Decoding success: The power of security selection

CONTRIBUTORS

Sonal Desai, Ph.D.

Chief Investment Officer, Franklin Templeton Fixed Income

Nikhil Mohan

Economist, Research Analyst
Franklin Templeton Fixed Income

Angelo Formiggini

Economist,
International Research Analyst

Patrick Klein, Ph.D.

Director of Multi-Sector Strategy,
Portfolio Manager
United States

John Beck

Director of Global Fixed Income,
Portfolio Manager
United Kingdom

David Zahn, CFA, FRM

Head of European Fixed Income,
Portfolio Manager
United Kingdom

In this issue

Fixed income assets broadly continue to provide strong levels of income, with many sectors now offering some of the highest yields seen in several years. Shorter-duration, high-quality assets remain attractive to us on a historical basis and can provide downside risk management amid both rising interest rates and widening credit spreads.

We still believe global central banks must continue to be vigilant as they strive to lower overall inflation. In our view, the market’s expectations that the US Federal Reserve (Fed) will be quick to respond to any deterioration of economic conditions with rate cuts is disconnected from the Fed’s own guidance. Our base case calls for no Fed rate cuts during this year; we also still see the European Central Bank (ECB) and the Bank of Japan (BoJ) continuing to tighten monetary conditions. We expect a short, shallow recession in the United States and the euro area.

Macroeconomic themes

Interest rates are likely to stay elevated for longer. The Fed maintains that bringing still-high inflation back to target is going to take time and therefore, rate cuts are unlikely in 2023.

Rising real wages. With US inflation expected to moderate further, real wages and real disposable income should continue to rise.

Aspects of elevated/sticky inflation. Elevated inflation persists as most of the Personal Consumption Expenditures (PCE) basket is still exhibiting price increases in excess of 5% year-over-year (Y/Y).

Portfolio themes

Security selection is key. Security selection has always been an essential tool in portfolio construction, but moving into a slowing economic environment sector and issuer selection becomes more important.

Conservatively positioning for spread exposure. Current corporate spread levels do not price in any sort of slowing economic conditions and remain well below levels seen in previous recessionary episodes.

Being mindful of interest-rate volatility. With the Fed reaching what we see as its terminal rate, we are slightly more constructive on duration than we have been for some time. However, intermediate- and longer-term yields remain too low.

WHAT ARE THE RISKS?

All investments involve risks, including 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.

Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline.

The price and yield of an MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. An MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of an MBS or in an MBS’s credit rating may affect its value.

Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity.

Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement.

Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton.

The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

This document is intended to be of general interest only. This document should not be construed as individual investment advice or offer or solicitation to buy, sell or hold any shares of fund. The information provided for any individual security mentioned is not a sufficient basis upon which to make an investment decision. Investments involves risks. Value of investments may go up as well as down and past performance is not an indicator or a guarantee of future performance. The investment returns are calculated on NAV to NAV basis, taking into account of reinvestments and capital gain or loss. The investment returns are denominated in stated currency, which may be a foreign currency other than USD and HKD (“other foreign currency”). US/HK dollar-based investors are therefore exposed to fluctuations in the US/HK dollar / other foreign currency exchange rate. Please refer to the offering documents for further details, including the risk factors.

The data, comments, opinions, estimates and other information contained herein may be subject to change without notice. There is no guarantee that an investment product will meet its objective and any forecasts expressed will be realized. Performance may also be affected by currency fluctuations. Reduced liquidity may have a negative impact on the price of the assets. Currency fluctuations may affect the value of overseas investments. Where an investment product invests in emerging markets, the risks can be greater than in developed markets. Where an investment product invests in derivative instruments, this entails specific risks that may increase the risk profile of the investment product. Where an investment product invests in a specific sector or geographical area, the returns may be more volatile than a more diversified investment product. Franklin Templeton accepts no liability whatsoever for any direct or indirect consequential loss arising from use of this document or any comment, opinion or estimate herein. This document may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

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Please contact your financial advisor if you are in doubt of any information contained herein.

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This document is issued by Franklin Templeton Investments (Asia) Limited and has not been reviewed by the Securities and Futures Commission of Hong Kong.

Unless stated otherwise, all information is as of the date stated above. Source: Franklin Templeton.

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