Spread Sectors Continue to Perform

Christopher J. Molumphy
Chief Investment Officer
Franklin Templeton Fixed Income Group

Financial markets have been rallying since the onset of spring, with the exception of a short pullback in late June, as the overall U.S. economy transitions out of the worst recession since the Great Depression. Now, there’s the possibility we might see some growth in the third quarter, and it seems even more likely toward the end of the year.

The debate now is focusing not so much on when the U.S. will emerge from recession as on the recovery's pace and strength. Historically, the U.S. typically sees above-trend growth in the 12 months following a cyclical downturn's end. However, while the recession seems likely to end soon, we believe there is a risk that growth potential will remain below trend for some time.

Significant headwinds include consumer spending, which typically represents around 70% of the U.S. economy, according to the Bureau of Economic Analysis. Consumers have been going through an extremely painful but necessary deleveraging process, with the savings rate rising from close to zero last year to 6.2% in May, although it retreated to 4.6% in June.¹ Also, July’s unemployment rate stood at 9.4%,² and we believe it will likely rise throughout 2009-potentially reaching 10%.

With unemployment still strong, we expect consumers will continue to limit their spending for some time. While we are finally starting to see signs that the housing market has bottomed-home sales have started to pick up for the first time since mid-2006, and we are starting to see a rise in some price measures³-we are still far from a complete recovery.

As is typical, financial markets have acted as forward economic recovery indicators. We have seen a broad-based rally in equities and a variety of fixed income instruments, with only U.S. Treasuries performing poorly-in stark contrast to the end of 2008, when Treasuries were the "safe haven" of choice for rattled investors. Yet, even with the recent significant rebound, we regard valuations in the fixed income market as generally fair or even cheap on a long-term basis. And if, as we expect, the U.S. economy enters a period of low growth, then many fixed income asset classes could look highly compelling on a risk-adjusted basis.

While investment-grade corporate bonds have rallied strongly, with a significant drop in spreads over U.S. Treasuries, the yield premiums demanded for such bonds remain close to levels seen in the depths of the last recession, suggesting they still hold potential. Indeed, from a long-term perspective, we continue to like spread sectors, e.g., corporate bonds and mortgage- and asset-backed securities, to name a few. Also, global bonds offer great total return potential and can provide diversification to a fixed income portfolio, in our view. Municipal bonds also appear to be attractive on an after-tax basis.

While we believe that inflation may loom as an important issue in the next three to five years, short-term inflation risks are probably overstated given rising unemployment in a U.S. economy essentially based on services.

Even if a spurt in inflation leads to higher interest rates, the implications need not be negative for a range of bond products. Investors can even employ several strategies to hedge against higher inflation and interest rates. One might invest in TIPS (Treasury Inflation-Protected Securities), keep duration short, examine multi-sector products such as total return funds or diversify into global bond funds.

1. Source: Bureau of Economic Analysis, 4 August 2009
2. Source: Bureau of Labor Statistics, 7 August 2009
3. Source: National Association of Realtors, 4 August 2009

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FTIF - Franklin Strategic Income Fund
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FTIF - Templeton Global Bond Fund
FTIF - Templeton Global High Yield Fund
FTIF - Templeton Global Total Return Fund