CONTRIBUTORS
Stephen Dover, CFA
Chief Market Strategist,
Head of Franklin Templeton Institute
The failure of Silicon Valley Bank (SVB) reminded us of the consequences of US Federal Reserve (Fed) tightening for the banking system as the US central bank continues to fight inflation, while trying not to throw the economy into a recession. While a recession is not certain, it is likely, with the full impacts not yet priced into the markets. Amidst this backdrop, I wanted to summarize how our investment managers view market opportunities and risks from a US perspective.
Capital markets backdrop
The continuing message for 2023 is one of caution amid concerns about risks to economic growth, corporate profits and the path of interest rates. This past quarter saw tremendous volatility in interest rates, including the largest single-day decline in two-year Treasury yields since 1987. The gap between stated Fed policy and market expectations for short-term interest rates is also a notable disconnect keeping volatility elevated.
Overall trend: time to consider increasing fixed income allocation and moving cash from the sidelines. We believe investors will be rewarded with a focus on higher quality and income allocations across fixed income and equities. A higher-yielding portfolio will, in general, provide more protection against price moves and reduce overall volatility. While money market yields are high now, they will drop when the Fed pivots to lower rates. Investors should consider “locking in” higher rates in longer-term fixed income investments. Any added duration may be a hedge against a coming recession.
Fixed income: capture higher yields but monitor quality
- Investment-grade corporate bonds offer higher yield. In a significant change from recent years, many corporate bonds now offer yields above the dividend yields offered by the stocks of the same companies.1 High-grade corporates currently have historically sound debt-to-equity ratios and offer opportunity for higher yield.2 If there is a recession and corporate profit margins come under pressure higher-quality bonds may offer more downside protection than equities.
- Municipal bonds have fundamental tailwinds. Municipals typically yield less than Treasuries as their benefit comes from having tax-exempt status, but yields across durations are currently similar. Going into a stressed economic environment, we believe municipalities are in a strong financial position from increased tax revenues and Federal aid during the pandemic.
- Selective high-yield bonds have potential for additional income. Over the past two years, yields on subinvestment-grade bonds have risen from roughly 4% to nearly 9%.3 Historically during recessions, default rates rise for high-yield investments, and spreads versus other fixed income securities widen.4 While we remain cautious overall on high yield, the sector has historically high creditworthiness and there may be opportunity in some individual company bonds.
- Fixed income outside of the United States—good rates and volatility tradeoff. Stronger economic growth rates outside the United States and potential dollar depreciation could provide opportunity in non-US debt, particularly in Asia. Global decoupling, led by China’s 2023 recovery, could offer global fixed income investors attractive returns and diversification opportunities.
Equity: focus on income and quality
- Quality theme extends to companies with stable cash flows and dividends. Companies with strong and more stable cash flows over the cycle and those with pricing power that can pass along higher costs are likely to better weather inflation and a recession. Historically, during periods of elevated inflation, returns from rising dividends become more significant from the combination of income and capital appreciation.
- Economic growth outside of the United States looks stronger. Equity markets outside the United States—in China, the emerging markets and Europe—are currently trading with lower valuations than US equities.5 In a year when US gross domestic product (GDP) and corporate profits’ growth will be below that of China, Japan and many emerging markets, we believe international equity allocations should be increased.
- Long-term opportunities in growth and innovative companies continue. Price corrections due to high inflation, rising interest rates and earnings shortfalls could create opportunities in sectors such as renewable energy, advanced graphics, biotechnology, alternative energy or the digital ecosystem—all areas we believe continue to have excellent long-term growth prospects.
Alternatives: current environment alters private market opportunities
- Private credit might benefit from the banking crisis. The banking crisis is likely to slow loan growth for many small and medium-sized businesses. Private credit may pick up some of that slack. We believe the ongoing market disruptions may present the most attractive investment opportunity for private credit since the global financial crisis.
- Commercial real estate opportunities differ by sector. Higher interest rates and the work from home trend have hurt the office space sector. There is still a severe shortage of housing in the United States exacerbated by shelter and home office demand. While office space is struggling, industrial, life science, self-storage and multi-family sectors remain strong.
Endnotes
- Sources: Bloomberg, ICE BofA, SPDJI. As of March 31, 2023.
- Sources: Franklin Templeton Institute Analysis, Bloomberg, ICE BofA. As of March 31, 2023. High-grade corporates represented by ICE BofA US Corporate Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
- Sources: Bloomberg, Credit Suisse. As of March 31, 2023. Subinvestment-grade bonds are represented by ICE BofA US High Yield Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
- Sources: Franklin Templeton Institute analysis, Bloomberg, US Federal Reserve, US Department of Treasury, Macrobond. As of March 31, 2023. High-yield bonds–Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged USD. Spreads are calculated against various US Treasuries, represented by short-term bonds–Bloomberg Short Term Treasury Index Total Return Index and US Treasury bonds–Bloomberg Barclays US Treasury Total Return Unhedged USD. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
- Sources: Franklin Templeton Institute Analysis, MSCI, Bloomberg, Macrobond. As of March 31, 2023. United States represented by MSCI US Index, Europe by MSCI Europe excluding United Kingdom Index, China by MSCI China Index, and Emerging Markets by MSCI Emerging Markets Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
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. Growth stock prices may fall dramatically if the company fails to meet projections of earnings or revenue; their prices may be more volatile than other securities, particularly over the short term.
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. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions.
Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
Investments in alternative investment strategies are complex and speculative investments, entail significant risk and should not be considered a complete investment program. Depending on the product invested in, an investment in alternative investments may provide for only limited liquidity and is suitable only for persons who can afford to lose the entire amount of their investment. An investment strategy focused primarily on privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity.
Investing in private companies involves a number of significant risks, including that they: may have limited financial resources and may be unable to meet their obligations under their debt securities, which may be accompanied by a deterioration in the value of any collateral and a reduction in the likelihood of realizing any guarantees that may have obtained in connection with the investment; have shorter operating histories, narrower product lines and smaller market shares than larger businesses, which tend to render them more vulnerable to competitors’ actions and changing market conditions, as well as general economic downturns; are more likely to depend on the management talents and efforts of a small group of persons; therefore, the death, disability, resignation or termination of one or more of these persons could have a material adverse impact on the portfolio company and, in turn, on the investment; generally have less predictable operating results, may from time to time be parties to litigation, may be engaged in rapidly changing businesses with products subject to a substantial risk of obsolescence, and may require substantial additional capital to support their operations, finance expansion or maintain their competitive position.
Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector.