A changing inflation and growth climate

Introduction

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

With these issues in mind, I moderated a panel of our leading economists including John Bellows, Portfolio Manager, Western Asset; Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income; Michael Hasenstab, Chief Investment Officer, Templeton Global Macro; and Francis Scotland, Director of Global Macro Research, Brandywine Global. The key question I wanted to address: What’s in store for investors in the second half of 2023?

Below are my key takeaways from the discussion.

• Inflation will continue to be an issue for the next 6–12 months. There are some indicators that point to slowing inflation and the global economy entering a period of disinflation, where the rate of inflation is falling and prices are not increasing as rapidly. 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. There is less risk of deflation, where prices actually fall.
• While inflation is coming down in many countries, the global economic recovery is uneven.
  • China is struggling to find sources of economic growth. An expected surge in growth did not materialize following post-COVID reopening. The Chinese government is likely to step in with more macroeconomic stimulus.
  • Supply-chain rebuilding and friend-shoring should contribute to growth opportunities in some countries. Supply chain rebuilding is leading to increased investment within Asia, particularly in countries like India and Indonesia. Other countries that should benefit include Mexico and Canada.
  • Japan benefited from recent increases in inflation after struggling with low economic growth for decades. The current inflation and growth levels created opportunities to deploy corporate cash balances. Japan also benefited from higher female participation in the labor force that prevented a labor shortage, which in turn supported growth.
• The upcoming economic data will likely provide further evidence of slowing growth and ongoing disinflation in the US. However, while markets have been anticipating a recession for some time, the strength of the US consumer will likely prevent a massive recession.
• Where will interest rates settle? There appears to be a disconnect with how fast rates will drop in the future. The financial market is pricing rate cuts with an expectation that inflation returns to pre-pandemic levels. However, we think the 10 years following the 2008 global financial crisis (GFC) were an aberration, and inflation is likely to revert to pre-GFC levels as the long-term norm (core inflation in the US averaged approximately 4% between 1958 and 2008, and just under 2% from 2009 through 2019.)¹
• Real interest rates are expected to continue increasing. The Fed just approved another interest rate hike and is expected to hold interest rates above 5% for several more quarters. While inflation is expected to slow or decline over this period, the result is real interest rates (nominal rates minus inflation) rising even if nominal rates do not. This creates a more positive return for investors.
• Where are the opportunities?
  • Fixed income investments are resuming status as good portfolio diversifiers. Unlike 2022, where both fixed income and equities had negative returns together, there is now a low correlation between fixed income investments, equities and other risk assets.
  • Selectively increasing duration offers an attractive total return. We see neutral to shorter duration providing better risk/return profiles for the rest of 2023. The current yield levels and the expected peak in interest rates combine for a positive expected total return.
  • High-yield debt is priced attractively as investors remain cautious about the economy. Current yields are providing active investors with high returns. However, investors need to be selective as some lower-quality corporate credit is susceptible to default risk and we have concerns about credit spreads widening.
  • Emerging markets can provide diversification. Many emerging markets have demonstrated strength, 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 (ECB) and the Fed. With many emerging market bonds enjoying attractive yields, this asset class provides another source of return that is not necessarily synchronized with the rest of the world.

While the investor experience for the last six months was extreme volatility in terms of interest rates and changing opportunities, we believe the Fed will continue to bring inflation more fully under control and might hold rates higher for longer than some expect. Growth opportunities vary around the world, and across sectors and maturities. Fixed income once again has a low correlation with other risk assets, providing potential diversification and increased portfolio protection.