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Bond Market 'Extremely Complacent' About Inflation

Templeton Global Macro Group's Sonal Desai sees a confluence of factors that could push prices higher than markets are currently expecting.

Karin Anderson: Hi, I'm Karin Anderson with the manager research group at Morningstar. I'm here today with Sonal Desai, portfolio manager and director of research for the Templeton Global Macro Group. 

Hi, Sonal. How are you today?

Sonal Desai: Very well, thanks, Karin.

Anderson: Thanks for joining us.

Desai: Thanks for having me.

Anderson: To start out, you've been warning for some time about the risks of inflation for global bond investors. You've positioned both Templeton Global Bond and Global Total Return very conservatively in terms of rate risk. What's changed now with your viewpoint now that we have a new administration here in the U.S. and ideas for growth reform?

Desai: So I'd say that we have indeed been positioned for inflation for a long time on the back of U.S. labor markets, wage growth, and the potential for inflationary pressures coming on the back of Fed policy and the growth outlook for the U.S. Now the new administration, we don't know how many of the different policies will get put into place. Clearly, there's uncertainty. But there's a running theme through most of them. Most of them would actually unbalance, increase inflationary pressures rather than produce them. I'm talking about, for example, immigration policy, the potential for tariffs of different types. Any of these are actually going to add to inflationary pressures. 

Separately, if you have a reduction in regulation on the financial sector, you might start seeing some kind of recovery and the money multiplier, money velocity could start coming back to its normal levels, all of which would add to inflationary pressures looking forward. We actually think that the market in general in the fixed-income space is extremely complacent about inflation right now.

Anderson: OK, great. So moving on, big topic of conversation is the French election and just some elections that have happened, state of the eurozone. You've avoided most of the eurozone for quite some time now. What's your thinking if Le Pen wins the French election, and kind of the future of that area and what opportunities might exist?

Desai: So actually, we think if Le Pen wins the French election, that would in the near term of course be incredibly negative. She has promised to have a referendum on the euro. This is not eminent, but it's something which would really spook markets. It's not our baseline that she does win the French election. I think though, markets are again, assuming if she does not win the French election, it means that the threat of populism has essentially been extinguished. 

That, I think, is a mistake because what we are seeing in Europe in general, be it in the U.K., the Netherlands, or potentially in France, we are seeing mainstream parties become a little bit more populist. In turn, this effectively undermines the political cohesion in the euro area in Europe, which is exactly what we thought brought us out of the eurozone debt crisis, for example. Today we don't have that anymore.

Anderson: OK, great. One last question for you. You invested very heavily in Mexico, in the peso as that market was selling off in 2015. It had a very difficult year in 2016 and has rebounded quite nicely here in 2017. What are your thoughts for Mexico and the Mexican peso for the rest of this year?

Desai: If I look at the Mexican peso, at its weakest post the Trump election, we were trading at 22 against the dollar. Today, we're more in the 18, 19 to the dollar range. The interesting thing is, everyone focuses on the market price and assumes that you're going to get a depreciation of the peso from that level in the event that you have a border adjustment tax or some form of restriction on Mexican imports into the U.S. We would say you need to look at fair value. Fair value to us is probably ranging around 15, 15.5. So there's a very comfortable cushion over there, even at current levels. 

Meanwhile, the Mexican central bank is one of the most proactive, pre-emptive central banks out there. Very conservative, very professionally managed. And we're looking at short-end rates in Mexico at 6.5%. Over the course of the year, they're likely to come to a 7 or beyond 7%. The differential between short-end rates in Mexico versus the U.S. is close to an all time high, if not at an all time high. So we actually see a lot of potential in Mexico.

Anderson: Wonderful. Sonal, thanks so much for sharing some of your insights with us today.

Desai: Thank you.

Anderson: Thank you.