Too hot, too cold, or just right?

Gauging global fixed-income opportunities

The metaphor of temperature (too hot, too cold or just right) aptly encapsulates the questions in current market dynamics. Are we overheating, signaling inflationary concerns and a potential bubble? Is the economy too cold, characterized by lagging growth and the risk of stagnation? Or perhaps we’re in that elusive “Goldilocks” zone, where things are just right, at least for now. We recently hosted a discussion with economists from across our firm to provide their varying views and insights related to these questions.

Our panel discussion included John Bellows, Portfolio Manager, Western Asset Management; Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income; Michael Hasenstab, Chief Investment Officer, Templeton Global Macro; and Paul Mielczarski, Head of Global Macro Strategy, Brandywine Global.

Whither the global economy?

Here are my key takeaways from the discussion:

The U.S. economy has been more resilient than anticipated, due primarily to the following factors: Lower inflation has boosted real income and spending power; excess savings built up during the pandemic has also aided spending. There has been a reversal of pandemic-related disruptions, such as a rebound in auto production and sales as chip shortages ease. The labor market has been strong, and may gather strength more broadly if the striking auto workers get the wage increases they are asking for.

There are significant risks as to whether U.S. economic resilience will continue into the fourth quarter and beyond. Many of the reasons for the U.S. economy’s resilience are starting to fade. Looking at the fourth quarter of 2023, U.S. student loan repayments will resume, which will likely be a drag on spending. The continuing threat of a government shutdown later in the year could be a negative for growth. Typically, there is a one- to two-year lag between higher interest rates and their impact on employment growth. The Federal Reserve started hiking around 18 months ago, indicating that a slowdown is more likely going forward.

Europe and China have shown slower economic growth than anticipated. Europe has shown great difficulty recovering from the trade shock of last year following Russia’s invasion of Ukraine. The downside in Europe may reflect the impact of policy tightening from the European Central Bank. China has experienced many challenges, including a decline in housing-related activities, putting pressure on corporate and local government balance sheets. The period of weak Chinese growth adds a disinflationary impulse to the global economy.

Oil prices are not anticipated to significantly impact core inflation. Currently, rising oil prices are linked to supply changes through production cuts. This will boost headline inflation in the short term but is less likely to impact core inflation. It is also different than last year where all commodity prices rose at the same time. We are not seeing this concurrent rise in prices of other commodities.

The uncertainty surrounding a U.S. government shutdown highlights the long-term challenge of fiscal stability. Although we just avoided a shutdown, it seems likely that another standoff will occur due to Congress’ dysfunction in its ability to reach a compromise agreement. The interest expenses as a percentage of the budget are huge and will grow as interest rates have risen. Because much of the government bond issuance is on the short end of the curve due to higher demand for those instruments, this exposes the overall budget to rising rates as bonds mature. Despite this, our panel still believes the U.S. dollar will remain the world’s reserve currency, primarily because there is no alternative that meets all the requirements at this time.

Shifting portfolio holdings into fixed income and out of cash is looking attractive as rates have risen. Fixed income creates total return by producing income, not just based on price movements. This is a stable and consistent contribution to portfolio return. Additionally, fixed income is a diversifying asset showing low expected correlation to equities going forward. Beginning to allocate out of cash holdings and into fixed-income options is attractive at these levels. Fixed income is a more attractive investment choice than equities at this time.

Fixed-income opportunities

Agency mortgage-backed securities (MBS). Within the United States, our panel finds MBS attractive. The yields in this sector are higher than investment-grade bonds with lower default risk. And they have lower volatility. Most agency MBS are on the intermediate part of the yield curve.

Emerging market and global market debt. U.S. investors have invested with a strong home country bias in recent periods, which has limited their ability to diversify. There are lots of global opportunities today for investors who take time to assess the return opportunities, balanced against risk in their overall portfolio. Emerging market bonds offer good opportunities, particularly in countries that are stepping in to fill direct trade with the United States in place of China. These include India, Vietnam, Indonesia and parts of Latin America. Additionally, in developed markets there are global fixed-income opportunities in countries such as Japan. These opportunities can also provide currency growth if the U.S. dollar weakens (for investors in local currency denominated fixed income).

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Franklin Templeton’s Insights page. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Disclaimer

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.

Important legal information. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

Image: iStock.com/Pridannikov