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Building portfolios in a sea of uncertainty

Published on 09-21-2023

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Buffeted by uncertainty about inflation, interest rates, recession


With the macroeconomic climate causing increased volatility across asset classes, traditional asset allocation strategies have not been providing the same type of risk/return characteristics that they have historically. So, how should investors position their portfolios across stocks, bonds and alternatives going forward?

Will interest rates stay higher for longer than the markets currently anticipate – and what does this mean for the broader economy? Given economic resilience in many sectors of the U.S. economy, is a recession now off the table? For our Investment Ideas series, I recently moderated a panel with Ed Perks, Chief Investment Officer, Franklin Income Investors, and Wylie Tollette, Chief Investment Officer, Franklin Templeton Investment Solutions, to help answer these questions and others. Below are some highlights from our discussion:

Rates higher for longer

Interest rates may stay higher for longer than anticipated. Federal Reserve (Fed) policymakers are likely reading the playbook from the 1970s, when inflation came roaring back after the Fed slowed its rate increases. As such, we don’t think the Fed is in a rush to lower interest rates anytime soon and would be surprised if it happens in the first half of 2024. The Fed has to ensure inflation isn’t just falling, but also gain confidence prices are anchored for a period of time and no longer detrimental to the economy.

If the U.S. economy remains resilient and avoids recession, it could be that we see a prolonged pause at a higher level. The rise in equity markets this year implies that investors seem to be pricing in Fed cuts a little earlier than we anticipate.

Recession waiting in the wings?

The U.S. economy may avoid a recession, but Europe is facing economic challenges. We think the U.S. economy might be able to avoid the textbook definition of a recession – two quarters of negative gross domestic product growth – but is likely tilting toward below-trend long-term growth. Certain industries or areas of the economy likely already have seen rolling recessions during the Covid-19 pandemic or coming out of it, and that may have staved off a single broad-based recession. For example, travel was hit hard during the pandemic, but rebounded later in the cycle.

While we anticipate a slowdown and not a recession in first half of 2024 in the United States, recessions are either already underway or look likely in certain regions of Europe where economies are more vulnerable. We are less sanguine about growth prospects and see more sticky inflation across Europe.

Many emerging markets are emerging stronger

Many emerging markets are ahead of developed economies in terms of where they are in their economic cycle. They saw inflation ramp up quickly post-pandemic but reacted even more quickly. With those emerging market central banks starting to ease, both earnings and valuations may see tailwinds. That said, we advocate for active management in emerging markets, as opportunities and risks are not uniform across the various subregions.

Fixed income outlook brightens

The opportunity set for achieving yield within fixed income has broadened. Higher interest rates are widening the opportunity set for achieving yield. For many years, fixed income was more of an insurance policy rather than a generator of income, but now we are excited about the types of yields offered across the credit spectrum.

Many high-quality corporate bonds had been yielding less than the dividends on their stocks, but today, many of those bonds yield 200-250 basis points above. Investment grade really stands out to us in the current environment as it offers a good income opportunity with less risk than high-yield bonds. We see a risk/reward opportunity in maintaining exposure to long duration as we near peak yields.

Equities require careful selectivity

Equity markets in 2023 have not been synchronized throughout the year. In May and June, there was a very narrow, tech-focused market advance. Recently we have seen a leadership change and broadening that reflects expectations of a lower-inflation, lower-growth environment. Some of the momentum growth darlings are now facing challenges.

This time of year (September/October) has historically been challenging for equities, so a slight tilt toward a “risk off” bias seems prudent. Markets are anticipating earnings growth of 12%-15% in 2024,1 and that seems like a high hurdle to achieve given the economic uncertainties we see.

More than 60/40

A wider array of asset classes and strategies may be required to meet long-term goals. The traditional 60% equities, 40% fixed income portfolio needs to evolve, as 2022 demonstrated. Alternative assets can play a significant and positive role in diversifying traditional bond and stock portfolios. It’s become much easier for many investors to access these markets, and while the democratization of private assets is a positive trend, one does have to be prepared for some illiquidity.

Private credit can be a non-correlated income enhancer for a portfolio, and private equity can provide long-term exposures within selected areas of the market not available in the public markets. Lastly, areas like convertible securities may offer another unique opportunity, providing a total return stream to investors as companies look for creative sources of financing in a tighter lending environment.

Bottom line

What I heard loud and clear from these discussions is that volatility and challenges are ahead of us, and that makes an even greater case for active management. Investors need to solve for increased volatility and capture alternative sources of growth and income when navigating the current economic environment. This can be done through more dynamic strategies and an expansion of the investment toolbox.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published on the Franklin Templeton website Insights page. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter. Tony Davidow, Senior Alternatives Investment Strategist at Franklin Templeton Institute, contributed to this article


1. There is no assurance any estimate, forecast or projection will be realized.


Content copyright © 2023 by Franklin Templeton. All rights reserved. Used with permission.

What are the risks? All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.

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