Positioning for 2022

Stephen Dover: Gene, we have a lot of questions, about inflation as we roll into 2022. So, how are you looking at positioning for inflation questions as we roll into this new year?

Gene Podkaminer: Thanks, Stephen. That's something that's been on our minds extensively. And, I think it has crowded out some of the other questions and risks that we were looking at earlier in the year.

There's been a lot of consternation and a lot of hand ringing around what the inflation path looks like. And, maybe even more importantly, what the response of policymakers to that inflation looks like as well.

The way that we're looking at inflation is, firstly, starting with the macroeconomic backdrop, understanding, is inflation being driven by the demand side or by the supply side? That's really a crucial differentiation. The demand-led inflation is something that policy makers can likely deal with in an appropriate manner with historical precedent. Supply-side inflation, if that occurs, is a different animal and would require different policy measures. Our read is that the inflationary pressures are really being caused more by the demand-side, but there's an understanding that the supply chain dynamics and some of the tangling of supply chains that we've seen over the last couple months are a real issue, but likely will get resolved. So, our view on inflation is that, look transitory as a word is out. Even the [US] Fed is saying, please don't use that word anymore. And, we've been telling that to our teams as well. Let's find a different word to use.

So, maybe it's something like temporary or longer lasting than transitory, but we don't think it's permanent. And, I think that's really the key, that we're not being locked into a permanently higher inflationary environment and we do think that some of the inflationary pressures are going abate. We may see that in the second half of 2022, but we should be prepared for higher inflation prints than we are used to seeing over the last five or 10 years to emerge in 2022.

Now, the question is: what do we do about that?

So, as you've been hearing, with taper talk and what we expect the Federal Reserve and other central banks to do, we think that equities are in a better position to capitalize on that over the next couple of quarters versus fixed income. Now, that doesn't mean dropping fixed income wholesale, fixed income is still an important hedge as a diversifier, rather than a place where we really seek return. Within equities and within fixed income, we lean more towards economies like the US and Japan, and then in a smaller degree, eurozone and Canada and away from emerging markets.

Stephen Dover: Ed, you particularly focus on income investors. And so, how does what Gene was just talking about, how does that affect strategies that are looking for income?

Ed Perks: The reality is it is very difficult to seek return in many different fixed income sectors. We have seen that in 2021. It's very possible. We continue to see that into 2022. It's been a more volatile year in rates. We've seen rates increase, we've seen them rally back, sell off again. Each time that's happened, you know, we've found pockets of opportunity. More of that opportunity today for us is in a shorter-duration securities, within the high yield market in particular, you know, that's an area that has performed better within fixed income. It has better carry, higher coupons. And generally it's a shorter duration asset class.

Stephen Dover: So, Ed, one of the things I've always found really interesting about income strategies is that it's not as simple as a mixture of, in essence, higher yielding equities and fixed income. So can you talk a little bit about some of the things that you can do in fixed income strategies that might be more complicated than individual investors can generally do?

Ed Perks: Yeah. See, you know, I think the key area and somewhat, you just touched on it, with some of the recent equity market volatility, particularly in some of last year's darlings, if you will, stocks that really benefited from the pandemic and the work from home, the “do everything at home” push. Many of those companies were very active in the convertible market. They were raising capital by selling zero coupon or very, very low coupon convertible bonds. And while they had no interest to us at the time with some of the volatility and recent downdrafts in these stocks, we now have what we would consider to be, you know, securities that are becoming somewhat orphaned. They now trade at big discounts to par. That convertible features is more out of the money at this point. So it has less impact on the value of the individual security. And yet, credit investors maybe are a little less focused on this unique area in the, what we would call, kind of busted convertible. So, we're finding, you know, some pretty attractive yields with you know, with what still could be down the line an equity option that could come back to life. So that's something that's pretty unique and that we're focused on and finding some opportunities. So it's always dynamic. But once again, it's always been about how do we maintain as broad an opportunity set as possible?

Stephen Dover: So, Gene, let's turn to valuation, multi-asset capital market expectations are really important to advisors as they look for the long-term strategic allocation for their clients. And you just finished this exercise for 2022, what are some of the highlights of expectations for valuations and returns going forward?

Gene Podkaminer: Yeah, so we did just finish our capital market expectations, as we speak we're putting the finishing touches on them, and we are really thankful to be able to take a step back every year and look at the longer term. So, look at that 10-year horizon that we craft the capital market expectations over. There's a couple of themes that emerged this year.

First, is that equity expectations in most of the developed world are a little bit lower than what we saw last year and the year before. Not in a giant way, but moderately lower. As Ed mentioned earlier, the starting point for fixed income is really important when crafting capital market expectations, you just can't get away from the starting yield levels and those are low. And so, we have seen expectations for fixed income that are also commensurately lower, but there are pockets where they're a little bit higher as well.

Now, I should mention that because capital market expectations are forecast over a long period of time. The change that one expects year over year is pretty small. So the velocity of change in those numbers is not giant. They're not going to be whipsawed around. What we've seen is a relatively healthy equity risk premium that still exists. So we believe, over the long term, that equities will still outperform fixed income. That doesn't mean that fixed income, isn't an important part of the portfolio for reasons that we've mentioned earlier in this conversation. In addition to diversification, there are certainly pockets of opportunities within fixed income, even over the long term to try to get some return into the portfolio. And then, looking at some of the other areas that investors are interested as well. We have forecasts for private asset classes and commodities and a couple of other specialized sectors.

When we put them all together into a well-behaved portfolio, we see that because equities drive much of the return for most portfolios, those numbers should really be viewed as a little bit lower than what we've seen before, partially because we've had such a tailwind over the last year or two, that if you think about the mean reversion aspect of them, long-term valuations, we don't really expect double digit returns from equities over and over and over again in a really consistent manner.

Our process involves four really key, meaningful areas, growth, inflation, rates, and valuation. I would say we really should be looking at what the path of future growth looks like and what interest rates look like as a response to inflation, growth has been certainly above expectations recently, as we bounce back from the COVID dip, and we don't expect that to persist in those types of numbers over long periods of time. But we do think that growth will come in higher over the next couple of years than what we've seen over the last couple of years. So that's an important thing to keep in mind as we look at capital market expectations, because growth of course is a very important driver of equity returns.

Stephen Dover: As you look at, Gene, client portfolios and everything, is there any particular area where people might find an opportunity that they're not thinking about?

Gene Podkaminer: There are a couple of areas I can think of. Maybe the first one is within the fixed income space it's pretty broad. On one side of the spectrum, you have relatively low risk government securities. And on the other side of the spectrum, you have high yield below investment grade fixed income that has a lot of equity characteristics. I think a question for investors is how they want to position within that fixed income spectrum in order to really meet two competing objectives. The first is get a little bit more return into the portfolio, but the second is not be too correlated with equities. So, looking at the space in the middle, not pure governments and not some of the riskier high yield securities, but the stuff in the middle opportunistically could be really important and regionally as well.

So having a focus that's beyond just US fixed income and US investment grade, looking out to some of the other regions, both to developed markets and also emerging markets. So I think that the fixed income area is ripe for a little bit more analysis, and maybe we can suss some more, both return and diversification out of it.

Within equities, many portfolios have a bias towards the United States, which on some level is understandable because it's such a giant part of the equity indices. But, looking at other areas is going to be crucial as well. So, looking at Europe and what that recovery potentially looks like with inflation and COVID and growth and interest rates. Also looking at Japan, and we just published a blog piece about Japan with some of the macroeconomic characteristics there will be important to look at. So don't just take a generic asset allocation and think that it's good enough. You have to really peel back the covers and understand what's going on in there. How are we positioned regionally? How are we positioned across the credit spectrum and the duration spectrum as well and craft each of those decisions to really match what the expected outcomes are of the investor.

Stephen Dover: Ed, let's just turn to you. In terms of value versus growth and how you look at those as we roll into 2022.

Ed Perks: And that's certainly an area that over the last 10 years, we've seen a large part of that period of tremendous of out-performance from growth sectors and growth companies. This last couple of years it's been a bit more mixed where we've seen pockets of very strong performance from value stocks and other times where, you know, some of the growth sectors have struggled a bit. I think some of that is, you know, valuations moved up very rapidly in many growth areas, it established, if you will kind of a very high bar for the performance of those companies. I think it's important to acknowledge that many companies have met those bars. But at the same time that treadmill maybe speeds up and creates some challenges and some volatility.

So, you know, as we think about our macro backdrop, Stephen, even though growth is moderating, we do still expect that growth will be settling in, certainly for the next four to six to eight quarters potentially at above the longer-term trend growth rates that existed prior to the pandemic. So, we do think that that's actually a pretty constructive time across the board and it doesn't necessarily favor growth over value. You know, our view is when there's broader growth pressures in the economy, in markets that value companies can really struggle, growth becomes more scarce. Therefore, growth sectors and companies become more attractive to many investors. We don't necessarily expect that. So, I think we have a pretty broad opportunity. It may, certainly, continue to be a little bit of a trade-off. We might see a quarter or two where value really outperforms, or a quarter or two where growth really outperforms. But in general, as we think about this next 12, 18, 24 months, we think investors can think broadly and look and find opportunities across both value and growth.

Stephen Dover: And, Ed, just some final closing thoughts on where you see risks to keep an eye on as we enter into 2022.

Ed Perks: I think a lot of these risks have come out in this conversation and, you know, maybe it's also an opportunity for us all collectively to thank the Fed for removing the word transitory from the debate. You know, that's certainly something that maybe was too much of a distraction. You know, but at the same time, it begs the question, well, if not transitory then what? And I think that's an acknowledgement that kind of in line with our expectations, as Gene described earlier you know, inflation's likely to be with us for a while. You know, we do think that the maybe worst of it is kind of happening now or has been happening these past couple of months. And as we make our way into and through 2022, it's going to be important to see some moderating in that.

And, we do think there is a path for that. You know, whether it be through easing some of these logistics bottlenecks that we've had in our economy, in the pandemic reopening as well as, you know, some of the stimulus driven demand spikes that we saw, you know, in the economy moderating as well. So we're going to have to continue to watch that very closely, you know, as Gene described, because those dynamics of demand driven versus supply side created inflation are very different. But we do now know it's not transitory. So, you know, we're going to watch that very closely. I think we're also being reminded here that, you know, the COVID-19 pandemic is likely going to continue to have an impact on economies on markets.

It's still very early days in the Omicron variant, but we have, you know, we have to go through this and we have to try to understand what impact it can have as these variants potentially surface. You know, hopefully this also drives an increase in in vaccinations around the world and increases protections and makes us all more durable to the impact that variants can have, you know, on the economy and on markets. But that's certainly going to remain an important factor, risk, potential, you know, as we move forward.

You know, and then finally, and I think Gene touched on this as well. You know, we are in a period where there's substantial policy transition happening in the US and around the world. Some of that is happening to remove some of the critical measures that were needed in the depths of the crisis. Some of those policy shifts are happening to deal with some of these pressures that now exist, particularly in inflation in areas like emerging markets, where we've seen many central banks you know, tightening a bit these past several months to deal with some of those pressures.

So we're going to have to continue to stay pretty vigilant on that front, you know, and then at the same time to maybe end on a little bit more of a positive note, it's a nice backdrop to invest in risk assets. We do think you want to be very selective on where you place those dollars but taking advantage of volatility if it sets in and following a pretty active approach is certainly something that we're going to be very focused on in 2022.

Stephen Dover: Well, Ed, Gene, thank you very for sharing your thoughts as we enter into 2022.

I want to thank you the audience for listening to this. On behalf of Franklin Templeton, I want to wish you a happy holiday season and the best as we roll into this next new year.

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