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.

John Bellows

At the June 14 Federal Open Market Committee (FOMC) meeting the Federal Reserve (Fed) left rates unchanged but kept alive the possibility of raising rates again at upcoming meetings. Arguably, the committee even leaned into the prospect of higher rates, as a majority of officials now forecast at least two more rate rises in their base case.

“Over the past few weeks, there has been a fair amount of drama surrounding this possibility,” says John Bellows, Portfolio Manager, at Western Asset, part of the Franklin Templeton.

Bellows says: “The amount of drama surrounding whether the Fed raises rates again at one of the next few meetings seems disproportionate to its importance. The big picture is unlikely to change materially whether the Fed ends its hiking cycle now or after one or two more rate rises.

“Here we summarise how we see the big picture, and in our conclusion, we also offer a possible scenario as to how the drama will be resolved over the coming weeks and months.

“The size of the possible future rate rises is small relative to the hikes already made. Indeed, the difference is a full order of magnitude: the Fed has raised rates 500 basis points (bps) to date, as compared to another 50 bps of possible rate rises that are reflected in the median projection of FOMC participants. In terms of surprises relative to expectations, which is often what matters most for financial markets, the difference is even starker. The upside rates surprise in 2022 was one of the largest on record, corresponding with the worst year in the last 150 years for returns on US Treasury bonds.^[1] If the Fed were to raise rates again now, in contrast, the surprise would be much more modest, as markets already reflect some probability of such an event.

“While most of the rate rises are likely in the past, the full impact of monetary tightening is likely still ahead. In part this is due to the oft-repeated observation that monetary policy has “long and variable lags.” There is another factor, however, that may be just as important in the current environment. The Fed plans to hold interest rates above 5% for the coming few quarters, while inflation is expected to decline over the same period. Consequently, real interest rates are expected to continue increasing even if nominal rates do not.

“Fed officials are taking note. According to their own forecasts, a restrictive level of rates today will be even more restrictive a few months from now, with the economic impacts increasing as a result. This should give pause to any attempt to calibrate policy based on a handful of data prints.

“Elevated funding costs challenge sectors of the economy that rely on leverage. In certain instances the resulting stress contributes to nonlinear developments, which in turn raises uncertainty and exacerbates downside risks. The turmoil in regional banks is the most recent example. While the stability in this sector over the past few weeks has been encouraging, the risks have certainly not gone away. It’s notable that regional-bank equities still trade at a discount of more than 30% to their February prices. More broadly, the environment remains challenging.

“As long as funding costs remain above the rate of return on high-quality investments, banks will struggle to provide credit to the economy. Tighter lending standards is the minimum that should be expected, with risks tilted toward additional unforeseen stresses.”

Bellows says: “In summary, the following three points constitute the big picture. First, any future rate rises are likely to be small relative to the rate hikes already done. Second, the full impact of the rate rises has yet to be felt, as it will likely increase in the coming quarters when real interest rates increase further. Finally, the stress caused by elevated funding costs is significant and likely to continue. None of these considerations will change much, if at all, should rates end up closer to 5.5% instead of at their current level. The big picture is already set; the die has already been cast.

“While it may not affect the big picture, the Fed’s actions over the next few FOMC meetings will undoubtedly receive a lot of attention, so here we’ll offer a view on the most likely outcome. We expect the upcoming economic data to provide further evidence of slowing growth and ongoing disinflation. The consumer price data released yesterday was somewhat mixed with regard to inflation last month.

“Going forward the trend will likely be clearer: the decline in shelter inflation is set to continue, while the recent rise in goods inflation is likely to reverse, leaving core inflation broadly lower on net. The last few months of slowing labor demand is also likely to continue, as indicated by the forward-looking business surveys. On their own these trends may not cement a Fed decision. Taken together, however, we expect they will be enough to forestall the Fed from raising rates as much as indicated in the FOMC projections.”

——–

Endnotes:
[1] Zweig, J. “It’s the Worst Bond Market Since 1842. That’s the Good News.,” The Wall Street Journal, May 6, 2022.

The post Don’t let drama over next few Fed meetings distract from the big picture 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.