Quick Thoughts: Investment Ideas—Building portfolios during economic uncertainty

With the macroeconomic climate causing increased volatility across asset classes, traditional asset allocation strategies have not been providing the same type of risk/return characteristics that they have historically. So, how should investors position their portfolios across stocks, bonds and alternatives going forward? Will interest rates stay higher for longer than the markets currently anticipate—and what does this mean for the broader economy? Given economic resilience in many sectors of the US economy, is a recession now off the table? For our Investment Ideas series, I recently moderated a panel with Ed Perks, Chief Investment Officer, Franklin Income Investors, and Wylie Tollette, Chief Investment Officer, Franklin Templeton Investment Solutions, to help answer these questions and others. Below are some highlights from our discussion:

Interest rates may stay higher for longer than anticipated. Federal Reserve (Fed) policymakers are likely reading the playbook from the 1970s, when inflation came roaring back after the Fed slowed its rate increases. As such, we don’t think the Fed is in a rush to lower interest rates anytime soon and would be surprised if it happens in the first half of 2024. The Fed has to ensure inflation isn’t just falling, but also gain confidence prices are anchored for a period of time and no longer detrimental to the economy. If the US economy remains resilient and avoids recession, it could be that we see a prolonged pause at a higher level. The rise in equity markets this year implies that investors seem to be pricing in Fed cuts a little earlier than we anticipate.

The US economy may avoid a recession, but Europe is facing economic challenges. We think the US economy might be able to avoid the textbook definition of a recession—two quarters of negative gross domestic product growth—but is likely tilting toward below-trend long-term growth. Certain industries or areas of the economy likely already have seen rolling recessions during the COVID-19 pandemic or coming out of it, and that may have staved off a single broad-based recession. For example, travel was hit hard during the pandemic, but rebounded later in the cycle. While we anticipate a slowdown and not a recession in first half of 2024 in the United States, recessions are either already underway or look likely in certain regions of Europe where economies are more vulnerable. We are less sanguine about growth prospects and see more sticky inflation across Europe.

Many emerging markets are emerging stronger. Many emerging markets are ahead of developed economies in terms of where they are in their economic cycle. They saw inflation ramp up quickly post-pandemic but reacted even more quickly. With those emerging market central banks starting to ease, both earnings and valuations may see tailwinds. That said, we advocate for active management in emerging markets, as opportunities and risks are not uniform across the various subregions.

The opportunity set for achieving yield within fixed income has broadened. Higher interest rates are widening the opportunity set for achieving yield. For many years, fixed income was more of an insurance policy rather than a generator of income, but now we are excited about the types of yields offered across the credit spectrum. Many high-quality corporate bonds had been yielding less than the dividends on their stocks, but today, many of those bonds yield 200-250 basis points above. Investment grade really stands out to us in the current environment as it offers a good income opportunity with less risk than high-yield bonds. We see a risk/reward opportunity in maintaining exposure to long duration as we near peak yields.

Equities require careful selectivity. Equity markets in 2023 have not been synchronized throughout the year. In May and June, there was a very narrow, tech-focused market advance. Recently we have seen a leadership change and broadening that reflects expectations of a lower-inflation, lower-growth environment. Some of the momentum growth darlings are now facing challenges. This time of year (September/October) has historically been challenging for equities, so a slight tilt toward a “risk off” bias seems prudent.  Markets are anticipating earnings growth of 12%-15% in 2024,^{1 and that seems like a high hurdle to achieve given the economic uncertainties we see.}

A wider array of asset classes and strategies may be required to meet long-term goals. The traditional 60% equities, 40% fixed income portfolio needs to evolve, as 2022 demonstrated. Alternative assets can play a significant and positive role in diversifying traditional bond and stock portfolios. It’s become much easier for many investors to access these markets, and while the democratization of private assets is a positive trend, one does have to be prepared for some illiquidity. Private credit can be a non-correlated income enhancer for a portfolio, and private equity can provide long-term exposures within selected areas of the market not available in the public markets. Lastly, areas like convertible securities may offer another unique opportunity, providing a total return stream to investors as companies look for creative sources of financing in a tighter lending environment.

What I heard loud and clear from these discussions is that volatility and challenges are ahead of us, and that makes an even greater case for active management. Investors need to solve for increased volatility and capture alternative sources of growth and income when navigating the current economic environment. This can be done through more dynamic strategies and an expansion of the investment toolbox.