Inflation, Interest Rates and the Search for Income

Inflation, Interest Rates and the Search for Income

June 22, 2021

Inflation, Interest Rates and the Search for Income

Host: Hello and welcome to Talking Markets: exclusive and unique insights from Franklin Templeton.

Ahead on this episode: despite the low-rate environment, we look for income opportunities within equities, fixed income and even real estate. Plus, how inflation concerns fit into income strategies.

Ed Perks, Chief Investment Officer from Franklin Templeton Investment Solutions, Mark Lindbloom, a Portfolio Manager from Western Asset, and Onay Payne, Managing Director and Portfolio Manager with Clarion Partners, join Franklin Templeton Chief Market Strategist Stephen Dover for this conversation.


Stephen Dover: Ed, let's start with you. Given the low interest rate environment that we're currently in, how should investors be thinking about income in this environment?

Ed Perks: I think maybe to start, it might be worthwhile, just thinking about the asset allocation decision-making process and the challenges that this experience which has been incredibly unique within financial markets, really going back throughout history.

Immediately after the pandemic hit, the tremendous response from central bankers globally, the tremendous fiscal response and that overall dovish policy—not just the magnitude, but the speed with which that accommodation was implemented—had a tremendous effect on our asset allocation, principally, because of what happened in rates markets. So, the tremendous decline in interest rates, bottoming out in the US, I mean, we can certainly look around the world and see plenty of assets with negative yields, which pose their own challenge to income investing.

But I think, as we really drill into that for income investing, a lot of it just became a challenge, not just from the income component with rates that low and, and many other sectors within fixed income taking their cue off of Treasuries, particularly as markets recovered. But, we also had a dynamic playing out in equity markets where growth was the darling and certainly even those companies, even more specific within the growth sectors, those that really benefited from the conditions during the pandemic, the change in all of our livelihoods and the work from home that was so prominent. But, it created tremendous dislocations and opportunity to pivot towards dividend stocks. And, that's something that has been a really important theme for income investors. We think that given relatively modest total return expectations from a lot of asset classes income, whether it be from dividend stocks or what I would like to call hybrid assets will remain a pretty attractive element for income investing.

So, what do I mean by hybrid assets? A simple way to think about them, would be to think of equities with potentially bond-like characteristics, or on the other end of the spectrum, bonds with equity-like characteristics. So, if I think about those two camps, certainly equities with bond-like characteristics, we can then think about things like convertible securities, structured equity, even the utility sector, which I think most would acknowledge have some characteristics of both asset classes. Real estate can be a really important component in solving that income need for many of our clients, and I would put that in that equity type assets with bond-like characteristics.

On the flip side, bonds with equity-like characteristics. So, moving out into the credit spectrum within fixed income. So high yield, floating rate term loans would be important aspects of solving some of that income need in this pretty challenging time.

So, I think from our perspective, we kind of start with that. What's really driving the asset allocation? Dovish policy and that remaining supportive, a rebound in global growth continues to be an important theme for us in our asset allocation views.

And then, finally, the expectations for inflation. It's probably the most complex problem we're looking at today, but, you know, for the time being, and the Fed has certainly delivered this message on point that what appears to be some inflationary pressures that we're seeing in the economies today. At this point we still are in the camp of these should not become overly problematic and we can continue on this path.

Stephen Dover: Thanks, Ed.

Mark, turning to you, you have some focus on unconstrained strategies, by definition, are in the fixed income place, but maybe talk to us a little bit about unconstrained strategies and how you're thinking about income or even income versus gains within fixed income. And then, for so many of us looking at fixed income and the possibility of interest rates rising, there's been a lowering, generally, in allocation to fixed income. So how do you approach that? How do you think about that?

Mark Lindbloom:  I guess, to start, from a philosophical point of view on why fixed income. You know, just start with the basics. For a long, long time, bonds have provided very reliable, safe income. And one of the challenges I think we all have, is okay, yeah, but there's hardly any income. And therefore, where do you find that?

The other, I think, complication of that is that given where rates are, the expectation almost unanimously is rates have to rise.

And while over some reasonable period of time, we don't disagree with that, it's a little bit more complicated than that, in terms of making the statement that fixed income isn't attractive in its various flavors.

Oftentimes, for example, where you get value from fixed income, number one, would be just a steep yield curve. You can gain yield by going out and that makes sense to investors, given the risks and uncertainty. Or, you buy alternative securities within the fixed income universe that do provide you more yield relative to the safe securities like US Treasuries. That is the role of fixed income for many of our investors and participants in the greater asset allocation scheme that we go about doing.

 Negative total rates of return are unusual, historically. They certainly happen. But, they are also usually followed by periods of time where returns are exceptional, given the rise in rates and usually some overreaction.

So, I think that what investors are missing are a couple of things. Number one that higher rates necessarily mean a negative total rate of return.

You have to take into account the income, but also while we, as investors, are factoring into our expectations of future rates, something we call “the forwards.” And many times, when you look at nominal interest rates or real interest rates or other sectors, investors over anticipate and therefore, if rates rise at a gradual pace or consistent with already expectations, it does not necessarily mean a negative total rate of return. There still is value in bonds in income in specific sectors.

The second thing I'll say in terms of the overall philosophy is the role of bonds as a diversifier in a broad-based portfolio. We get the income, the income is low, but will bonds act as a diversifier if we see a different environment than what we're in today? That is the fairly rosy scenario for 2021 from an equity point of view, an earnings point of view, and economy, Fed, fiscal, right on down the line, will bonds help if somehow that rosy scenario is disrupted? We push back hard on those that say, “No, they won't. Rates are just too low. The correlations have shifted and therefore, our bonds don't serve the same instrument or the same sector that they have historically.”

We just think that that is flat out wrong and that if we do get into a different sort of environment, or if, hypothetically, we start to raise interest rates and we see that start to pinch economic growth or earnings or equity markets, bonds will behave as they have for my 43 years in the business. There are always those periods of time where correlations do go to one. And there's no doubt about that, where bonds don't behave well, but we do think, that they will continue to provide the income, they will continue to provide the diversification for investors going forward and we push back again, Stephen, pretty hard on that.

Stephen Dover: Let's turn to something really different and that's commercial real estate. Commercial real estate for institutional investors is often 10 to 15% of their total investment, but of course, for individual investors, they haven't had access to commercial real estate, or they don't think of it in that same way. Onay, can you kind of walk us through what you mean by commercial real estate, what the sectors are, and how you think about that from an income point of view?

Onay Payne: So, when we talk about commercial private real estate and principally talking about institutional private real estate, because a lot of retail investors here to for not had access to institutional private real estate. They've had access to publicly traded REITs [real estate investment trusts], which are a very, very different animal to private real estate. They behave much more similar to the market, whereas commercial private real estate really as a diversifier and has very low correlation to fixed income, to public equities, and to publicly traded REITs. Within the institutional private real estate universe, we typically are talking about the four food groups, the major four food groups, so industrial warehouses, so the Amazons of the party logistics taking over warehouse space to take advantage of the rise in e-commerce activity that we've seen over the past decade, but at which has in particular accelerated over the past year, it's now about 20% of total spending. So, that's one sector, industrial warehouses.

We also see the multifamily sector. So, apartments, in contrast to home ownership where we have a number of people who either rent by choice or by necessity. Apartment buildings are part of the institutional commercial private real estate sphere.

We also have retail. So, that ranges from everywhere from malls, big shopping centers, to neighborhood centers, grocery anchored retail. During the pandemic, fewer restaurants were open. So, grocery anchored shopping centers did pretty well.

We also have the office sector. Most of us are probably still dialing in from home. So, the office sector has certainly gone through some changes over the past year, but we continue to believe there's going to be some consistent demand, particularly as we reach herd immunity and most of us end up back in our offices, as opposed to our home offices.

We have some alternative sectors within real estate that are continuing to gain some strong capital markets reception. There are a number of them: self-storage… Life sciences is a big one, given the significant amount of both public and private investment in health care and that has never been perhaps more prominent than over the past year, given the amount of money that was invested into vaccines. And it's, as you can probably imagine, it's really hard for scientists to work from home. So, we've seen a lot of capital going into the life sciences sector and all the alternatives, but those are the major four food groups and some of the alternative sectors which we've continued to see increased amounts of investments in.

Lastly, I'll mention hotels in the hospitality sector are part of commercial private real estate. It's a smaller component of what most institutional investors are investing into these days, given it tends to be higher volatility, perhaps not as much a consistent level of income, but hospitality is also a factor.

And then, going to the impetus behind increases in allocations to private real estate over time, particularly from institutional investors. We've touched on a few of them already. So number one, low correlation. Low volatility, last year while public markets saw pretty significant draw downs, perhaps 30-40% in some cases, the institutional commercial private real estate index really saw draw down only about 2.5%. Total returns were still positive with about a 4% income return, so slightly positive total return, even in this crazy environment. So, a low correlation, diversification benefits, durable income.

Over the past 10 years, we've only seen private real estate deliver annual income less than 2% or 3% in very few quarters. It's typically trended to be about 5% of that 10-year period. Low volatility, as we've talked about. And then, also finally, the potential for attractive total return. So you've got that stable, durable income component, and then also the potential for some appreciation to increase your total return, depending on the type of real estate, whether it's lower risk, lower volatility, core real estate or higher risk, higher return.

Stephen Dover: Within those different sectors within commercial real estate, where are you seeing opportunities and frankly, where are you seeing things that aren't going so well in real estate?

Onay Payne: Sure. So given the increased demand for e-commerce, demand for industrial warehouse space continues to be quite robust. So, number one, industrial warehouses.

Number two, multi-family. So apartments. Even though we saw challenges and may not have been able to work from the office when we were working remotely, most of us were doing so from home. So, some of us can afford to own or choose to own a home, but many of us, in the US population, continue to be renters. And so, there continues to be stable demand for apartment products.

We also know that affordability in the US is at all-time lows. So, there continues to be strong demand for multi-family, which ends up being one of the resilient and defensive asset classes, given that you can adjust leases, basically, on an annual basis. Whereas, many of the other property types, leases are two, probably more five- to 10-year terms. So, the multifamily, you can adjust leases really quickly and benefit on the upside.

On the other side, we saw some challenges with retail. So many of us, most of us were probably not spending a lot of time in malls. So, malls have had some challenges. Office space has had some challenges, as we've seen significant drops in occupancy and in the course of many institutional portfolios, we're still seeing physical occupancy levels, below 30%. We do think that will turn around in time.

The city continues to be a hub for culture, for innovation, for collaboration. So, longer-term the impact of the pandemic on the office sector will continue to evolve, but there's going to be a place for the physical office, we feel firmly, as well.

So, that's a little bit of contrast. It really has been a tale of two cities with quite bifurcated results in what we've seen in the different property sectors.

Ed Perks: Stephen. If I can jump in, but I just hear something there from Onay and from Mark, really going back to his comments that really resonates with what we're thinking about and really engaging clients in multi-asset portfolios is, you know, the tale of two cities, the have, the have-nots, the idea that 2021 has really been about and what will likely continue to be about, active management and more specifically, these reopening trades and being able to go from these very, you know, bigger, more macro elements that have affected markets to, how do we really position, how do we really take advantage of these different fundamental, drivers and influences that are so real and such a result of the pandemic and the situation that we've been in. So, you know, I think that continues to be a really important theme for all of our clients to be thinking about.

Stephen Dover: Mark, how are you looking at inflation as we roll into 2022, 23 and beyond?

Mark Lindbloom: We can talk about this for hours and I'll try to be pretty concise about it. Huge debate for all of us and just to cut to the quick, the majority of our group is relying on the historical secular reasons that inflation is here as still being very relevant. The Fed credibility, technology, globalization, demographics, et cetera. Also questioning whether the amount of fiscal policies that we're seeing put in place—which are extraordinary—will lead to inflation. Not a proven fact, in our opinion.

The minority of our group is that shaking their heads, saying, “What are you guys talking about?” This is a Fed like we haven't seen since Arthur Burns, they want inflation. They want very low unemployment. They want climate constraints, et cetera. Secondly, the fiscal side is much, much different than we've seen. And finally, this minority says the social side is something completely different than what we've seen over the last 40 years. You put all that together and we're likely to see higher nominal growth and higher inflation and rates going forward.

Our point on this, Stephen, is maybe. We want to keep a very open mind to it. Do we have to say today that we are at this inflection point and for the next 5, 10, 15 years inflation is going to be considerably higher? We think not. We are thinking, once we get past these bottlenecks, which are scary, that we will see inflation return to a more comfortable range.

Stephen Dover: So, Ed, what are your thoughts around that? Looking out past 2022 and beyond, inflation at a, kind of, comfortable range, or what are your thoughts?

Ed Perks: Yeah, I think a lot of what Mark said, certainly, resonates with our team, especially that dynamic of having a difference of opinion on our team. I think every investment team that we've engaged with in Franklin Templeton has described a similar dynamic. And, you know, maybe at this point that it might be closer to a simple majority, you know, on certain teams, but that debate rages and I think there are those powerful effects that Mark described that those secular reasons why we've been in a much lower inflationary environment for the longer-term, really, from that declining inflation in the eighties, really, onward. But, I think the team focuses on some unique aspects of it that, it's always dangerous to say “this time is different or things are changing,” but I think it's important to understand that, even in the last decade, we had dynamics like labor force participation rates expanding, and that helping. We had certainly those long-term effects of the global labor arbitrage, particularly, you know, with China. I think those certain aspects of those relationships are changing.

And, I think the one thing that may be a bit different with demographics is we've had such incredible wealth creation in this cycle. And, do we see a similar type return to the labor force that we saw after the financial crisis, when, you know, we had tremendous wealth destruction and many people needed to return to the labor force. So, there's just a lot of really complex issues that I know will occupy a significant amount of time for our investment team as we move forward.

But, I think we ultimately fall in the same camp that it's not likely to become problematic. But, what that comfortable rate is, I think remains a significant question. Is it something closer to 2-2.5%? Is it something higher than that, which certainly could have implications for valuations across a lot of sectors.

Onay Payne: Just one point to insert here, As you talk about the huge amount of wealth creation in the US over the past year. In particular, now, by our estimates, they have about $17 trillion in pent-up consumer demand, which should support real estate, you know, so retail, apartments, et cetera. And, I wonder how you think about it because when we think about employment growth, which is one of the huge drivers of real estate, one of the things that gives me both comfort and also a little bit of dismay is that the majority of the wealth created in the stock market over the past year really has been from the top 2%, right? So, I have very little fear or concern that we won't see a huge return to the workforce in coming quarters. Will that return be slower? Perhaps. As increasing numbers get more comfortable with being vaccinated and with the protocols that we have in each of our offices, et cetera, but very little concern from my perspective, with respect to us getting back to full employment or what we thought would be full employment. Do you see that differently, Mark or Ed?

Ed Perks: Yeah, Onay, I think you make a great point around a lot of that wealth effect. I think there are some, you know, potentially unique, and some of these are longer term, certainly, demographics and that wave of generational wealth being handed down. That's something that is, we've known is there, is increasingly a real dynamic in our economy. That certainly could influence your return to work. There's certainly the behavioral, just what impact did the pandemic have on people's livelihoods? And, you know, we all know situations where people have picked up and moved out and maybe decided to do something else with their lives as a result of the pandemic. And maybe, then the final aspect of it, and I'm certainly not going to proclaim to be an expert in any way on crypto, but I do think that the majority of the wealth creation within crypto is likely in the younger demographics and that certainly could change some of the dynamic around that labor force participation rate increasing.

Mark Lindbloom: Yeah, the way we look at this and why we're willing to be patient is a good way to put it, I think, is if you run this experiment and you close economies around the globe down for essentially one year, and then you restart them, fortunately given the advancements and the game-changers of vaccines and the improvements that we're seeing in the economy, it's not going to be smooth. I kind of equate it to the old car you fire up after years, and it kind of spits and sputters, it smokes, but eventually you get the thing running pretty well, and, that's exactly what we think we're going through. Therefore, on the labor side, like a lot of other shortages, given the dislocations that we've all been through over the last year, we also believe that we will get people back into the labor force.

Yes, there are some folks of 55 and over who say, “Oh, you know what? The markets are great. Unlike the financial crisis, I'm going to retire.” Or, at least retire for a while until they want to do something else. It will take some time for people to move, to retrain, to get back to work, to figure out if it's home or if it's the office, but we do think that these bottlenecks on labor, as well as other areas, will eventually dissipate and that we will see that inflation rate come back to more acceptable levels.

Onay Payne: I think in this discussion on this particular point, but the entirety of the discussion really underscores the concept that was raised by Ed and Mark a couple of times during the course of this discussion. Really, it is all about active management. So, we don't take any of these forecasts or considerations for granted. This is going to continue to be an evolving situation, whether it's with respect to the return to the office, or how consumers utilize that pent-up demand, how it is expressed in our economy, but I think, from my perspective really reinforces the need for active managers that are thinking about this daily, having these types of conversations, debating them within their teams and amongst their peers.

Stephen Dover: Thank you, Onay. Thank you, Mark. Thank you, Ed. This has been a great conversation. It feels like we're just getting started, but unfortunately, we're at the end of our time.

Host: And that’s it for this episode of Talking Markets with Franklin Templeton. We thank you for listening. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other place you listen to your podcasts. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.

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