Macro Perspectives: Recession, inflation and duration consideration

Author: Stephen Dover, CFA, Chief Market Strategist, Franklin Templeton Institute

From a macroeconomic perspective, 2022 centered around the actions of reserve banks around the world. While the fight against inflation continues into 2023, the discussions are more focused on recession and potential weakness in the US Dollar. I recently gathered with some of our economists across the firm to discuss these topics – here are some of my key takeaways:

• US inflation is trending lower, but the fight isn’t over yet. This contrasts with Europe, where inflation remains higher and has not peaked. Asia has generally seen milder inflation. Japan, for the first time in over 20 years, is experiencing inflation and positive real interest rates. Our economists disagree on how quickly and how far inflation will fall. The market consensus suggests US inflation will run at roughly 3% for the full year. Internally, we have a healthy debate on how quickly inflation will fall and whether it will get to the US Federal Reserve’s (Fed’s) 2% target.

• Interest rates are near peaking. In the United States, we expect the Fed’s policy rate to rise to at least consensus expectations of around 5%, with the possibility of reaching 5.25%. Our economists disagree on how long the Fed will hold rates at the higher level. The implications for fixed income and equity investors are that the Fed is unlikely to provide a “Fed put” if the market has a correction.

• How deep might a US recession be? One could describe 2023’s economic outlook as “the most-anticipated recession ever,” with surveys of economic forecasters and market behaviour in 2022 providing the evidence. Everyone seems to “know” the United States is going to have a recession, and everyone seems to “know” it will be mild. Whenever “everybody” thinks something, that type of herd mentality makes me nervous because often the herd is misguided. I gain some comfort from internal discussion and healthy debate among our economists, whose views on recession vary from the possibility of no recession at all, to a “normal” recession, which typically lasts about 10 months.

• Time to consider increasing fixed income allocation. Fixed income is now providing income again. Rates are near a peak, and 2023 may be a year of positive returns for fixed income. We see a general shift toward larger fixed income allocations no matter how one is currently positioned.

• There’s a quality bias when leaning into fixed income. We believe investment grade and sovereigns are particularly attractive in this environment, with continued economic uncertainty perhaps providing opportunities on a selective basis in areas like high yield.

• Opportunity outside of the United States. This year, analysts expect US growth to come in below that of Japan – which has not happened for over two decades – while emerging and developed Asia overall will likely see higher growth than the United States. Meanwhile, Europe’s economy is doing better than many forecasts expected, due largely because of a mild winter.

• Expect volatility. While our economists agree that taking a long-term strategic view suggests taking on a bit more duration, there may be tactical opportunities within the fixed income markets.

• Emerging markets may have tailwinds. Both debt and equity markets in emerging markets are seeing favourable conditions. Relatively stronger growth rates combined with tempered inflation – and the potential US Dollar may have peaked – provides opportunities, particularly in Asia.

• Asia generally, and specifically Japan and China, may provide new opportunities for active investors. With a whiff of inflation in Japan, it is now facing different dynamics than during previous decades of deflation. Meanwhile, China is finally coming out of COVID-19 lockdown, which should help spur renewed consumption and improve global growth prospects.

  These are my main observations as we lean into 2023. The table below explores some of these issues more deeply from the lens of the economists across Franklin Templeton.