Persistent, the New Transitory

We have just published our Q4 Franklin Templeton Fixed Income Views paper, with a summary of our updated macro outlook and investment recommendations (see links to the full paper at the bottom, with separate links for US institutional, US retail and readers outside the United States).

Here are the key highlights:

Supply-side-driven inflationary pressures remain center stage. Central bankers have insisted that inflation pressures are transitory, but disruptions to global supply chains persist, with component shortages and delivery delays pushing up prices; and, in the United States, the transition from unemployment to employment remains below historical trend, with several sectors showing high quit rates and robust wage increases.

High inflation rates are beginning to filter through into inflation expectations: a recent New York Federal Reserve (Fed) Bank survey shows three-year ahead inflation expectations at 4%, and the University of Michigan consumer sentiment survey indicates consumers expect inflation to keep eroding their purchasing power.

Persistent, it seems, is the new transitory.

With household consumption and gross domestic product (GDP) growth proving resilient to the Delta COVID-19 variant, higher inflation has prodded the Fed to indicate it will most likely start tapering in November, assuming that economic progress continues broadly as expected. Tapering would proceed apace, with the Fed anticipating that asset purchases would come to an end by mid-2022; this would open the way for possible interest-rate adjustments. The Federal Open Market Committee, however, remains deeply divided on the timing of interest rate hikes, with half of its members anticipating a 2022 start and the other half looking at 2023. The median view implicit in the “dots” has become noticeably more hawkish in the last several months, as inflation pressures have proved more persistent than expected.

Overall, the updated macro outlook confirms the main pillars of our investment strategy approach:

• With inflation risks tilted to the upside, we continue to favor shortening duration; we remain moderately bearish on both US Treasuries and eurozone government bonds, and neutral on Japanese government bonds.
• We maintain our moderately bullish view on emerging markets (EMs) government and corporate debt. While they have lagged in vaccinations and economic activity, we believe EMs stand to benefit from the synchronized recovery in developed markets and from the recent approval of an additional US$650 billion International Monetary Fund Special Drawing Rights allocation.
• US municipal bonds, both tax-exempt and taxable, continue to provide attractive investment opportunities, in our view, supported by both market technicals (including lower primary issuance) and fundamentals (a rapidly recovering economy and elevated stock market values underpinning local public finances). We have upgraded our view on euro high-yield corporates and continue to see selected value opportunities in US high-yield corporates.
• An active fixed income investment management approach remains essential, as sectors and individual companies will be affected in a very differentiated manner by a range of factors including the lifting of COVID restrictions, the influence of residual pandemic fears on consumer behavior, component shortages and other supply chain disruptions, policy and regulatory changes and technological innovation—as well as market technicals.
• Finally, recent developments underscore that investors need to be prepared to navigate significant bouts of volatility as markets reassess the likely timing and impact of monetary policy changes.

Links to Franklin Templeton Fixed Income Views paper:

Readers outside the US: Persistent, The New Transitory

US Institutional: Persistent, The New Transitory

US Retail: Persistent, The New Transitory

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. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value.?Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments.?Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

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