Second-half outlook for inflation, rates, recovery

Where investors should seek opportunity

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 U.S. history, a near-default by the U.S. federal government, and universal predictions of U.S. 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.

Uneven global recovery

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.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. 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.