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Fixed-income assets are the preferred bet for portfolio managers, who also see undervalued small-caps.

Amid expectations of the US Federal Reserve maintaining high-interest rates, a panel of investment experts and portfolio managers advised investors to consider opportunities in the fixed-income asset class.

According to Chief Investment Officers (CIOs) and Portfolio Managers gathered at the Franklin Templeton APAC Investor Forum 2023 in Hong Kong last week, opportunities can also be found in mid-cap and small-cap growth businesses, which are generally undervalued, offering diversification beyond large-cap companies.

Amid expectations of a slowdown or mild recession in the US economy, portfolio managers are betting on emerging markets, in particular Asia.

“A weakening US dollar should support emerging markets, particularly those that will benefit from shifting supply chain dynamics. Lower debt levels, inflation, interest rates, and solid fiscal policy puts many Asian countries in a more favourable position. We see the greatest opportunities in Japan which is seeing a reversal of multi-decade trends that are now showing positive momentum. We also see opportunities in Southern Asia,” said Stephen Dover, Chief Market Strategist and Head of the Franklin Templeton Institute.

Speaking about the most suitable asset classes for investors, Dover noted that fixed income globally is attractive as interest rates are at 10-year highs and are likely near peak levels in most regions.

“As the financial market adjustment to the ‘’old normal’’ of higher rates takes time and brings about more volatility, we encourage investors to look for investment opportunities in fixed income which delivers attractive income while acting as a reliable diversifier to equities again,” said Sonal Desai, Chief Investment Officer, Franklin Templeton Fixed Income.

She further said that at the moment investment grade credit bonds with their all-in yield at 6 per cent, high-quality mortgages and select opportunities in the high yield look attractive.

According to Ed Perks, Chief Investment Officer, Franklin Income Investors, for income investors, higher interest rates are widening the fixed income opportunity set for achieving yield, and investment grade corporate bonds stand out in the current environment as they offer attractive income, total return, and risk management potential.

“Looking ahead, if we do see the US economy start to decelerate and the Fed progresses closer to its inflation target and gain comfort with lowering rates in the second half of 2024 into 2025, that would provide a nice tailwind for total returns in fixed income,” said Perks at the sidelines of the Forum.

Mid-and Small-cap businesses undervalued, offer more potential

According to Jonathan Curtis, incoming Chief Investment Officer, of Franklin Equity Group, mid-cap and small-cap growth businesses offer advantages that could make them attractive investments in the current environment.

“We believe mid-cap and small-cap growth businesses are generally undervalued at the moment compared to their large growth counterparts. The price-to-earnings multiple on the market cap-weighted S&P500 hasn’t been this elevated vs the S&P500 equal-weighted index for at least the past 13 years. Second, mid-cap and small-cap businesses tend to be more sensitive to the economic cycle and may benefit from still resilient consumer spending and business activity,” said Curtis.

However, he also cautioned investors regarding indicators that lower-income consumers may feel the effects of rising interest rates.

“Mid-cap and small-cap businesses offer more potential for innovation and disruption than large-cap businesses, as they are often nimbler and more adaptable to changing customer preferences, innovative technologies, and competitive pressures. They may also have more opportunities to expand into new markets, acquire other businesses or become acquisition targets themselves,” said the incoming CIO of Franklin Equity Group.

No rate cuts are expected before the end of 2024
According to Sonal Desai from Franklin Templeton Fixed Income, it is possible that the US Federal Reserve will not start easing the high interest rate pressure at least until the end of 2024. Since March 2022, the US Fed has executed 11 rate hikes, bringing the federal funds rate within the 5.25% – 5.5% target range, marking the highest level in 22 years. During its two-day meeting last week, the central bank chose to forgo an interest rate increase for the third time this year.

“I think we are getting closer to peak rates and the markets are starting to internalise what the Federal Reserve intends to do over the coming quarters; however, they are still overestimating the likelihood of rate cuts next year,” said Desai.

Sonal Desai highlighted key factors driving the scenario, which include expected US fiscal deficits in the coming years, causing supply challenges, anticipated reduced interest from major US Treasury holders, Japan and China, and the persistent nature of inflation, making it challenging to achieve a 2 per cent inflation rate.

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