2020—Will the economy survive the politics?

Fixed Income Views: Signs indicate significant volatility from multiple sources, including political uncertainty, geopolitics and the media’s instinct to hype every risk that emerges.

Franklin Templeton Fixed Income

In this issue

New year, new decade—we’re off to the races. None of the doom-and-gloom predictions materialized in 2019. Trade tensions did not spiral into out-of-control trade wars, new tariffs did not have a major macroeconomic impact, the US economic expansion did not halt and China’s economy did not stall. The lesson learned is that last year, too many people worried too much about the wrong things.

In 2020, we believe the right investment decisions will revolve around three key factors: the potential for volatility from US politics, the ongoing tug-of-war between the financial markets and the US Federal Reserve (Fed), and the dangers of adaptive expectations.

We will again face significant volatility from multiple sources, including political uncertainty, geopolitics and the media’s instinct to hype every risk that emerges. We believe US politics will be the main source of volatility as we head toward the 2020 US presidential election, as uncertainty on the course of future economic policy will weigh heavily on markets. Regardless of who wins, US public spending and debt are likely to keep growing, which would make valuations for many risk assets look even more stretched.

The tug of war between the markets and the Fed is also likely to resume. In 2019, when the markets put the pressure on, the Fed capitulated and lowered interest rates. Several asset classes rallied during the year despite weakening fundamentals, with the Fed’s interest-rate cuts playing the determining role.

The Fed will aim to keep short-term rates anchored at current levels; too accommodative for what we expect to be another year of healthy real US gross domestic product (GDP) growth. We also expect inflation will rise above the Fed’s 2% target— the question is by how much. Even a moderate increase in consumer inflation might push long-term rates up more than markets expect. The idea that inflation is no longer a concern, widely embraced by policymakers and analysts, is a dangerous assumption.

We do not forecast any dramatic shifts in the macro outlook in 2020; if anything, we believe the consensus remains too pessimistic. Global growth should remain on an even keel, but risks remain elevated and investors should prepare for, and be ready to capitalize on, periods of significant volatility.

The risk that has featured most prominently in the last few weeks is the recent coronavirus outbreak, which originated in China. The information available to date is limited and allows only a very preliminary assessment. So far, the virus’s mortality rate appears to be lower than the SARS outbreak of 2003 (at 3% versus 9%). The coronavirus seems to be more highly contagious, however, spreading at a faster pace—the count of affected individuals and fatalities could therefore rise significantly in the coming months, and the mortality rate might be worse than its initial estimates. At this stage, the information available on the virus as well as the prompt reaction of health services and authorities in China and around the world, seem to suggest that the risk of significant global contagion is limited. Even if contagion is contained relatively rapidly, a negative impact on China’s growth in the first half of the year is probably inevitable, through lower consumption and travel. Global tourism is also likely to suffer a temporary setback. Should the outbreak worsen significantly, factory closures might also impact global supply chains to some extent. At this stage, the most likely scenario appears to be a moderate temporary hit to Chinese and global growth, which should be partially cushioned by policymakers’ accommodative stance. If that is the case, risk appetite should rebound after an initial period of concern.

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WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. 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. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. AMBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.