Navigating the bends

Rivers are one of nature’s curious phenomena. Rarely straight, they are shaped by small disturbances that bend the flow of water into new space. Similarly, our economy experiences disturbances that create new twists and turns. This week we, the Franklin Templeton Investment Institute, looked at disturbances to consumers, governments and capital markets, and how these shifts are impacting investors.

Looking first at the economy, the intersection of supply and demand for all goods and services helps explain total output, or gross domestic product (GDP), and the price level. When output and prices rise in tandem, as has been the case recently, we can infer that demand has accelerated more than supply. Today, GDP is making new highs and inflation is hitting levels not seen since 1982. Meanwhile, total US employment remains at around three million jobs below its pre-pandemic peak. Demand has surged and supply is struggling to keep apace.

After injecting trillions of dollars in 2020 and 2021 to rescue the economy, governments around the world are now turning off the spending spigot, or at least taking new programs off the table. Over the next two years, GDP growth will likely remain strong, but it should slow as government spending recedes and the economy returns to “normal.” Moving forward, we believe the private sector will need government stimulus as a driver for demand. But if it does not get it, we think both growth and inflation will be on downward glide paths even without Federal Reserve (Fed) tapering, interest rate hikes or balance sheet reduction. The economy is expected to also be more dependent on a rising pool of labor and higher productivity to maintain its growth trajectory.?

Consumers may see declining purchasing power

One challenge, however, is that labor participation has been on a multi-decade decline, exacerbated by the pandemic and an aging population. If we don’t see a meaningful increase in productivity, and if worker shortages and supply chain issues remain under pressure, then we believe higher trend levels of inflation could ensue.

This creates the potential for an environment where the concept of “real” returns and purchasing power versus “nominal” becomes a more important factor in people’s lives.?Simply put, if “nominal” wage growth is 3% and inflation is 4%, then “real” wage growth is -1%.?The same concept holds for nominal interest rates and the return one receives after inflation.?It is hard for many of us to get our heads around the idea of negative real interest rates, but it has been a reality for many. While higher levels of savings during the pandemic may have provided a cushion, they are not a long-term solution for individuals who need income from their assets to be higher than inflation. Declining purchasing power is one of these disturbances that alters the shape of the economy and can even have political consequences.?

Governments may need to shift expectations

This “real” conversation also impacts how we should consider the path of future monetary policy. For more than a decade, central banks around the world have forced interest rates to historic lows and swelled their balance sheets without generating a coincident rise in overall consumer inflation. It would be odd to now believe that monetary policy has suddenly become more impactful. While much attention is given to tightening monetary policy to rein in demand (and inflation), that focus may be misplaced. The current rise in inflation appears more related to supply/demand issues and rising energy costs than to easy monetary policies.????

Sharp turns for capital markets

These issues create multiple challenges in terms of investment decision- making. While low interest rates and quantitative easing have not created consumer inflation, they have contributed to asset inflation, especially in the stock market. A tailwind of liquidity may soon become a headwind as policy makers consider raising interest rates and, at a minimum, slowing the purchases of assets (quantitative easing). Slowing growth and higher inflation also impact expectations for corporate earnings. Geopolitical uncertainty increases the variability and risk of potential global growth outcomes. In our analogy, the bends and curves are becoming more pronounced.

So, what will the Fed do? And what should investors do?

The Fed is likely to act prudently, meaning that it will act carefully to avert the risk of slowing growth too much. Yet caution also creates the perception that the Fed is “behind the curve.” Perhaps, but current market expectations for inflation remain anchored at levels consistent with the Fed’s 2% target. Survey- and market-based measures of inflation expectations don’t indicate runaway inflation expectations. In short, the Fed’s focus on delivering its dual mandate of full employment and stable prices should not require it to squeeze demand too hard. Unless inflation expectations change, investors might want to follow prudently along, not positioning for either very high or very low inflation. Investors may have to adjust to higher volatility as market participants digest these rapid twists and turns. Moreover, considering that real GDP growth is likely to return to near pre-pandemic levels, but with the equity market almost 30% higher, we believe there is less room for error in terms of valuation and earnings growth expectations. Given these conditions, volatility may be a healthy barometer that external disturbances are not being ignored. Yet, volatility often provides opportunities for investors to look for new sources of alpha in a changing market dynamic.

New curves are always reshaping the flow of rivers, the economy and financial markets. Neither policymakers nor investors can accurately predict the magnitude of the shifts, but they can learn to navigate a changing environment by being flexible in their decision-making process.

For additional views on what is fueling inflation, read Macro Perspectives: Have we reached the pivot point?

US: Macro Perspectives: Have we reached the pivot point?

International: Macro Perspectives: Have we reached the pivot point?

?

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.?Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline.

?Important Legal Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

?The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized.

?The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

?Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data.?Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

?Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are?not FDIC insured; may lose value; and are not bank guaranteed?and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

?CFA? and Chartered Financial Analyst? are trademarks owned by CFA Institute.

?

?

?

?