Finding the path to normal

Are markets correctly pricing inflation? What’s next for the economies and global markets following the recent banking sector turmoil? Will the US dollar weaken? Our economists discuss key questions facing investors today in our latest Macro Perspectives.

Introduction

As central banks wrestle with how to respond to volatile economic data and banking turmoil, while also fighting inflation, Franklin Templeton’s economists provided their perspectives on what’s next for economic growth, interest rates, inflation and fixed income markets.

Our panel discussion included John Bellows, Portfolio Manager, Western Asset; Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income; Michael Hasenstab, Chief Investment Officer, Templeton Global Macro; Gene Podkaminer, Head of Research, Franklin Templeton Investment Solutions; and Francis Scotland, Director of Global Macro Research, Brandywine Global.

Below are my key takeaways from the discussion:

• Very little has changed in the forward outlook from last quarter to this quarter, despite the tumultuous feel of events. If anything, the case for fixed income has strengthened and plays an even more pivotal role in portfolios. The estimates of the top rates that the Fed Reserve (Fed) will target have come down a little but remain very similar to prior estimates.

• Confidence in the banking system remains a risk as the full ramifications of the turmoil are still unclear. The banking turmoil seems to have only impacted specific banks with management shortcomings and particular issues with their asset/liability mix. Until some time has passed, and we can assess how banks perform and how the public views and uses banking, we will not have a complete answer.

• The path to getting inflation into the 2% target zone is still not clear, thus creating differing views of pending rate hikes and how long before a pivot. Some panelists see the stickiness of inflation persisting and see continued rate hikes in an attempt to reach the Fed’s inflation goal. These panelists see a top rate of roughly 5.25%, which would hold for the remainder of the year. This is slightly lower than the forecast from last quarter. As negative economic data become visible, the odds of rate hikes decline. One panelist thinks the Fed will discontinue rate increases now or very soon due to economic dislocation, which will cause inflation to drop. 

• The US dollar will likely weaken. The US dollar has had exceptional returns, but if focus returns to the fiscal deficit, current account deficit and relative growth differential, the US dollar could weaken. It may not be a dramatic weakening but will almost certainly be volatile.

• Asia, particularly China and Japan, look poised to show strong economic growth and opportunity. There is a divergence in growth opportunities between Asia and the rest of the world. China’s reopening will create consumption-driven economic activity. This should cause a positive ripple effect across the region and the globe. Japan has particular strength in automation, which will be a competitive advantage as supply chains are restructured.

• Geopolitical conflict remains a key risk. The continuing areas to watch are US/China and US/Russia relationships. There are also risks of an unanticipated (or “unknown unknown” risk) conflict, given the volatile economic and political conditions in many regions around the world.

• In a welcome change from last year, fixed income is again exhibiting diversifying characteristics to other portfolio assets. Fixed income finally has more “income” and is providing some diversification from equities. All of the panelists are more positive on fixed income in general and increasing duration than in the previous quarter. The short end of the yield curve is more expensive, so our panelists are focused on broader exposure and are moving to neutral or longer duration. One panelist is focused on five-to-10-year bonds for the best opportunities. The focus remains on high-quality bonds in this environment.

• Volatility creates investment opportunities. Often markets initially overreact to economic events, which creates opportunities to invest. It is a difficult and important lesson to remember and was reinforced by several panelists.

While it may be a rocky road, we believe it is important to develop a long-term outlook and construct a well-diversified portfolio to best capture opportunities. Diversified portfolios can help weather changing conditions and provide a range to take advantage of opportunities under many scenarios. A larger fixed income allocation can provide more income to portfolios and hedge some market risk from other asset classes.

Stephen Dover, CFA
Chief Market Strategist,
Franklin Templeton Institute

WHAT ARE THE RISKS?

All investments involve risks, including 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. 

Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions.

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 emerging markets involve heightened risks related to the same factors. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. 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. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.

Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Investments in lower-rated bonds include higher risk of default and loss of principal.

Diversification does not guarantee profit or protect against risk of loss.

Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments.

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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. All investments involve risks, including possible loss of principal.

Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. FT 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.

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Investments entail risks, the value of investments can go down as well as up and investors should be aware they might not get back the full value invested.