This is a summary of ‘Allocation Views’ published on 12 October 2023 by Franklin Templeton Investment Solutions.
The month of September saw a notable decline in global equities, perhaps driven by surprisingly sharp rises in longer-dated government bond yields across developed markets. All of this occurred against a backdrop of relatively benign inflation and growth data. Perhaps policy changes were the culprit?
What is interesting is that rate hikes were not the key. Rather, in delivering well-anticipated decisions, central banks injected some uncertainty over how long they would sustain elevated rates. The US Federal Reserve (Fed) held rates unchanged but hinted at one last hike still to come this year. Perhaps more tellingly, the Fed “dot plot” led financial markets to accept that rates would stay “higher for longer” or perhaps even “higher forever.”
This led to an ongoing rise in the so-called “term premium,” or the return over anticipated short-term rates required to compensate for the uncertainty of holding longer-dated bonds (see Exhibit 1).
Uncertainty Rises to Multi-Year High
Exhibit 1: US 10-year Treasury Term Premium
As of September 30, 2023
It has become increasingly difficult for the Fed and the European Central Bank (ECB) to manage policy expectations. During September, in raising rates once more, the ECB strenuously reiterated its desire to see inflation return to target, but, in reality, it offered little or no firm guidance on the path of rates that might achieve this goal. With inflation continuing to moderate as hoped, a slowing in the pace of rate hikes had already occurred, and debate about where the peak in rates would stand had morphed into acceptance that it was quite close to hand. If central banks were to simply say “that’s us done with raising rates,” investors would have been in danger of getting ahead of themselves and assuming a rapid pivot to lower rates in the quarters ahead.
Even as inflation is likely to ease through the end of this year, it seems less certain that the Fed will rush to cut rates before the impact of slower growth is felt, as it will be these forces that cement the return to target levels of inflation. Only in select emerging economies are we now starting to see moderation in monetary policy, which may help to support these markets.
Overall, this sees our policy theme remain quite a negative driver for financial markets, even as it has evolved to downplay the likelihood of any further rate hikes, while emphasizing “Policy to Remain Restrictive” even as we move into 2024.
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