CONTRIBUTORS
Francis A. Scotland
Director of Global Macro Research, Brandywine Global
This is an extract from the recently published Global Investment Outlook: Flexibility, resilience and opportunity.
Soft landing
Our base case has been that a recession is not needed for normalization to occur, providing the Fed reacts to lower inflation with timely interest-rate cuts. The longer the Fed ignores the retreat in inflation, the longer the Treasury curve will remain inverted, and the higher the probability of a recession or some discontinuous event that increases recession risk. The odds of recession are not trivial. However, it is not the most likely scenario given our constructive view on inflation.
Interest rates and inflation
Price inflation has been in full retreat. US core CPI may already be below the Fed’s 2% target after adjusting for shelter, which the CPI methodology does not capture well. With the lagged effects of monetary tightening yet to be realized, the risks point in the direction of an undershoot on inflation targets. This material drop in inflation removes any need for the Fed to keep raising rates and increases the probability it will cut rates, which would be very stabilizing. There is no macro inflationary pressure coming from China, and Europe may be even more disinflationary. In the United States, the remarkable resilience of the dollar and these external deflationary forces are helping suppress domestic inflation.
Adjusting the US Core Consumer Price Index (CPI) with Current Rents Shows a Different Inflation Picture
US Core CPI Inflation: Year-Over-Year Percent Change
As of September 1, 2023
Sources: Brandywine Global, Macrobond, Bureau of Labor Statistics, Apartment List, Zillow.
Catalyst
After nearly three years of disappointing long-term Treasury total returns, mean reversion and normalization argue for a meaningful rebound. A major slump in nominal economic activity will likely be the main catalyst for a rebound in fixed income. That slowdown should primarily come through inflation, but the Fed, if it stays too heavy-handed, could also play a role. If the Fed behaves according to our script, we will be looking for rate cuts sooner and faster than the market is currently pricing.
Best opportunities
We believe 2024 could be a strong year for investors in general. From a valuation perspective, we believe the bond market looks more attractive than the capitalization (cap)-weighted equity market, although there are clearly sectors trading at steep discounts to intrinsic value that also stand to benefit.
Risks
Risks include geopolitical upheaval, recession, and US fiscal policy and the upcoming election. The US budget deficit is unsustainable given the level of interest rates relative to economic growth, yet political discord will likely make any significant fiscal consolidation difficult.
Major surprise
The biggest surprise could be how low inflation gets. If the Fed leans into that inflation story and normalizes the Treasury curve, 2024 may go out with strong growth and low inflation.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.
Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector.
Investments in alternative strategies, may be exposed to potentially significant fluctuations in value.