Franklin Templeton: Soft landing? Central banks trying to thread the needle

by | Sep 20, 2023

Sonal Desai, Chief Investment Officer, Franklin Templeton, provides her latest quarterly analysis on the macroeconomic conditions and developments across the world’s regional economies impacting investment processes. 

The full report can be found attached, which provides an outlook for fixed income sectors based on Franklin Templeton’s analysis of macroeconomic themes and the technical conditions for each asset class, with a summary of the key findings below: 

Overview

“We have upgraded our view on both the US and euro area (EA) economies, and we are no longer projecting a technical recession in the former. Where we break from market consensus is in our view on the US Federal Reserve’s (Fed’s) path to monetary policy normalisation. The market appears to be confident in the Fed’s ability to orchestrate a “soft landing” that would allow the Fed to cut interest rates throughout next year. We feel the trajectory of disinflation in both the United States and EA will flatten—and central banks are thus likely to keep rates higher for longer.

“Spreads in fixed income sectors are pricing in a quite sanguine environment, with levels leaning toward long-term averages, much tighter than previous periods of stress.

“We retain the view that both active portfolio management and superior security selection will be the main drivers of returns for investors.”

Macroeconomic themes

  • Economic conditions have remained resilient
    • “US gross domestic product (GDP) growth held firm at a 2.4% annualized pace in 2023’s second quarter.1 Consumer sentiment is rebounding, home prices and equity markets have continued to climb, and job layoffs have fallen materially since their January peak. The recovery in sentiment complicates the Fed’s process of taming inflation and raises the question of whether Fed policy is sufficiently restrictive now, or if the Fed will need to hike rates further and keep them there for a longer time frame. Elsewhere in the EA, while economic growth has continued to show resilience as well, sentiment indicators are trending downward, in a divergence from the United States.”
  • Wages remain a driving factor for inflation
    • “With US headline inflation expected to moderate further during this year, real wages and real disposable income should continue to rise. Wage gains are also progressing strongly in Japan. As the US labour market imbalance gradually softens, however, there is likely to be less upside pressure on nominal wages, which in turn will limit how high real wages will rise despite the decline in headline inflation. While private consumption spending is expected to slow during the rest of the year, we still think real wage and disposable income growth will help support the consumer sector, which should help prevent the US economy from slipping into a recession in the second half of the year.”
  • Upbeat employment expectations
    • “With the easing of employment jitters after the banking turmoil, the New York Fed’s Survey of Consumer Expectations indicates that consumers remain confident in their ability to hold onto their current jobs. Small businesses report significant difficulty in filling vacancies, and the hiring outlook continues to hover around historic levels. Overall, still-strong employment expectations and declining inflation have also led to a rebound in consumer expectations. A tight labour market, still-elevated wage growth and a decline in headline inflation have meant rising real hourly wages have turned more positive. Since February 2022, inflation has decelerated, leading to a rise in aggregate purchasing power.”

US economic review

More questions than answers

  • “With a pause in June and a 25-bp increase of the fed funds target rate in July, the Fed remains steadfast in its goal of bringing US inflation down to its 2.0% target.
  • “The Fed continues to pursue a data-dependent reaction function, closely watching US economic conditions to guide its future decisions.
  • “Although we have seen a rapid drop in headline inflation measures, the Fed is more focused on “supercore” inflation, which excludes food, energy and shelter prices.
  • “This measure, which is over half the core personal consumption expenditures (PCE) basket, has yet to fall below 4.0%.3 The future for the supercore measure remains uncertain because it is the labour market that holds the key to understanding the category since wages are the largest cost for non-housing core-services companies.
  • “There has been some progress in terms of bringing the labour market into better balance, but the correction process still has some ways to go. Job growth has averaged 150,000 over the past three months, still above the Fed’s 100,000 estimate of natural job growth. The pace of the labour market correction hasn’t been quick enough to bring year-over-year wage growth closer to 2.5%–3.0%— a level Fed Chair Jerome Powell has said he would like to see. Despite a small decline in quit rates, consumers appear to remain confident in their ability to hold onto their current jobs.
  • “Falling inflation levels and a strong job market have raised real wage growth, adding fuel to the fire of consumer consumption. Real PCE has continued to rise as fast as it’s ever done in the past 23 years. Household balance sheets, on aggregate, do not appear to be cash constrained.
  • “That means that even though one can expect a weakening in consumer spending (especially purchases of big-ticket items) in response to higher benchmark interest rates, it is unlikely to face a sharp, sudden drop because of cash constraints.
  • “Overall, while there has been significant progress on headline inflation, getting it to fall faster to the Fed’s 2.0% goal remains a significant challenge. We think the Fed may favour doing more and hike by 25 bps in September or November, taking the real policy rate up to 1.9% by year-end and 2.2% by end-2024.”

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