A memo that highlights Franklin Templeton's Mid-Year Outlook for equities, fixed income and real estate.
Insights from specialist investment managers Brandywine Global, Clarion Partners, ClearBridge Investments, Martin Currie, Royce Investment Partners and Western Asset
SAN MATEO, CA, June 17, 2024 – Franklin Templeton's specialist investment managers provide their outlooks on the U.S. Federal Reserve, the global economy and key asset classes for the second half of 2024. They include insights from the following firms:
- Brandywine Global Investment Management expects high yield bonds to continue to benefit from an attractive yield as well as strong fundamentals and favorable supply-demand dynamics. Headquartered in Philadelphia, Brandywine Global looks beyond short-term, conventional thinking to rigorously pursue long-term value. Based in Philadelphia, it has $61 billion in assets under management (AUM) as of March 31, 20241.
- Clarion Partners provides its view on U.S. commercial real estate. Clarion is a leading U.S. real estate investment manager headquartered in New York with approximately $75.6 billion in AUM.1
- ClearBridge Investments provides its views on the outlooks for both large cap growth and international growth stocks for the remainder of the year. Headquartered in New York with $187.9 billion in AUM,1 it is an authentic active global equity manager with a legacy dating back over 50 years.
- Martin Currie, a firm that dates back to 1881 and has $20.7 billion in AUM,1 provides its outlooks on global emerging markets. Headquartered in Edinburgh, Scotland, Martin Currie is driven by its purpose of Investing to Improve Lives.
- Royce Investment Partners offers its outlook on regional banks. Royce specializes in actively managed strategies that invest in the broad and diverse small cap universe with unparalleled knowledge and experience gained through more than four decades of investing. It has $12.7 billion in AUM.1
- Western Asset Management provides its outlooks on global fixed income as well as U.S. municipal bonds. Western Asset is a globally integrated fixed income manager, sourcing ideas and investment solutions worldwide. Based in Pasadena, CA, it has $385.4 billion in AUM.1
Brandywine Global: High yield bond market outlook by Bill Zox, CFA, Portfolio Manager
The high yield asset class continues to benefit from an attractive yield around 8%, strong fundamentals and favorable supply-demand dynamics. The one metric that warrants caution – a spread over Treasuries that is near the tight end of the historic range – must be managed but is not in our view enough to offset the many positive factors. Defaults have stabilized at well below average levels since late last year. Interest coverage has stabilized at well above average levels.
The management teams of high yield issuers have had almost two years to prepare for higher interest rates and possible recession. And, except for the lowest 10%-15% of credit quality, they have had good access to capital, not just in the high yield market but in loans, private credit, asset-backed securities and public and private equity. High yield issuers with publicly traded equities can access the convertible bond market at the same low interest rates we saw from 2020-2021 if they are willing to give up some of the upside on their stock, which may well be at a high valuation.
Since 2022, most of the new issuance in high yield has been for refinancing. We have not seen much, if any, of the risky bond structures or financing of bad businesses that precipitated major sell-offs in prior high yield cycles. This very limited net new supply is being met with strong global demand for high yield bonds from allocators who understand these positive factors and the long history of compelling risk-adjusted returns that the asset class has delivered.
Clarion Partners: U.S. commercial real estate outlook by Indraneel Karlekar, Global Head of Research and Strategy
Positive macro outlook
Heading into the second half of 2024, the U.S. economy remains resilient despite higher interest rates and heightened geopolitical uncertainties. Strong consumer spending, job growth and robust corporate profits continue to support the economy. Overall inflationary conditions have moderated considerably relative to the highs seen in 2023, though the “last mile,” moving to the Fed's target of 2%, is proving more challenging. As a result, the Fed has pushed back its timeline on cutting interest rates to later in 2024, yet is also signaling that it still believes an easing in monetary policy is forthcoming.
Clarion Partners anticipates greater improvements in overall real estate liquidity and deal flow in 2H 2024. Although credit spreads have tightened and financing costs have started to improve, a sustained recovery in real estate capital markets will be largely dependent on the Fed's actions.
With new supply numbers leveling off significantly, we expect demand fundamentals across all property types to benefit in the years ahead. We are cautiously optimistic about the next 12 months and maintain the position that the real estate asset class offers attractive risk-adjusted returns over the long term.
Five structural themes driving real estate investing
Through the first half of 2024, overall U.S. institutional-quality property fundamentals remained reasonably well positioned. Excluding office, most sectors have experienced near-record high rents and low vacancy levels.
Clarion Partners has identified demographics, innovation, shifting globalization, housing and resilience as five discernable structural themes that will impact property demand in the years ahead. In an evolving and cyclical world, we believe that sectors benefiting from these themes will deliver durable investment performance, lower volatility, and a broader investment universe to investors.
These include industrial property, rental housing, necessity retail and select alternative sectors, such as self-storage, life sciences, medical office buildings (MOBs) and single-family rentals (SFRs).
Looking forward
Clarion Partners is cautiously optimistic about 2024, believing that the current market dislocations may create attractive buying opportunities over the next 12-18 months. Potential investment risks include elevated inflation, higher-for-longer interest rates, refinancing risk from the wave of maturing real estate loans and political uncertainty in an election year. As such, it is prudent for investors to monitor macro developments closely, underwrite new investments conservatively and deploy capital selectively.
ClearBridge Investments: Large cap growth outlook by Margaret Vitrano, Portfolio Manager
Optimism for a soft landing inclusive of rate cuts has been the driver of momentum over the last year. In such a scenario, we should start to see early cyclicals work, including industrials, consumer discretionary and semiconductors. The Philadelphia Semiconductor Index is up over 50% since last June, so we do not expect the same early cyclical recovery there but do see selective opportunities among chip stocks servicing recovering areas of technology.
Generative artificial intelligence (AI) is a secular growth trend we continue to watch closely as every company is thinking about their AI strategy. The biggest beneficiaries so far have been the picks and shovels – GPU, AI server and faster computing providers. Enterprise software makers are trying different models and data sets, refining go-to-market offerings and pricing. But with no prevalent AI use case yet to emerge, we expect implementation and uptake to be more constrained.
If rates remain higher for longer, the most expensive stocks in our universe may be more at risk. We have been trimming these companies in favor of more reasonably priced growth businesses with good cash flow support. In this scenario, companies with lower free cash flow yields are likely to see less multiple compression.
One of our larger concerns is the cadence of rate cuts the market is pricing in. The Fed doesn't want to be wrong and have to reverse course on rate cuts if inflation and/or employment pressures remain stubborn. Many components of input costs are reversing higher after a prior decline, including crude oil, materials, industrial metals and agriculture, while unemployment remains low and labor costs elevated. The key questions today are whether the neutral rate is higher than 2%, and whether inflation is structurally higher than in decades past, a debate that will take time to settle.
ClearBridge Investments: International growth outlook by Michael Testorf, Portfolio Manager
We believe international growth equities will gain favor in the second half of the year as Europe has cut rates ahead of the Fed and credit flows in the eurozone are rising, both on the corporate side and the consumer side, which is often a leading indicator of GDP growth.
Recent results validate the need for investors seeking international exposure to include growth equities. While the macro picture in Europe remains muddled, markets appear to be looking past recent disappointing GDP growth in the region as evidenced by improvements in the Citi Economic Surprise Index. Investor flows into Europe are also demonstrating green shoots after an extended period of outflows, with a pickup in share buyback activity being a catalyst.
International growth equities in general, and European stocks in particular, look quite attractive compared to their U.S. peers. Judging by forward P/E multiples, the eurozone is trading at less than two-thirds the U.S. — its cheapest relative levels since before the COVID-19 pandemic. Given an improving rate environment and the resilience companies there have shown through the Russia-Ukraine war and an inflation scare, we continue to favor Europe and the U.K.
In Japan, actions taken by the government and exchanges to improve corporate returns and encourage greater equity ownership are beginning to flow through to better earnings. Companies are also sitting on high cash levels that can be directed to shareholder-friendly activities such as buybacks and dividends.
Outside our MSCI EAFE benchmark, we have meaningful exposure in Canada, which we view as a good alternative to Australia, where we are underweight. Canada is resources rich and home to some best-in-class growth companies.
Martin Currie: Susan Gim, Institutional Portfolio Manager
The return of emerging market (EM) growth stocks
In an environment of slowing global economic growth and peaking interest rates, growth stocks are well placed to lead the way. Value has now outperformed growth in EM for three consecutive years, and we believe this has created attractive valuations for EM growth stocks.
China: Misconceptions create opportunities
A key drag on EM returns has been the performance of the Chinese market. We feel there are significant misconceptions about China and this is driving material disconnects between share prices and fundamentals. We see signs of geopolitical repair and more domestic shareholder-friendly messaging around private businesses in the country. We think investors will begin to reassess their increasingly cautious approach amidst this unprecedented divergence between share prices and fundamentals.
EM offers opportunities in technology and India
Over the long term, technology has been the best performing sector in EM; it represents 23% of the MSCI Emerging Markets Index as of May 31, 2024. We believe the sector remains a fantastic long-term opportunity. Despite narratives around onshoring, the reality is that the global technology supply chain continues to be heavily reliant on companies within EM countries. They are essential for the advancement of global technology. EM technology companies provide investors with a diverse range of opportunities and they are currently trading at materially lower valuations than U.S. peers.
We believe India is the greatest economic opportunity globally in light of its demographic trends, which include a growing middle class. There is a rich opportunity set within the country, including companies with long-term structural growth potential and well-regarded management teams. These including luxury retailers harnessing the power of technology in a market historically reliant on in-person service, retail and corporate banks reaching historically under-penetrated parts of the market using technology and innovative business practices, and global industry-leading materials companies driving positive change in an environmentally lagging sector.
Royce Investment Partners: Regional bank outlook by Miles Lewis, Portfolio Manager
We think that investors may be mistaken in thinking that the current “higher-for-longer” rate environment will be a negative for regional banks, including an adverse impact on their fundamentals. However, we think a longer-term view reveals that we are seeing a positive normalization of the bank operating environment. It is true that the speed with which rates rose over the past two years was difficult for banks on both the asset and liability sides of their balance sheets, but that is now in the rearview mirror. What matters most for our small cap investments is the forward-looking view, and in reality moving away from the zero interest rate period (ZIRP) is structurally better for banks.
ZIRP was difficult in that it flooded banks with deposits when money was essentially free. Looking at simple supply/demand dynamics, this meant that there was increasing capital chasing loans, which compressed yields and led to weaker terms. In other words, the banks were forced to mostly compete on price in such a high supply market. Now that we have moved away from ZIRP, the opposite holds true. We are now seeing our bank holdings being able to not only move rates higher on loans, but to also increase the spreads as they price more appropriately relative to the risk.
Throughout the history of financial markets, there have been many analogous situations—those in which fundamentals worsened when capital was flooding the industry, and then fundamentals improved dramatically as capital was fleeing the industry. The energy sector offers a recent example where capital discipline has been instilled before financial returns dramatically improved.
It is also quite interesting that when we ask bank CEOs whether they would prefer to operate in the ZIRP environment or a “higher-for-longer” environment, they all affirm that a normalized rate environment is much better. The only remaining challenge is the inverted yield curve. However, it can't stay inverted forever, and we think that once the curve normalizes this will highlight the improved spread fundamentals that we're discussing here.
Western Asset: Global fixed income outlook by Michael Buchanan, Co-Chief Investment Officer
The market consensus expectation is for interest rates to remain "higher for longer" due to resilient economic growth and persistent inflation, which continues to exceed the Federal Reserve's target. This outlook suggests that any potential rate cuts by the Fed would be limited and likely not occur until the latter half of the year. However, there's also a strong possibility that if inflation rates gradually decline, even if unevenly, it could pave the way for the Fed to eventually lower rates further, although the timing and extent of such cuts remain uncertain.
Western Asset holds a constructive view across most fixed income sectors, encouraged by the slow but steady resolution of inflationary pressures and other challenges that arose during the Covid crisis, although geopolitical risks remain a significant concern. A peaceful navigation through these risks could lead to a more favorable outlook for fixed income markets, especially as growth is expected to slow and inflation to decline, potentially allowing the Fed to adjust its policy stance.
We believe that this positive macroeconomic outlook promotes renewed optimism for fixed income and even suggests an “end of cash” era, arguing that cash equivalents are often the worst-performing asset class; this is supported by the evidence that fixed income investments typically outperform cash, especially when the Fed enters a policy easing cycle. Historical trends show that diversified bond portfolios can offer healthy returns even when the Fed pauses rate cuts. Moreover, fixed income offers valuable portfolio diversification benefits, as the historically negative correlation between equities and bonds has resumed after being disrupted by the high inflation environment of 2021-2022.
We believe that in this environment, active management is critical to help investors identify attractive opportunities. Specifically, high yield credit, structured products, emerging market debt and agency mortgage-backed securities (MBS) present compelling prospects due to their attractive spreads and strong fundamentals. Additionally, we see potential in municipal bonds (munis), as historical data suggests that entering the market before the Fed initiates rate cuts has typically led to more favorable outcomes compared to investing after the initial rate reduction in a cycle.
In summary, our outlook at Western Asset is supported by expectations of easing inflation and eventual rate cuts. This favorable environment strengthens our conviction to increase exposure to select fixed income sectors that present attractive return opportunities. We also underscore the importance of active management to nimbly position portfolios and seize compelling opportunities as they arise, in an effort to maximize returns for our clients.
Western Asset: U.S. municipal bonds by Robert E. Amodeo, CFA, Head of Municipals
In the first half of 2024, the U.S. municipal bond market contended with ongoing rate volatility, elevated new-issue supply and demand that has not materially returned following two consecutive years of municipal mutual fund outflows. Munis underperformed other fixed income sectors despite an improving fundamental backdrop as upgrades outpaced downgrades.
Regarding the second-half outlook, Western Asset remains optimistic about the municipal market. Absolute municipal yields and tax-exempt income opportunities may have peaked, and year-to-date underperformance has contributed to improved relative value. Regardless of the number or magnitude of Federal Reserve rate cuts that might occur by year-end, we expect a trend of slowing growth and inflation will lead absolute rate levels lower over the longer term.
From a technical perspective, elevated supply conditions and lackluster demand can support long-term tax-exempt income opportunities in the second half of the year. Tax-exempt supply is tracking to reach the highest level in a decade as municipal issuers continue to break ground on new projects following years of negative net issuance. From a demand perspective, elevated cash on the sidelines could remain relatively sticky and require material Fed rate-cut expectations to return to the municipal asset class.
From a credit perspective, the muni market has demonstrated ongoing resiliency as tax collections remained strong and upgrades have continued to outpace downgrades this year. Western Asset expects incremental income opportunities will continue to exist for investors willing to access the lower end of the credit spectrum. However, certain revenue sectors warrant caution given more challenged fiscal prospects and less federal support against a backdrop of a potential economic slowdown.
Ahead of a potentially volatile election season where tax policy will likely come back into focus, above-average tax-exempt income opportunities, elevated supply and strong credit fundamentals all contribute to a compelling entry point for long-term investors. We believe this opportunity is magnified for active managers that can navigate market inefficiencies and the yield curve, as well as credit conditions, in pursuit of attractive risk-adjusted returns.