Growing macroeconomic uncertainty and rising real rates have resulted in one of the most volatile fixed-income markets in history. With the US and Europe battling an economic slowdown, it is time for fixed-income investors to remain cautious and keep ‘dry powder’ ready to deploy at the right time, according to a report by global investment firm Franklin Templeton.
In a recent report titled “Paradigm Shift”, Franklin Templeton says, “Overall, as we have been cautioning for some time, fixed income investing will continue to be challenged by rising rates and higher volatility, putting a premium on an active, research-driven, selective investment approach.”
“We continue to recommend that investors keep dry powder to deploy as we gain greater visibility on the extent of the growth slowdown ahead to identify rising income-generating opportunities in the fixed income universe,” it adds.
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The report says that technical conditions will likely continue to add pressure in several segments of the fixed-income universe. “Fundamentals, however, remain resilient in several fixed income sectors, providing support and selected investment opportunities.”
Franklin Templeton is bullish on municipal bonds and also sees emerging market debt as “being fundamentally supported by increased and improving external balances.”
Since emerging market central banks have also placed themselves ahead of the curve in the fight against inflation, the global investment firm is expecting that the fixed-income asset class would soon recover some of the ground lost so far this year.
In the US, the Federal Reserve increased interest rates by 75 basis points in September and it is expected to continue to remain on the rate hike path in the coming meetings. The European Central Bank (ECB) also increased interest rates by 75 basis points in September, the first such hike for the region in 11 years. ECB is also facing more challenges, especially from Russia’s decision to curtail gas supply.
Is a recession coming in the US?
The report says that bringing inflation back to target has “now become paramount”. It is the “crucial objective to be achieved before inflation expectations can become de-anchored in a more structural way.” Whether the current situation fits the definition of a recession? Franklin Templeton finds the question more academic than substantial. Instead, it is seeing a “shallow recession accompanying a slow disinflation, with monetary policy remaining tight for longer”.
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Recommendations for investors
The report makes the following recommendations to investors:
1. De-risk portfolio from lower credit-quality issuers and cyclical industries that are more vulnerable to a demand slowdown. “We are likely to see shorter-duration, high-quality assets outperform and provide greater protection from potential fundamental weakness,” it says.
2. Keep duration exposure short but be ready to reposition: The report says there is more room for interest rates to rise. “As yields continue to rise, however, income-generating opportunities are increasing in fixed-income markets. As technical conditions and investor sentiment stabilizes, healthy fundamentals should provide a tailwind for select opportunities.”
3. Position portfolios to take advantage of opportunities: “While volatility will continue due to slowing growth, greater market uncertainty, and less favourable market technicals, yields and valuations have become more attractive, in our view. We would continue to take advantage of market dislocations to add risk exposure to issuers with relatively stronger balance sheets and less rate-sensitive end-market demand,” it says.
