CONTRIBUTORS
Stephen Dover, CFA
Chief Market Strategist
Head of Franklin Templeton Institute
In light of changing expectations on the path of interest rates and inflation this year, the conversation about whether it makes sense to stay in cash is even more relevant for investors today. For our latest “Investment Ideas” panel discussion, I asked two of our portfolio managers, Julien Scholnick, Portfolio Manager at Western Asset Management, and Joanne Driscoll, Portfolio Manager and Head of Short-Term Liquid Markets at Putnam Investments, to weigh in on the macroeconomy, taking some cash off the table, and the diversity of opportunities within fixed income. Following are some takeaways from our conversation.
Inflation is looking “stickier” this year. Inflation has not come down as quickly as the market—and the US Federal Reserve (Fed)—had anticipated, leading to a recalibration in interest-rate expectations. Joanne sees one interest-rate cut this year, likely in December, while Julien feels there could be two if inflation continues to trend down and the Fed gains more confidence in the inflation trajectory. Either way, it looks like the final stretch to get inflation back to the Fed's 2% target is going to be more challenging. It is hard to “dial back” some of the price increases, such as wages and food prices.
Regulatory shifts create opportunity at the short end. Tighter US regulations regarding the investible universe for money market funds will impact their liquidity and reporting requirements, which will also likely constrain their performance. That creates more opportunities elsewhere to invest in short-term (less than three years) fixed income strategies in lieu of money market funds. Comparing short-duration products to other parts of the fixed income market historically (such as longer-term corporates) presents a compelling case, offering what we view as attractive returns with less risk, even as a permanent place in a portfolio. Given how tight spreads are across sectors, that’s another reason to be shorter on the curve and higher in quality, to limit duration/interest-rate sensitivity.
Fixed income valuations create opportunities. For many years, opportunities in fixed income to generate yield were limited to less-liquid, lower-quality sectors. Today, higher-quality, liquid portions of the market look attractive to us—including agency mortgages and investment-grade credit. While cash may look attractive today, an investor will face reinvestment risk as the Fed starts cutting interest rates—so locking in longer maturities now makes sense. It’s rare for cash to outperform other asset classes for a long period of time and the panelists saw opportunities in many areas within fixed income, including emerging markets and US municipal bonds. A structural allocation to commercial paper can add liquidity and flexibility, and pivoting between floating-rate and fixed-rate securities can also help manage duration and incorporate one’s view on interest rates and the Fed.
Diversification within fixed income makes sense. In 2021, 2022 and into the first part of 2023, correlations broke down between risk-free US Treasuries and higher beta spread products as well as equity markets. Later in 2023 and into 2024, the negative correlations reasserted themselves given some stress events and concerns about growth. In periods where inflation runs below 3%, there is a negative correlation, so if inflation continues to trend toward the Fed’s target, we believe that negative correlation should hold. Diversifying across the maturity spectrum can limit some idiosyncratic issues within the current environment.
The upcoming US elections create some uncertainty. The fiscal issues facing the United States, such as the high amount of debt, will likely be a focal point heading into the elections and beyond. Trade policy and tariffs will also have implications for the markets. The tax cuts of the prior (Trump) administration may or may not be extended, which could impact consumer spending. It’s difficult to position for the US election or others happening this year across the globe, but we think it makes sense to have a more defensive posture with US Treasuries and perhaps rotate some riskier assets into higher-quality fixed income sectors. There could also be an exogenous shock from geopolitical events, a slowing of growth in China or other crises that again reinforces the prudence of diversification.
Our conclusion from this conversation? It’s certainly time to consider moving out of cash—and there are plenty of places within fixed income to do so.
Stephen Dover, CFA
Chief Investment Strategist
Head of Franklin Templeton Institute
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and 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. Floating-rate loans and debt securities are typically rated below investment grade and are subject to greater risk of default, which could result in loss of principal.
Active management does not ensure gains or protect against market declines.