Quick Thoughts: Preparing for policy pivots

After more than two years of higher inflation and interest rates, global markets are confronting a new set of fixed income opportunities and risks as central banks prepare to cut rates and elections worldwide reshape political leadership. And Franklin Templeton Institute Strategist Christy Tan recently published research focusing on the need to reconsider portfolio strategies with greater awareness of credit fundamentals and geopolitical instabilities.

I recently discussed many of these themes with a panel of fixed income leaders from three investment teams at Franklin Templeton:

• Sonal Desai, Chief Investment Officer of Franklin Templeton Fixed Income, a team that focuses on combining deep fundamental research with rigorous portfolio construction with the goal of delivering consistent and resilient returns across different market environments.   
• Michael Hasenstab, Chief Investment Officer, Templeton Global Macro, an unconstrained global fixed income manager that uses a high-conviction approach seeking to capture long-term value across global interest-rate, currency and credit markets.
• David Hoffman, Head of Global Fixed Income at Brandywine Global, which looks beyond short-term, conventional thinking to pursue long-term value across differentiated and alternative fixed income and equity solutions.

Each investment manager at our firm has an independent view about markets arising from a distinct, well-defined investment process rooted in research. I’m happy to share a brief summary of their views.

Inflation and interest rates

Since we saw inflation begin to rise in 2021, Sonal has held the view that price pressures would be persistent and challenging to bring down quickly, and recent data is proving her view to be correct. Even at the beginning of 2024, when the markets appeared to price in six or more rate cuts by the US Federal Reserve (Fed), Sonal held to the view that only one or two cuts were likely this year—which is close to what the market is now pricing. Sticky inflation, Sonal believes, will mean the upcoming cutting cycle will be shallower than previous ones, with the silver lining that the risk of recession is lower. David believes the US economy is weakening but suggested that the Fed might not understand the underlying risks very well. He is less confident in the Fed’s ability to steer the economy. While Michael also foresees US growth decelerating and expects interest rates to fall in coming years, he highlighted improvement in other markets and regions, including India, China, Japan and Latin America.

Emerging markets

When I noted that emerging markets are underinvested compared with the United States, Michael and David agreed and pointed to many bright spots. Michael observed that many countries had shown resilience during the COVID-19 pandemic and have managed their fiscal accounts and trade balances well. India, in Michael’s view, has diversified its economy into higher value-added services while being able to control fiscal deficits. The result is that India can potentially attract more capital from abroad, including a share of the capital that has traditionally flowed to China. David likes Indian bonds from a yield perspective, but he noted that currency appreciation is unlikely because India prefers to control its currency. Sonal emphasized the importance of taking an active, selective approach in emerging markets.

I asked our panelists for their thoughts about China. David is encouraged by the government’s pivot toward supporting industrial production and trade, while trying to help the economy move beyond the residential real estate crisis. Many insolvent private real estate companies have gone out of business, and the authorities have supported efforts to purchase some of the backlog of unsold housing. Internationally, China is focused on making trade deals to achieve faster growth.

Trade and globalization

I asked the panelists for their views on changes to global supply chains as a consequence of the pandemic, sanctions associated with the Russia-Ukraine war and tensions between China and the United States. Michael believes geopolitical conflicts will mean that regional trading systems are likely to replace global supply chains, with China and the United States leading two increasingly separate trading blocs. This trend should create opportunities in many countries. The US$100 billion of foreign direct investment that had been flowing into China each year will now be distributed among several countries, with some of it likely to go to India and Japan, among other Asian and select Latin American beneficiaries. Sonal noted that the priority in US trade policy is shifting from reducing cost to increasing security and reliability, and that this factor should contribute to the stickiness of inflation.

The US dollar

The dollar has remained strong as the Fed has held rates steady, and I asked the panelists for their outlook. All of them agreed the dollar will probably weaken in coming years. The dollar’s exceptional strength in recent years, Michael said, was largely due to sustained US economic growth, but as the economy starts to slow and interest rates come down, the massive US trade deficit and fiscal deficit will likely take a toll on the dollar. David noted that his team is generally less sanguine on dollar-based assets relative to other currencies.

Elections

In a historic year for elections, I asked how the US election in particular might have an impact on global markets. All three of them agreed that the noisy rhetoric between the US presidential candidates obscures the fact that neither candidate supports free trade or fiscal consolidation. David noted a concern that markets could react negatively if one party sweeps both the US presidency and Congress. He would view a post-election selloff in US Treasuries as a potential buying opportunity, because, with the deficit already near unsustainable levels, neither party will find it easy to expand fiscal policy further.

Looking more broadly, Michael noted that recent elections outside the United States had little negative impact on markets globally. He cited the example of President Lula in Brazil—markets feared his election, but Lula has governed with reasonable policies. David agrees that Latin American economies have become more reliable at preventing inflation in recent years, and he asserts that emerging markets generally have more stable macroeconomic balances than the United States.

Portfolio strategies

My ultimate question was how their views guided their current portfolio strategies. For the past year, investors have been able to hold cash instruments yielding about 5% and avoid market volatility. Sonal believes it is important to begin diversifying fixed income exposure even before the Fed begins cutting interest rates. Risk-averse investors might consider moving from cash to short-duration bonds, but Sonal also finds valuations attractive in high-quality assets like agency mortgages and favors selective opportunities in areas such as high yield, which are offering strong risk-adjusted return potential.

While David is pessimistic about dollar-based assets, he favors a long duration position in US Treasuries given that interest rates are likely to come down. He agreed with Sonal about agency mortgages, highlighting that the wave of prepayments during the pandemic means that mortgage yields are likely to be more stable than in most previous cycles. Corporate bonds are less attractive in David’s view because credit spreads are narrow, and this sector is less likely to benefit from a slowing economy.  

Michael believes that it is an opportune time to diversify into emerging markets and certain developed markets, to take advantage of the expected US dollar decline as well as attractive risk-adjusted returns available in countries that are showing significant structural improvement.