Investors are split between “cautious optimism and flat out angst” due to the market unrest that has been playing out across Wall Street and the world economy, Franklin Templeton strategists say.
“Investors are hopeful the U.S. Federal Reserve will engineer a soft landing and economic data suggest inflation has peaked, yet uncertainty, regional bank turmoil and geopolitical risks have investors bracing for what might be the most telegraphed recession in history,” Franklin Templeton said.
The global asset manager recently brought together three market strategists to assess “The 4 R’s Shaping Market Dynamics: Risk, Rates, Recession and Regulation” as part of the Megatrends Accelerate Webcast Series. Franklin Templeton said it has found “investment opportunities at play that could be the best since the global financial crisis of 2008.”
“Overall, I would say that growth has been quite resilient, particularly if you look at the labor market, which has been quite strong,” said Paul Mielczarski, head of global macro strategy at Brandywine Global Investment Management, a Franklin Templeton company. “We have seen some consequences of the tightening cycle in terms of the regional bank shocks and defaults in the second quarter of 2023, but I do feel that the full impact of tightening is still yet to come.”
Mielczarski said he sees a soft landing ahead if there is a recession. For equity and credit markets, the soft landing is already priced into investments, he said. However, Brandywine is being cautious on credit investments. “What we do find interesting are agency mortgage-backed securities, which we think are more attractive than investment grade bonds given that they have relatively high spread levels to Treasuries but carry no risk of default,” he said.
Mielczarski told the webinar audience, “Over the past six to eight months, we've had a strong rebound in global growth. That was driven by three main factors. One was the removal of Covid pandemic restrictions in China. Second was the reversal of the energy shock in Europe. And lastly, a decline in headline inflation boosted consumer incomes and spending. Now, because we've had this recovery in global growth at a time when many investors were positioned for recession, risky assets have delivered solid returns in the first half of the year.”
A moderation in energy prices has brought overall inflation down from about 9% to 4% in the past year, but this is still too high for the Federal Reserve Bank. “Now, going into the second half of the year, we do expect core inflation momentum to fall a bit closer to the Fed’s target” of 2%. A decline in U.S. inflation should bode well for emerging market investments, he said.
Sonal Desai, portfolio manager and chief investment officer of Franklin Templeton Fixed Income, disagreed somewhat.
“We tend to be a bit less optimistic about core inflation in the second half of the year. For one thing, we are seeing core goods prices not continue to slow at the pace that we had originally anticipated. We’re just not getting there quickly enough,” Desai said.
“Fixed income is now finally delivering income again. However, we have also seen a lot of volatility in the last six months, driven largely by the fact that markets are desperately trying to predict the Fed’s actions, as opposed to looking at what the economy is actually doing and assessing what the macro developments imply for policy rates,” she explained.
Desai noted that Franklin Templeton is “staying quite high in quality. We are also maintaining relatively short to neutral duration, even within investment grade in areas which we like, going only as far as intermediate duration.”
For clients, the firm is telling them opportunities are there to add more risk at more attractive levels because “we think some valuations are pretty rich right now. I think long end duration is likely to sell off and as it does, we will be looking to add long duration,” she added.
Rich Byrne, president of Benefit Street Partners, a private credit fund based in New York City, and a Franklin Templeton company, said he thinks the market ship has already “hit the iceberg” because of the shocks that have taken place. Future implications are already locked in, he said.
“We went from interest rates being near zero to more than 5% and we saw multiple consecutive 75 basis point hikes. When that happens in a market, a shock that big and that quick, it has real implications. We think people should follow the lending market’s queue because it has profound implications about future default rates and the refinancing of existing loans,” he said to investors.
Opportunities still are available for the discerning investor.
“Private equity firms and real estate developers still have a lot of money and want to put it to work, but the lending market has recalibrated where a new deal prices. So equity checks are going to need to be bigger,” Byrne said. “Obviously, rates are higher and best of all you’re getting your pick of the litter around deal flow. This is true in commercial real estate as well as retail. Maybe not in office, but in multifamily and other categories because there isn’t that much money chasing deals. Capital is very hard to raise.”
For private credit, Benefit Street Partners is emphasizing companies with stable, predictable, non-cyclical earnings. The stable sectors include media and healthcare.
“We’re trying to avoid technology risk, or anything where you’re betting on big earnings momentum or new technology or multiple growth,” he said.
The firm also is avoiding businesses that rely on labor because the firm said it feels labor costs are going to remain high, which will impact the retail sectors.