Diverging views on the economic path

Introduction

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 for this edition of Macro Perspectives 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.

Here are my key takeaways from the discussion:

• The US 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 have 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; and
  • 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 and some disagreement among our panel as to whether US economic resilience will continue. Many reasons for the US economy’s resilience are starting to fade. US student loan repayments will resume in the fourth quarter of 2023, which will likely be a drag on spending. Continuing government dysfunction could be 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 (Fed) started raising interest rates around 18 months ago, indicating that a slowdown is more likely going forward. Our panelists expressed differing views on whether the resilience can continue, and if the United States can avoid a recession.

• Economic growth in Europe and China have been slower 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 and geopolitical tensions. This will boost headline inflation in the short term but is less likely to impact core inflation. It is also different than last year when all commodity prices rose at the same time. We are not seeing this concurrent rise in the prices of other commodities.

• The uncertainty surrounding recent ongoing threats of a US government shutdown highlights the long-term challenge of fiscal stability. US Congress remains dysfunctional in its ability to reach compromise agreements. The interest expense as a percentage of the budget is large 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 and are re-issued at current rates.

• Shifting portfolio holdings into fixed income and out of cash is looking attractive to us as interest 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, and should show low expected correlation to equities going forward.

• Where are the opportunities within fixed income? The panelists offered some similar but also differing viewpoints, including:
  • Overall, the panel agrees that fixed income is very attractive relative to the past 15 years and relative to other asset class choices. They believe it is a good time to begin moving cash off the table and to invest in fixed income opportunities;
  • Investment-grade bonds. Credit quality is high as corporate balance sheets remain healthy. This creates a safer potential for total return, regardless of duration;
  • High-yield bonds. There will likely be volatility over the next 18 months due to a perception of higher credit risk, but higher-rated, high-yield bonds are offering attractive risk-adjusted returns;
  • Agency mortgage-backed securities (MBS). Within the United States, our panel is in agreement that MBS is an attractive opportunity. The yields in this sector are higher than investment-grade bonds with lower default risk. And they have lower volatility;
  • Emerging market debt. A focus on emerging market bonds in countries that are stepping in to fill direct trade with the United States in place of China is particularly warranted. These include India, Vietnam, Indonesia and parts of Latin America; and
  • Global developed markets. In developed markets there are fixed income opportunities—Japan being one standout. These opportunities (as well as emerging market bonds) benefit if the US dollar weakens (for investors in local currency denominated fixed income).