Quick Thoughts: Impacts of ceilings, tightening and liquidity

In the first half of 2023, investors faced aggressive Federal Reserve (Fed) 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.

I moderated a panel of our leading economists that 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 Francis Scotland, Director of Research, Brandywine Global. I asked this key question, what’s in store for investors in the second half of 2023?

Below are my key takeaways from the discussion.

• Inflation is going to continue to be an issue for the next 6-12 months. There are some indicators that point to a slowing in inflation and that the economy is entering a period of disinflation, where the rate of inflation is falling as prices are not increasing as rapidly. (This is not deflation where prices are falling.) 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.
• Where will interest rates settle? While the markets generally anticipate another interest-rate hike from the Federal Reserve (Fed), there appears to be a disconnect with how fast rates will drop in the future. The market is pricing rate cuts back to pre-pandemic levels, but we think the 10 years that followed the global financial crisis were an aberration; inflation is likely to revert to pre-GFC levels as the long-term norm.
• Real interest rates are expected to continue increasing. The Fed has communicated its intention to hold interest rates above 5% in coming quarters, while inflation is expected to slow or decline over this period. This results in real interest rates showing increases even if nominal rates do not.
• While inflation has been coming down in many countries, the global recovery has been uneven.
  • China is struggling to find sources of growth. A surge in growth did not materialize following the post-COVID reopening of the country. It is not a pending collapse, but will require more economic management.
  • Supply chain rebuilding and friend-shoring should contribute to growth opportunities in some countries. Supply chain rebuilding is increasing investment within Asia, particularly in countries like India and Indonesia. Other countries that should likely benefit include Mexico and Canada.
  • Japan has benefited from recent increases in inflation as it has struggled with low growth for decades. The current inflation and growth levels have created opportunities to deploy corporate cash balances into investments. Japan also benefited from higher female participation in the labor force that has prevented a labor shortage, which in turn has in supported growth.
• Where are the opportunities?
  • Fixed income currently shows low correlation with equities, which we think makes fixed income investments good portfolio diversifiers. Unlike last year’s experience where the correlation of fixed income and equities aligned, fixed income investments are showing low correlation with equities and other risk assets.  
  • Selectively increasing duration offers an attractive total return. Neutral to shorter duration has provided a better return/risk profile to date in 2023. However, given current yield levels and the expected peak in interest rates, the expected total return from extending maturity is emerging as an attractive option.
  • ​​​​​​​High-yield debt is priced attractively as investors remain cautious about the economy.  Current yields are providing active investors with opportunities. However, investors need to be selective as some lower-quality corporate credit is susceptible to default risk.
  • ​​​​​​​Emerging markets can provide diversification. Many emerging market countries showed strength managing through COVID-19 and subsequent inflation shocks, 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 and the Fed. With many emerging market bonds enjoying attractive yields, this provides another source of return that is not necessarily synchronized with the rest of the world.

While the last six months have been extremely volatile in terms of interest rates and changing opportunities, we believe there is still a need to continue to bring inflation more fully under control as we look forward. The growth opportunities vary around the world, and across sectors and maturities. Fixed income is once again showing low correlation with other risk assets, providing potential diversification and increased portfolio protection.

To hear more, listen to the webinar replay here.