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com
Forthedevelopedworld,economicpolicytoolsarelosingtheirefectiveness.After
decadesofrelyingonpolicytostabilizedemand,lowerthecostofcredit,andprevent
theemergenceofsystemicfnancialcrises,policyintheUnitedStates,Japan,and
Europemaysimplyhavenomoreroomtorun.Thishasimportantconsequences
forthedevelopedworldasitrespondstohighratesofgrowthincountriesinthe
emergingworld.Theabsenceofefectivepolicystabilizersmaymakethedeveloped
worldincreasinglysusceptibletoeconomicdisruptionsfromtheemergingworld,
includinggreaterrisksofrecession.
Thishasimportantimplicationsforsafe-havenseekersandrisk-assetinvestors
alike.Aswediscussinthispaper,anefectivelypolicy-freedevelopedworldimplies
thatnon-traditionalsourcesofincomemaybenecessarytoofsettheimpact
ofglobalmacroeconomicuncertaintyandstilloferattractivereturnpotential.
Furthermore,emerging-marketfxed-incomeexposuresmayhaveanincreasingly
importantroletoplayforthoseseekingdiversifed,income-generatingportfolios.
Policy impasse, then and now
Wehavelivedinapolicy-freeworldbefore.Inthelate19thcentury,Europehad
noefectivemonetaryorfscalpolicywithwhichitmightstabilizetheeconomic
shockscausedbyincreasedU.S.competition.Atthetime,theUnitedStates
wasoneoftheworldsfastest-growingemerging-marketeconomies,climbing
from8.9%ofworldoutputto18.9%ofglobalGDPby1913.Inthefaceofthisrapid
change,andlackingpolicytools,Europeprovedtobehighlyvulnerable.
Growth volatility tends
to rise when policy levers
are weakened, increasing
the severity of economic
disruptions.
European nations economic
health varies widely,
refecting the failure of EU
policy to fx the underlying
problems of the broadening
debt crisis.
Multi-sector fxed-income
approaches that source
returns in out-of-benchmark
exposures may help mitigate
the impact of growth and
market volatility.
The high quality of growth
in emerging markets argues
for a close analysis of the
opportunities in emerging-
market debt.
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Policy impasse and the
repricing of risk
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Undertherestrictionsimposedbythegoldstandard
oftheera,countrieshadnoexchangeratepolicy,and
interestratesmovedupanddowninresponseto(or
toforestall)movementsinbalancesofgold.Andthere
wasreallynothinginthewayoffscalpolicy.Govern-
mentrevenueswerequitesmall,andspendingwas
verylimited.Therewasnoexpectationthatgovern-
mentswoulddoanythingtomoderatethebusiness
cycle.Tarifswouldberaisedandloweredinresponse
tospecifcdevelopments,butfewotherinterventions
werecommon.Asaresult,growthwasvolatile.Inthe
UnitedKingdom,thestandarddeviationofannual
growthwas2.54%inthe25yearsbetween1870and
1895,andgraduallywounddowntoapproximately2.1%
by1910(Figure1).(Forperspective,U.K.growthvolatility
was1.66%between1985and2008.)Inthelate1800s,
realeconomicvolatilityintheUnitedKingdommade
formorefrequentrecessions,whichbatteredworkers
andcompanies,andcausedfrequentboutsofdefation
(Figure2).
Wemaywellbeintheprocessofrepeatingthishistory.
Today,theUnitedStatesjoinstheUnitedKingdom
andEuropeintheroleofpolicy-freesovereigns,while
emergingmarkets,particularlyChina,playtheroleofthe
late-nineteenth-centuryUnitedStates.
Figure 1. U.K. growth volatility as the United States emerges
U.K. real GDP growth (%), 18311913
-6
-4
-2
0
2
4
6
8
10
1913 09 06 03 00 97 94 91 88 85 82 79 76 73 70 67 64 61 58 55 52 49 46 43 40 37 34 1831
Source:TheU.K.recessionincontextwhatdothreecenturiesofdatatellus?,SallyHills,RylandThomas,andNicholasDimsdale(2010).
Figure 2. U.K. defation a common condition as the United States hits the scene
U.K. consumer price infation (%), 18701913
-5
-4
-3
-2
-1
0
1
2
3
4
5
6
1913 09 06 03 00 97 94 91 88 85 82 79 76 73 1870
D
e

a
t
i
o
n
Source:BankofEngland.
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Figure 4. A developed world of debt
20
40
60
80
100
2017E 2016E 2015E 2014E 2013E 2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994
D
e
b
t
-
t
o
-
G
D
P

(
%
)
Germany
Sweden
Norway
U.K.
U.S.
Source:OECD.DataareasofJanuary1ofeachyearindicated.
Theconventionaltoolsofpolicyarerelativelystraight-
forward.Centralbanksconductmonetarypolicyby
infuencingthepolicyrate,orthekeyshort-terminterest
rate,whichafectsthemoneysupplyandtheexchange
rate,andinturninfuencesthecostoffnancingeconomic
activity.Intheyearsleadinguptothe2008fnancialcrisis,
monetarypolicywasextremelyaccommodativeand
frequentlyrelieduponallowingforadjustmentsto
interestratesinresponsetoeconomicshocks.Between
1990andtheeveofthefnancialcrisisin2008,theU.S.
FederalReservewasquiteactive,initiatinghikesorcutsin
itspolicyrate31%ofthetime(Figure3).
Figure 3. U.S. monetary policy formerly a
much-used tool
Breakdown of U.S. monetary policy rate
change, 19902007
Months with rate hikes
Months with rate cuts
Neutral months
14%
17%
69%
Source:U.S.FederalReserve.
Now,withtheU.S.federalfundsratecloseto0%,there
isnowayforratestogodown.Moreover,giventhe
unusedcapacityintheeconomyandtheuncertain-
tiesemanatingfromEuropeandwithrespecttoglobal
growthingeneral,itdoesnotappearthatrateswillbe
raisedinthenearfuture.
Similarly,thefscallandscapealsoappearsuncertain.
Inthepast,governmentsinthedevelopedworldwere
frequentlyabletostimulatetheeconomy,especiallyas
debtlevelswererelativelymodest.Priortothe2008
crisis,U.S.andU.K.generalgovernmentdebthadlong
remainedfatorelsedeclined,andcomparedfavorably
withthatofcountriessuchasSweden,Norway,and
Germany.
1
Incontrast,thepresentU.S.andU.K.govern-
mentdebtlevelshavetickedupandareprojectedto
risesubstantiallyinthenextfewyears,whichnotonly
hasjeopardizedtheirAAAstatus,buthasalsobrought
publicawarenesstotheirprecariousfscalpositions
(Figure4).Itfollowsthatitisextremelyunlikelythat
developedworldgovernmentscancontinuetoinject
thesamedegreeoffscalstimulusthattheywereableto
provideinthepast.Thefscalstanceneedstobetight-
ened.Theonlyquestionsabouttighteningfscalpolicy
arehowquicklyandbyhowmuch.
Eurozone divergences
Thedeeplydisruptiveeventsof2008continuetomake
itdifculttoseehowfaralongwereallyareonthepath
toasustainableglobalrecovery.Foronething,seasonal
economicefectsthataretypicallytakenintoaccount
asyearlydownwardadjustmentscanbedifcultto
1 Generalgovernmentdebt-to-GDPisameasurecompiledby
OECDasGrossGeneralGovernmentFinancialLiabilities,which
aggregatesindebtednessatlocal,state,andfederalgovernment
levels.Asaresult,itmaydeviatefromthemeasurescommonly
citedinthefnancialpress,whichprimarilylookatfederalgovern-
mentindebtedness.
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disentanglefromtheexogenousefectsofasystemic
bankingcrisis.Buthistory,webelieve,isadecentguide
towherewestandinalong-termstructuralsense
becauseoftherelationshipwecanobservebetween
policyanddiferentiatedglobalgrowth.
Asanillustrationofthis,wecanlookmorecloselyat
Europe,wherepolicyappearstobeworkingonthe
surface,butmaymasktheemergenceofotherprob-
lems.Figure5isareal-timeindexthatapproximates
GDPgrowthintheEuropeaneconomy.Inthesecond
halfoflastyear,Europedecelerateddramaticallyin
responsetotheintensifcationofsovereign-crisispres-
sures.Asweknow,therewasahugeresponsetothis
collapse,withinjectionsofliquiditybytheEuropean
CentralBank(ECB)appearingtohavestabilizedthe
economy.Butitisimportanttonotethatinthefall
of2011,GDPgrowthdeceleratedasrapidlyasitdid
followingtheGreatRecessionin2008.Therefore,itwas
quiteplausibletohavebelieved,asmanydid,thatthe
eurozonecouldbefacingasevererecession.
Figure 6. Some divergences are dangerously wide
Economic sentiment indicator
0
20
40
60
80
100
120
140
2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002
-37
-31
-25
-19
-13
-7
-1
5
Spanish business condence indicator (RHS) Germany IFO Index
Sources:GermanyIFOIndex;SpanishMinistryofIndustry,Tourism,andTrade.
Figure 5. The eurozone as a whole appears to be stabilizing
Eurozone GDP coincident indicator (%)
-1.5
-1.0
-0.5
0.0
0.5
1.0
2012 2011 2010 2009 2008 2007 2006 2005 2004 2003 2002
Source:ThomsonDatastream.
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Figure 7. The fatlining of short-term U.S. Treasuries
3-month Treasury bill rate (%)
0
1
2
3
4
5
6
2007 2008 2009 20!0 20!! 20!2
Source:ThomsonDatastream.
WhenweconsiderthepictureofstabilizationinFigure
5,oneofthenaggingproblemsisthefactthatwhat
appearstrueoftheeurozoneasawholeisnottrueof
someofitsparts.Figure6contraststheIFOIndexin
Germany,whichrefectshowwellGermanyisdoing,
andtheOrganisationforEconomicCo-operation
andDevelopments(OECDs)leadingindexforSpain.
WhereasGermanybouncedbackstronglyafterthe
GreatRecession,Spainstruggledthroughahalf-hearted
recoveryandisnowinworseshapethanitwasinthe
heartofthedownturn.Soalthoughtheshort-term
fnancialpressuresinEuropehavediminishedrelative
tothelatesummer/earlyfallof2011,longer-term
macroeconomicpressuresarerisinginEuropeandthe
potentialforgrowthvolatilityisverymuchalive.
Intheabsenceofpolicymechanismstobufereconomic
shocksfromtheemergingworldwhererapidgrowth,
forexample,hashelpedtotriggerglobalcommodity
boomseconomicvolatilityacrossthedeveloped
worldcouldeasilytickhigher.And,aswesawwiththe
UnitedKingdompriortoWorldWarI,itcouldmeanthat
thedevelopedworldmustgoforwardunderthethreat
ofmorefrequentrecessions.Inourview,thisshould
promptinvestorstothinkmoreabouthowthemarkets
arepricingormispricingdiferentformsofrisk,asthis
canhelpunderscorewheretodaysmoreattractive
investmentopportunitiesreside.
The repricing of risk
Currently,investorsinU.S.Treasurybillsareactinglike
theinvestorsofthe1890s,whofedtoU.K.government
bondsbecausetheypresentedtheleastamountof
liquidityriskandonlymodestcreditrisk.Inavolatile
world,certaintyisprized,andtheUnitedStatesat
presentfulfllstheroleprovidedbyU.K.government
securitiesinthe19thcentury.Treasurysecuritiesarethe
mostactivelytradedgovernmentsecuritiesintheworld,
withanaveragedailytradingvolumeofmorethan
$567billion.Moreover,despitetherecentworryovera
downgradeofU.S.debt,theUnitedStatesisstillwidely
consideredoneofthemostcreditworthysovereigns.
Therefore,itisnotsurprisingtousthat,sincethe2008
fnancialcrisis,theyieldsonshort-datedTreasury
obligationshavehoveredaroundzero.Yieldson
3-monthU.S.Treasurybillsaveraged4.75%intheyears
from1985to2007,butasofearlyMarch2012,stoodat
only0.07%(Figure7).
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Quiteclearly,thisbottomingyieldtrendsignalsthevalue
investorsplaceonsecuritiesthatwillberedeemedat
facevalue.Asecuritythatofersagovernmentguar-
anteeandunsurpassedliquidityinshort,thevirtual
promiseofcapitalpreservationisvaluableindeed.
Butsustainedlowsafehavenbondyieldsalsosuggest
thatriskingeneralisstillbeingreevaluatedbythefnan-
cialmarkets.Indeed,excessperceivedriskinthemarket
isefectivelybeingcompensatedforbyliquidity;that
is,themostliquidareasofthemarketcommandalarge
premiumfrompotentialbuyerswhileassetsthatare
perceivedtohaveliquidityproblemshaveplummetedin
price.Thisisevidentinthewaymarketspreadsappear
outofsyncwiththefundamentalriskstheyrepresent
(Figure8).
High-yieldcorporatespreads,forexample,continueto
beatwidelevelsrelativetotheirhistoricalaverages,asif
theywerepricedforaneconomiccontraction.Thisisnot
toosurprisinggiventhegeneralperceptionofeconomic
volatility,butitissurprisingwhenviewedinthecontext
ofstrongcorporatefundamentals,historicallylow
defaultrates,andanimprovingoutlookforcorporate
upgradesversusdowngrades.
Anotherareathatrefectsthemarketsuncertainty-
drivenrepricingofriskisinnon-agencyresidential
mortgage-backedsecurities(non-agencyRMBS).While
securitiesinthisareahavebeenheavilypressuredby
markettechnicalsandheightenedriskaversion,there
ismuchtorecommendselectareasthathavehigh
expectedreturns,depressedvaluations,andhealthy
fundamentalcashfows.Similarly,agencyinterest-only
(IO)cashfowscanbeviewedashighlyattractive.Inthe
caseofthesemortgage-relatedsecurities,spreadshave
morethandiscountedpotentiallyhigherprepayment
speedsthatmayresultfromgovernmentinterven-
tioninthehousingmarket.Thoughitmaytaketime,
webelievethatspreadswilltightensignifcantlyasthe
marketgraduallyunderstandsthatitsrepricingofriskin
thisareadramaticallydepartsfromthesectorspositive
fundamentals.
Higherrealeconomicvolatilityarguesforhigherex-ante
riskpremiainassetmarkets.Andinthisunstableenvi-
ronment,cashfowmattersalotsimplybecauseit
cancompensateforhighervolatilityinmarketsand
economies.
Figure 8. Market spreads not driven by fundamental risk
Current spreads relative to historical period (in basis points)
Sector
Average OAS
(12/31/9712/31/07)
Month-end
3/31/12 Diference
Agencies 34 36 2
Agency MBS 56 53 -3
Investment-grade corporates 130 176 46
High yield 511 576 65
AAA CMBS 89 169 80
Non-agency RMBS 123 700 577
Agency IO 150 750 600
Emerging-market debt 425 359 -66
Sources:Barclays,Putnam,asof3/31/12.
Allspreadsareinbasispointsandmeasureoption-adjustedyieldspread(OAS)relativetocomparablematurityU.S.Treasuries,withtheexceptionof
non-agencyRMBS,whichareloss-adjustedspreadscalculatedusingPutnamsprojectedassumptionsondefaultsandseverities,andagencyIO,which
iscalculatedusingassumptionsderivedfromPutnamsproprietaryprepaymentmodel.AgenciesarerepresentedbytheBarclaysU.S.AgencyIndex.
AgencyMBSarerepresentedbytheBarclaysU.S.MortgageBackedSecuritiesIndex.Investment-gradecorporatesarerepresentedbytheBarclays
U.S.CorporateIndex.HighyieldisrepresentedbytheBarclaysU.S.CorporateHighYieldIndex.AAACMBSarerepresentedbytheAaaportionofthe
BarclaysInvestmentGradeCMBSIndex.Emerging-marketdebtisrepresentedbytheBarclaysGlobalEmergingMarketsIndex.Thenon-agencyRMBS
spreadisestimatedusingtheaveragemarketlevelofasampleofbelow-investment-gradesecuritiesbackedbyAlt-Acollateral.AgencyIOisesti-
matedfromabasketofPutnam-monitoredinterest-onlysecurities.
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The historic opportunity of emerging markets
Wewouldalsocontendthatanoutlookforcontinued
economicvolatilityinthecomingyearswhetherit
isdrivenbydeveloped-marketdeleveragingorthe
impactofemerging-marketgrowthonglobaleconomic
dynamicsimpliesthatinvestinginemergingmarkets
mattersmore.Indeed,emergingmarketsmatterina
waytheyhaventfor100years.Thisisthecasenotonly
becausetheemergingmarketsarewherethegrowth
is;itisalsobecausetheunderlyinggrowthisarguably
steadierasaresultofthefactthatpolicystabilizersinthe
emergingmarketsarestillviable.
Thegoodnewsforinvestorsisthatemerging-market
debtisincreasinglydiverse.Themostestablishedform
ofemerging-marketdebt(EMD)investingdollar-
denominateddebtisjustoneareaofpotential
opportunity,althoughitisahistoricalanomalythatis
graduallydisappearingatthesovereignlevel.Inshort,
fscallywisesovereignsdonotwanttoborrowina
foreigncurrency,whilefscallyimprudentsovereigns
simplycannotborrowinforeigncurrency.Thesefactors
havecontributedtothegrowthoflocalcurrencydebt,
anareathatismostavailableinmarketswithmore
developedfnancialsystems(Figure9).Luckilyforglob-
allymindedinvestorstoday,localEMDcontinuestobe
anattractiveassetclass.Asitprovidestwosourcesof
potentialreturnincomefrombondsandapprecia-
tionfromcurrencyfuctuationsitispotentiallyquite
attractivetolong-termdebtinvestorsconcernedabout
developed-worldvolatility.
Figure 9. Emerging-market debt:
growing locally
EM debt in U.S. dollars
EM debt in local currency
2010
2002 42% 58%
34% 66%
Sources:JPMorgan,May2011.
Outsidetheaforementionedareas,manycountriesare
alsodevelopinginfation-linkedmarkets.Thisopens
thepossibilityforinvestorstoestablishyield-curve
strategiesanddurationpositionswithamixofdiferent
countriesratherthanstayconfnedtoahard-currency
market.Inshort,awiderangeofattractivesecurities
aswellassomehighlyliquidopportunitiesandrapidly
deepeningmarkets,canbefoundinEMD.Aspolicyand
cyclicaldivergencebetweentheemerginganddevel-
opedworldcontinues,rateandcurrencyideasshould
continuetoproliferate,andthuswillremainanimportant
sourceofreturnpotentialforopportunisticinvestors.
JUNE 2012|Policy impasse and the repricing of risk
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Conclusion
Regardlessofwhichsafehavensinvestorscontinueto
pursuegoingforward,itisclearthatweareenteringa
periodofincreasingstructuralvolatilityinthedeveloped
worldeconomy.Prospectively,wehavenomorepolicy
tools.TheFedcannotcutinterestrates.Itcanexpand
itsbalancesheetfurther,butthiswillhaveadiminishing
impactoninterestratesaroundtheeconomy.Andifit
choosestoincreaseinterestrates,itwillnotlikelyincrease
thembyverymuch.InEurope,policymakershavedone
whattheycanwithintheboundsofprodigiouspolitical
constraints;andinspiteoftheseeforts,growthdiver-
gencesamongEUmembernationsaredangerouslywide.
Whatsmore,debtlevelsintheUnitedStatesandEurope
arelikelytoremainhighandwillconstrainpolicychoices
foratleastadecade.FortheUnitedStates,theonly
debatemaybehowquicklyandbyhowmuchweseea
tighteningofpolicyinthewakeofthe2012election.In
suchaperiod,theriskofassetswillreceiveheightened
attention,eventhoughattractivevaluationsmaybe
passedoverbecauseriskappetiteremainslow.Forthese
reasons,webelieveaglobalapproachisnowessential,
andinvestorswoulddowelltolookbeyondthepricing
inofbleakoutcomestotheglobalopportunitiesmade
availablebypolicyandcyclicaldivergence.
Consider these risks before investing: International
investinginvolvescertainrisks,suchascurrencyfuctua-
tions,economicinstability,andpoliticaldevelopments.
Investmentsinsmalland/ormidsizecompaniesincrease
theriskofgreaterpricefuctuations.Fundsthatinvestin
bondsaresubjecttocertainrisksincludinginterest-rate
risk,creditrisk,andinfationrisk.Asinterestratesrise,the
pricesofbondsfall.Long-termbondsaremoreexposed
tointerest-rateriskthanshort-termbonds.Unlikebonds,
bondfundshaveongoingfeesandexpenses.Lower-rated
bondsmayoferhigheryieldsinreturnformorerisk.Funds
thatinvestingovernmentsecuritiesarenotguaranteed.
Mortgage-backedsecuritiesaresubjecttoprepayment
risk.Commoditiesinvolvetherisksofchangesinmarket,
political,regulatory,andnaturalconditions.
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