Stephen Dover

Franklin Templeton, a global investment manager, says that although inflation will continue to be an issue for the next 6–12 months and the global economic recovery is uneven, there are opportunities ahead.

Stephen Dover, chief market strategist at the Franklin Templeton Institute notes “In the first half of 2023, investors faced aggressive US Federal Reserve (Fed) monetary policy tightening, consecutive quarters of falling corporate profits, two of the largest bank failures in US history, a near-default by the US federal government, and universal predictions of US and global recessions.

“With these issues in mind, I moderated a panel of our leading economists including John Bellows, Portfolio Manager, Western Asset; Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income; Michael Hasenstab, Chief Investment Officer, Templeton Global Macro; and Francis Scotland, Director of Global Macro Research, Brandywine Global.

“The key question I wanted to address: What’s in store for investors in the second half of 2023?

“Below are my key takeaways from the discussion.

• Inflation will continue to be an issue for the next 6–12 months. There are some indicators that point to slowing inflation and the global economy entering a period of disinflation, where the rate of inflation is falling and prices are not increasing as rapidly. Failure of inflation to retreat is a risk, and core price inflation has been sticky, but the lagged effects from tighter monetary policy have yet to be fully felt. There is less risk of deflation, where prices actually fall.
• While inflation is coming down in many countries, the global economic recovery is uneven.
  • China is struggling to find sources of economic growth. An expected surge in growth did not materialize following post-COVID reopening. The Chinese government is likely to step in with more macroeconomic stimulus.
  • Supply-chain rebuilding and friend-shoring should contribute to growth opportunities in some countries. Supply chain rebuilding is leading to increased investment within Asia, particularly in countries like India and Indonesia. Other countries that should benefit include Mexico and Canada.
  • Japan benefited from recent increases in inflation after struggling with low economic growth for decades. The current inflation and growth levels created opportunities to deploy corporate cash balances. Japan also benefited from higher female participation in the labor force that prevented a labor shortage, which in turn supported growth.
• The upcoming economic data will likely provide further evidence of slowing growth and ongoing disinflation in the US. However, while markets have been anticipating a recession for some time, the strength of the US consumer will likely prevent a massive recession.
• Where will interest rates settle? There appears to be a disconnect with how fast rates will drop in the future. The financial market is pricing rate cuts with an expectation that inflation returns to pre-pandemic levels. However, we think the 10 years following the 2008 global financial crisis (GFC) were an aberration, and inflation is likely to revert to pre-GFC levels as the long-term norm (core inflation in the US averaged approximately 4% between 1958 and 2008, and just under 2% from 2009 through 2019.)
• Real interest rates are expected to continue increasing. The Fed just approved another interest rate hike and is expected to hold interest rates above 5% for several more quarters. While inflation is expected to slow or decline over this period, the result is real interest rates (nominal rates minus inflation) rising even if nominal rates do not. This creates a more positive return for investors.
• New investment opportunities Fixed income investments are resuming status as good portfolio diversifiers. Unlike 2022, where both fixed income and equities had negative returns together, there is now a low correlation between fixed income investments, equities and other risk assets.
  • Selectively increasing duration offers an attractive total return. We see neutral to shorter duration providing better risk/return profiles for the rest of 2023. The current yield levels and the expected peak in interest rates combine for a positive expected total return.
  • High-yield debt is priced attractively as investors remain cautious about the economy. Current yields are providing active investors with high returns. However, investors need to be selective as some lower-quality corporate credit is susceptible to default risk and we have concerns about credit spreads widening.
  • Emerging markets can provide diversification. Many emerging markets have demonstrated strength, partially by controlling debt issuance to a greater extent than their developed market counterparts. They also reacted quickly to bring inflation under control, raising rates ahead of the European Central Bank (ECB) and the Fed. With many emerging market bonds enjoying attractive yields, this asset class provides another source of return that is not necessarily synchronized with the rest of the world.

“While the investor experience for the last six months was extreme volatility in terms of interest rates and changing opportunities, we believe the Fed will continue to bring inflation more fully under control and might hold rates higher for longer than some expect.

“Growth opportunities vary around the world, and across sectors and maturities. Fixed income once again has a low correlation with other risk assets, providing potential diversification and increased portfolio protection.”

Read the paper.

The post New investment opportunities arise in the changing inflation and growth climate: Franklin Templeton appeared first on AdviserVoice.

Francis Scotland

Brandywine Global, part of Franklin Templeton, presents a more optimistic view on inflation in its latest macroeconomic update.

Francis A. Scotland, Director of Global Macro Research at Brandywine Global says “The financial and monetary variables point to a positive direction. Inflation is the final piece in a falling line of dominoes. What went up in 2020 and 2021—cryptocurrency, commodities, real estate, economic growth, and inflation—have retreated in perfect sequence starting late 2021 and early 2022. Now it is inflation’s turn.

“We believe keeping conditions tight until inflation has receded to target is a strategy for overshooting the objective and moving straight to deflation. A lot of lip service—but perhaps not enough credence—is given to the notion of policy lags. What the Fed implements today affects the economy months or years later. The retreat in inflation seen since June of last year has little to do with Fed policy, in our view. The reaction to what the Fed has done or is going to do is yet to come.”

He says the world is out of sync on many other issues.

“The Fed wants things to slow; China’s leaders want things to pick up; the European Central Bank’s (ECB’s) monetary vise already has the economy in a technical recession, but it must do more because of stubbornly higher inflation; and in select emerging countries policy is even more stringent than in the U.S., judging by yield curves.

“This divergence explains why global growth is uneven and argues for much reduced inflation. China’s reopening has fizzled due to feeble domestic consumption. Nothing could be more crystal clear about the state of domestic demand in China than its inflation data.

“According to the latest data from China’s National Bureau of Statistics, core CPI is close to zero, producer prices are falling, and China is exporting its deflation to the rest of the world. Efforts to reflate the system with public policy are compromised by a number of factors. China’s augmented budget deficit is probably already over 10%, based off an April 2022 report by the Institute of International Finance. The authorities do not want to boost leverage, nor do they want to fire up property speculation.

“However, the priorities of President Xi Jinping are the biggest impediments to rebooting China. Under his leadership, anti-corruption, national security, oversight of private companies, property speculation, and the stability of the Chinese Communist Party have taken priority over economic growth. President Xi did a U-turn on COVID containment late last year and elevated growth as a priority in the wake of public protests. But the follow-through has been tepid.

“ECB rate hikes have already led to a technical recession, but it seems likely to worsen because of the economic zone’s stubbornly high inflation rate. Europe’s monetary profile is horrible, in my view; banks are not lending—annual growth in lending to both households and businesses dropped close to zero in April, according to the ECB.

“Bank lending is much more important in Europe than the U.S. and accounts for the majority of financial intermediation. The poor lending data rhymes with the June production manager surveys, showing a generalised contraction in European manufacturing. Meanwhile, the non-manufacturing survey is barely holding above 50. One reason for the stubborn nature of inflation is fiscal policy. Roughly 800 billion euros in fiscal support have been provided to EU business and households to help offset energy costs,” says Scotland.

In this scenario, we are bullish bonds across our portfolios through investments in Treasury bonds, mortgage-backed securities (MBS) bonds, and select emerging market bonds, adds Scotland.

He says “The biggest pricing anomaly in the fixed income markets is the U.S. yield curve, more extremely negative than at any time in modern history except for the early 1980s. Yield curves in some emerging countries are even more inverted. We believe the risk/reward profile warrants long duration positioning. Everything mentioned earlier points to a bull steepener in the yield curve.

“A Fed-provoked recession could trigger a bond rally; our base case of falling inflation and a mild economic downturn would also support the bond market but with less upside.

“There is some near-term risk to the upside in yields if the Fed continues to raise rates and nominal GDP growth remains strong a while longer. However, history shows GDP itself is a poor early warning indicator of a sudden drop-off in activity, the data generally remaining firm right up to the moment it weakens.

“On the currency front, I believe the U.S. dollar is overvalued based on most metrics but not in the extreme. In addition, tight monetary policy and expansionary fiscal policy is typically constructive for a currency, which is the current policy backdrop in the U.S. Consequently, our foreign currency allocations out of dollars are on a selective bilateral case-by-case basis. Companies have not been complaining about the strength of the dollar despite wider current account and trade deficits. Similarly, the dollar has not responded much to Treasury Secretary Yellen’s admission that Americans should expect a decline in the greenback as the world’s reserve currency as China, Russia, and some other prominent countries look for ways to dethrone it and escape potential U.S. sanctions.

“The reality is that no other major economy has the depth of capital markets, the institutional infrastructure, and the laws that could replace dollar hegemony for now. It is hard to picture what will provoke a meaningful retreat in the dollar this year given the Fed’s determination to restore low inflation, not to mention the darkening outlook in Europe.

“Expectations that the euro could rally because the Wagner rebellion in Russia might hasten an end to the war seem a bit optimistic given that Putin has no history of retreat, only escalation. The threat of confrontation with NATO in the event of Russia using nuclear weapons or blowing up the Zaporizhzhia nuclear power plant suggests that there are tail risks at least in both directions.

“Nor does China’s desire to support its economy seem overly bullish for the renminbi or, therefore, overly bearish for the dollar. Longer-term U.S. fiscal degradation could lead to massive tax increases, which would be very negative for the currency. The only positive in that equation is that most of the Western world is in the same boat,” says Scotland.

The post A world out of sync with inflation appeared first on AdviserVoice.

In the latest edition of Franklin Templeton Investment Institute Macro Perspectives, Franklin Templeton’s investment specialists discuss what’s fueling inflation and how policymakers are combating it. They offer differing views on whether inflation will abate or accelerate as the year progresses.

The paper also explores the potential impacts of the US Federal Reserve’s (Fed’s) pivot on interest rates, Omicron-driven uncertainty, China’s macro playbook, and wage and labor expectations.

Investment Specialist Highlights

Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income: “I think the market is being somewhat sanguine about what will happen in the second half of 2022. There is an expectation that inflation will decline sharply. I think that might be optimistic because a lot of the factors driving inflation will still be with us. The Fed is already behind the curve.”

John Bellows, Portfolio Manager, Western Asset: “Our view is that inflation is going to moderate over the next six to 12 months. If there is an environment where expectations are for higher inflation and maybe the Fed is irresponsible in its rhetoric or policy response, that creates a bit of a behavioural self-fulfilling prophecy where people expect higher prices, and businesses raise them.”

Gene Podkaminer, Head of Research, Franklin Templeton Investment Solutions: “Labour supply has not returned in the United States, which is one of the unique aspects about the American economy compared to other developed countries—we would expect the labour shortage to provoke a rise in real wages.”

Michael Hasenstab, Chief Investment Officer, Templeton Global Macro: “Most countries tend to follow the Fed, but in this cycle, we’ve seen substantial rate hikes ahead of the Fed, particularly in Latin America. In Asia, several countries have been able to maintain higher policy rates throughout the pandemic, giving them a buffer against Fed tightening. Certain local-currency valuations within these regions appear highly compelling.”

Francis Scotland, Director of Global Macro Research, Brandywine Global: “Looking at valuations, some emerging market currencies look attractive to us. A lot of emerging markets have been raising interest rates to the point now where they may start to pivot in the other direction. We do see idiosyncratic opportunities popping up across the emerging market space.”

Read the Report.

The post Inflation and interest rates- have we reached the pivot point? appeared first on AdviserVoice.

Francis Scotland

Francis A. Scotland, Director of Global Macro Research at Brandywine Global, a Legg Mason Affiliate, discusses the Fed’s recent action and the prospects for improved sentiment as the U.S. and other nations look to “better balance the hard-trade-off between containment of COVID-19 and economic disruption as a result of this pandemic.”

Events surrounding the pandemic continue to evolve fast and furious.

The Federal Reserve (Fed) recently announced a range of new actions, dramatic in terms of both initiative and scale. However, the nature of the economic crisis would suggest a lot more will come before this is over.

The Treasury market

The Fed was forced to move aggressively. Treasury yields had been rising since March 9 until the 23rd, which made no sense in view of the collapse in economic activity taking place. The rise in nominal yields coincided with retreating breakeven inflation rates—10-year Treasury Inflation Protected Securities (TIPS) spiked by about 100 basis points (bps) from their low on March 9, while the dollar surged, and gold tumbled. Some tied the phenomena to an unwind of risk parity trades. Others worried about the scale of debt issuance accompanying the massive fiscal support being organised for the economy. Neither was the real reason.

Forced liquidation in order to raise dollar cash was the most likely cause of the back up in long bond yields. The speed of the deterioration in financial conditions has been outpacing the Fed’s response to the crisis. That may have started to change yesterday: the yield on 10-year TIPS is down about 60 bps from last Thursday’s peak, breakeven inflation rates are rising, the dollar is off, and gold has rallied. Real yields need to stay down and move lower because market conditions are still not very liquid.

These technical points on the Treasury market are the proverbial tip of the crisis iceberg. Measures taken to address the pandemic are hammering the economy. The longer the measures to contain the spread of the virus remain in place, the greater the prospect of a nightmarish economic scenario. As Larry Kudlow indicated yesterday, the decision on when to pivot away from measures aimed at containing the virus to rebooting the economy will be very difficult, but crucial in every respect.

Containment and economic activity

Economic activity in the U.S. is collapsing. The cause of the contraction are the government-ordered lockdowns and restrictions on public activity aimed at controlling the spread of the virus. The nosedive in activity has been accelerated by warnings from health officials along with fear and anxiety fostered by the daily reporting on the spread of the virus and by announcements of the shutdowns themselves. The virtually shuttered hospitality industry is the most visible example of the economic fallout, but the ripple effects are growing with manufacturing sliding and the auto sector facing industry-wide shutdowns. The services sector, normally a source of stability in a downturn, is leading the way over the cliff. Making matters worse is the cumulative restriction on public sector activity as the frequency of infection builds. More countries and large regions of the developed countries—including several large U.S. states—have announced full-scale lockdowns of everything but essential services.

The severity and speed of the demand shock is enormous. China’s economy may have plunged as much as -20% at annual rates in the first quarter. Increasingly, U.S. analysts are calling for similar contractions in annualised growth in the U.S. during 2Q. The stock market is forecasting a recession; past correlations and regional surveys suggest that ISM new orders will fall close to or below the 40% level, and U.S. unemployment insurance claims could skyrocket from current levels of 280,000 to over 2,000,000. James Bullard, President of the St. Louis Federal Reserve Bank opined last week that the unemployment rate could surge to 30%.

The financial calculus faced by closed business and unemployed households is the rate of cash burn. For companies it is working capital. For households it is savings. Liquidity crises that remain unresolved morph into insolvency and bankruptcy. Companies have drawn on credit revolvers, raised financing where possible, and begun layoffs. Credit markets have broken down with spreads blowing out. For an economy like the U.S.—with an elaborate and sophisticated integration of finance and commerce—the downward spiral is vicious.

The lender of last resort

In this environment, the Fed on March 23 acknowledged its role as the lender of resort and stated that it will boost its balance sheet by any amount needed to stabilise the Treasury market. The central bank made history by opening a new liquidity pipeline directly to the corporate sector with its Primary and Secondary Market Corporate Credit Facilities. In addition, the central bank indicated that it expects to announce a Main Street Business Lending Program for small- and medium-sized enterprises, aimed at keeping the credit lines open to them during the crisis and for sustaining employment. These measures aimed at getting liquidity and credit to the business sector are all in the right direction. Ultimately, the firepower that the Fed brings to sustaining credit lines could be dramatic if it is able to lever up against much larger funding support from the Treasury, which is expected would follow passage of the extraordinary fiscal support measures currently under discussion in Washington.

These dynamics underscore how different this crisis is from 2008-09, a comparison many are drawing. A breakdown in the financial plumbing during the Great Financial Crisis threatened a massive economic contraction. The economy stabilised only after the financial plumbing cleared—and with the help of a lot of fiscal stimulus. This time around it is the economic shock created by the lockdowns and curtailment of economic activity that has triggered the financial seizure. The Fed will work hard to minimise the blowback from the financial system to the real economy.

But the contraction in economic activity at the root of the crisis won’t end before government-imposed measures aimed at curtailing the spread of the virus are lifted, notwithstanding the size and scale of Fed initiatives or the breadth of fiscal policy being mustered to soften the downside.

Reevaluating containment policies

The economic damage is not going to end before the lockdowns are suspended, which keeps the U.S. administration focused on timelines. There was a lot of eye-rolling over President Trump’s weekend tweet about reevaluating the need for more containment policies at the end of this week. It is easy to be cynical. The U.S. administration downplayed the health risk initially and only presented a plan to attack the epidemic a little more than a week ago. Trump identifies his future electoral success with the economy.

My own view is that Trump is correct in deliberating on when and how he should pivot from his focus on containing the virus to getting people back to work. There is a practical limit to how long a full-scale lockdown can be put in place and I agree with the president that this period is measured in weeks, not months. Yes, quarantining and social distancing ultimately will resolve the pandemic. Yes, the U.S. was slow to respond initially and is already late to react. But the longer the economy is on pause, the harder it gets to start up again. Too long a lockdown could bring on a terrible economic outcome of bankruptcy and depression, no matter how much policymakers try to avoid it. That would lead to socioeconomic disruption on a scale at least equal to or worse than what we are living. From a human and psychological perspective, it is questionable how much people can sustain before they go crazy from the stress of fighting the phantom enemy, unnatural isolation, the inability to connect with family and friends, and the lack of income and purpose resulting from work shutdowns.

Trump anticipates push back at the state level when he finally announces that it is time to go back to work—another reason why he is thinking of ending the containment message sooner rather than later. This is what happened in China. Provincial governments—responsible for the health of their populations, as in the U.S.—resisted the central government’s call for people to return to work. High frequency data show economic revival on its way in China with most people back to work, but it is uneven and many parts of the economy are still operating substantially below full capacity.

Factored into Trump’s thinking is that this isn’t 1918, despite all the comparisons with the Spanish Influenza epidemic. In the 100 years since that time, science and technology have advanced dramatically and the best minds in the world are working on solutions to the crisis. In addition, resources are being marshalled to help the healthcare industry boost capacity. Makeshift medical facilities are being set up across the country with assistance from the military. Factories are shifting and ramping up production of equipment needed to manage the case load like respirators. The ideal outcome would be rapid and mass escalation in testing. Learning to live with the threat of terrorism after 9/11 meant intense and widespread security screening at airports around the world. Similarly, learning to live with this threat could involve some combination of systematic temperature surveillance as is the case currently in several Asian countries.

All of this suggests that Trump is likely to pull the switch on reversing the containment strategies sooner rather than later, possibly some kind of return-to-work in stages. On the virus front itself, there is some good news: new cases have been down two days in a row in Italy, suggesting that flattening the viral curve to manageable levels involves weeks of containment not months. Any order to return to work might include an announcement for the older and more vulnerable segments of society to continue their isolation but for the bulk of the labor force to return.

An end to negative sentiment?

The number of new cases will rise sharply in the U.S. over the next few weeks based on the pattern of infection in other countries—the economic data will be ugly. But asset market valuations are multiple sigma away from levels associated with any kind of return to normalcy. The pivot back to firing up the economy, coupled with all the current fiscal and monetary firepower in play, and more likely to come—argue for an end to the current negative sentiment in asset markets, sooner rather than later.

The post Coronavirus pandemic: difficult tradeoffs appeared first on AdviserVoice.