Inflation will continue to challenge investors for the next 6–12 months, according to economists at Franklin Templeton, coupled with an “uneven” global economic recovery.
The investment manager’s economists noted that inflation, while now in decline across many countries, has challenged the global economy throughout the post-pandemic period.
“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,” commented Franklin Templeton Institute chief market strategist Stephen Dover.
“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.”
Francis Scotland, director of global macro research at Brandywine Global, said that inflation has been the “numero uno” issue for some time, which he expected will continue.
“However, I think the economy is heading for a big period of disinflation, and we may even end up with a whiff of deflation at some point next year,” he suggested.
Mr Scotland added that, while recent data clearly shows that the pandemic-related inflation surge is reversing, uncertainty remains on exactly how far it will fall.
“I think the next six to 12 months are going to be very important,” he said.
“Our thesis has always been for an economic soft landing, contingent on inflation falling far enough, fast enough, for the Fed to pull back (on its rate-hike cycle) before it overshoots. We are in that window right now.”
Franklin Templeton also highlighted an apparent disconnect between the expectations of the market and how fast interest rates may actually fall in the future.
“The financial market is pricing rate cuts with an expectation that inflation returns to pre-pandemic levels,” Mr Dover stated.
“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.”
According to the investment manager’s forecasts, real interest rates are expected to continue to rise as a result of ongoing disinflation, leading to a more positive return for investors.
Opportunities for investors
Among the opportunities available to investors over the coming months, Franklin Templeton affirmed that fixed income investments were regaining their status as good portfolio diversifiers following the strong correlation between equities and fixed income seen last year.
“To move from an environment like that to the one we’re in now – where correlations are behaving more as traditionally expected, with inverse correlations – means investors are getting some diversification benefits. It’s an important change in 2023,” commented John Bellows, portfolio manager at Western Asset.
Furthermore, Franklin Templeton pointed to the potential diversification available through investments in emerging markets as an opportunity for the future.
The chief investment officer of Templeton Global Macro, Michael Hasenstab, argued that emerging markets had demonstrated their resolve and strength during the pandemic.
“There wasn’t a debt binge, and policies were generally quite responsible in terms of tightening when necessary to bring inflation under control,” he said.
“Many emerging markets are getting some basic things right that some developed countries are not. Emerging markets, having proved their resolve, now will likely benefit from not having a debt overhang. By contrast, the US debt-to-gross domestic product ratio has surged.”
While urging investors to remain careful and look at emerging markets country by country, Mr Hasenstab claimed that higher yields compensated for potential risks in many cases.
“I think relative economic growth rates and the evidence of good policy in the face of a once-in-a-100-year shock should give us some encouragement,” he stated.
“Asia has a lot of these opportunities. Latin America has some as well. They’re quite different and, again, each country requires careful scrutiny. But in general, emerging markets can offer diversification.”
In terms of other opportunities, Franklin Templeton predicted that neutral to shorter duration will provide better risk/return profiles for the remainder of the year and asserted that current yield levels and the expected peak in rates would combine for a positive expected total return.
Additionally, the investment manager assessed high-yield debt as being priced attractively but noted that investors needed to be selective since lower-quality corporate credit may be susceptible to default risk along with concerns about credit spreads widening.
“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,” Mr Dover concluded.
“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.”
