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.
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 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 US economic resilience will continue into the fourth quarter and beyond. Many of the reasons for the US economy’s resilience are starting to fade. Looking at the fourth quarter of 2023, US 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 US 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 US 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.
- Where are the opportunities within fixed income?
- 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. US 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 US dollar weakens (for investors in local currency denominated fixed income).
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
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