Sonal Desai, chief investment officer for US-based investment manager Franklin Templeton Fixed Income, discusses the global macroeconomic outlook and opportunities in fixed income.  

Franklin Templeton has said that it has upgraded its view on both the US and euro area economies; it is no longer predicting a technical recession in the US.

“Where we break from market consensus is in our view on the US Federal Reserve’s path to monetary policy normalisation,” Sonal Desai, chief investment officer at Franklin Templeton, said in a statement. 

“The market appears to be confident in the Fed’s ability to orchestrate a “soft landing” that would allow it to cut interest rates throughout next year,” she added. She feels that the trajectory of disinflation in both the US and eurozone will flatten – and central banks are therefore likely to keep rates higher for longer.

“US gross domestic product growth held firm at a 2.4 per cent annualised pace in 2023’s second quarter,” she said. “Consumer sentiment is rebounding, home prices and equity markets have continued to climb, and job layoffs have fallen materially since their January peak,” Desai said.

“The euro area economy has continued to show resilience, posting a better-than-expected 0.3 per cent quarter-over-quarter increase in real GDP during the second quarter of 2023,” she continued. “Nonetheless, internal demand has appeared weak overall, though services spending has remained robust.”

Asset allocation
“Spreads in fixed income sectors are pricing in a quite sanguine environment, with levels leaning towards long-term averages, much tighter than previous periods of stress,” Desai said. She retains the view that both active portfolio management and superior security selection will be the main drivers of returns for investors.

“Overall bond yields have increased during the past year, with the benchmark 10-year US Treasury (UST) notes' yield climbing over 150 basis points. Current yields are the highest they have been since the beginning of the global financial crisis, opening the potential for good income opportunities for bond investors,” she continued.

With her view that the Fed will keep interest rates higher for longer, Desai prefers duration exposure to be focused on the shorter end of the yield curve to take advantage of higher yields. She also believes that longer-date UST yields are likely to rise and has positioned the firm’s portfolios for the curve to steepen (less inversion) over the medium term.

Desai's outlook for fixed income sectors is based on the analysis of macroeconomic themes and the technical conditions for each asset class. In particular, she is optimistic about US treasury inflation-protected securities, saying that low breakeven inflation rates make TIPS an attractive hedge against any reacceleration in US inflation rates.

Desai is optimistic about emerging market sovereign debt, with a preference for EM high-yield issues, given progress on external financing agreements and policy adjustments toward economic orthodoxy. Payden & Rygel also believes that emerging market debt is an attractive opportunity in 2023. See more here.

Meanwhile, Desai favours European investment-grade corporates, believing that euro IG bonds provide attractive carry in this interest-rate environment, but spreads remain tight. Fundamentals continue to be positive but are likely to deteriorate in a slowing European economy, she said.

Desai is neutral on emerging market corporates and continues to see pockets of attractive relative value compared with EM sovereigns and US corporates. She is also neutral on euro high-yield corporates and believes that current high yields are attractive enough to compensate for potential increases in default rates.

However, she maintains a cautious approach to US investment-grade corporates. Significantly, Desai has also downgraded the outlook for Japanese government debt as she sees that the market is in an unstable equilibrium. The Bank of Japan has yet to make substantial moves to address increasing inflation. Yields are most likely to move higher over the medium term, making JGBs unattractive, in her view.