 20%.
And I think, you know, so we dont think its anywhere near or base case but we dont want to rule it out
or be Pollyanna-ish by any stretch of the imagination.

Karlen Powell:

Ken, do you see the upcoming US presidential election or any political turmoil globally generating significant investment risks in 2016?

Ken Leech:

You know the US Presidential electionits interesting because I talked to my friends around the globe
who were just fascinated by the news, obviously, Donald Trump has just dominated the news in the US
and around the world.
For a long time, its interesting when you think about other countries, they wouldnt even be considering
who was running or what was happening until about 3 months before the elections as opposed to United
States where it seems like the election/campaign has already been going well over a year old and yet we
are still eleven months away. From our perspective at the moment dont see that being a major disruptive
force, although I do think that though as we get closer depending on how the elections go, I do think
that, you know, the possibility of understanding the policy perspective of the various candidates will be
pretty important. Particularly from our case, you know, we are very focused on the regulatory environment
especially in some of the industries, and I think its going to be very important who wins, but until we see
who the nominees are I dont think thats worth trying to guess.

Karlen Powell:

Well, unfortunately thats all the time we have for questions. Thanks again, Ken. And thank you to our
listeners for tuning in. You will be able to access the re-play of this web-cast using the original link where
the slide using this presentation, will also be available for download and if we were not able to answer your
questions during the web-cast, your clients service executive will contact you shortly and please be on the
look out for Western Asset next webcast.

Operator:

This concludes conference call. You may now disconnect. END

Western Asset

12

January 7, 2016

Copyright Western Asset Management Company 2016. This presentation is the property of Western Asset Management Company and is intended for the sole
use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and
proprietary information. This material may not be reproduced or used in any form or medium without express written permission. Past results are not indicative of
future investment results. This presentation is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained
herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any
security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset
Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or
needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility
to be aware of and observe the applicable laws and regulations of your country of residence. Potential investors in emerging markets should be aware that investment
in these markets can involve a higher degree of risk. Any forecast, projection or target is there to provide you with an indication only and is not guaranteed in any way
Western Asset Management Company Distribuidora de Ttulos e Valores Mobilirios Limitada is authorised and regulated by Comisso de Valores Mobilirios and
Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western
Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary
Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business,
investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and members of JIAA (membership
number 011-01319) and JITA. Western Asset Management Company Limited (WAMCL) is authorised and regulated by the Financial Conduct Authority (FCA). In
the UK this communication is a financial promotion solely intended for professional clients as defined in the FCA Handbook and has been approved by WAMCL.
Potential investors in emerging markets should be aware that investment in these markets can involve a higher degree of risk.

Western Asset

13

January 7, 2016