Unprecedented economic cycle gives rise to asset allocation opportunities

Fixed income – the time is now, the question is how

Unprecedented economic cycle gives rise to asset allocation opportunities

An unprecedented tightening cycle has given rise to unprecedented opportunities. While the last few years have been challenging, interest rate hikes have helped to rejuvenate the fixed income landscape. According to Franklin Templeton, now that rates have likely peaked, the environment is ready to flourish, and many experts believe this is a generational moment with opportunities across the fixed income spectrum.

“Fixed income managers are calling this the greatest opportunity in decades,” says Stephen Dover, head of the Franklin Templeton Institute. “We know that fixed income markets are more volatile than ever. But there are many different ways to navigate that complexity …. The time is now the question is how.”

Opportunity to further derisk portfolios

After the global financial crisis in 2008, funded status of corporate pension plans plunged from around 100 percent to only 80 percent – erasing years of hard-fought gains. It has taken more than a decade for most plans to slowly climb back to healthier funded status levels – the average pension was just 88 percent funded at the end of 2020. But the rise in interest rates has resulted in many corporate DB plans reaching fully-funded status, now 104 percent on average, in less than two years – creating a critical opportunity to further de-risk their portfolios.

A study from Franklin Templeton conducted by Coalition Greenwich says 73 percent of pension plans report funding ratios of 100 percent or higher while 23 percent report funding ratios in excess of 110 percent. The challenge pension funds now face is preserving these healthy funding levels; 70 percent of plans in the study indicate that protecting funded status at current levels is a top investment priority compared to 20 percent of plans that cite generating returns to maximize funded status as their top investment priority.

Every market is not the same and not every market is on the same cycle, says Brian Kloss, portfolio manager at Brandywine Global, a Franklin Templeton company. “There are some that are much closer to others. And there are correlations that we can talk about. But things are happening, whether it's monetary policy, fiscal policy, geopolitical issues, all these factors create opportunities, and this is why we think investors need to be active and not passive with respect to the allocation.

“If you can think holistically about the impact of valuations across asset markets, you can have a very attractive return, given what we're starting with today.”

Canada – a frustrating economy

“The Canadian economy has been frustrating for some time,” says Tom O’Gorman, director of fixed income with Franklin Templeton Fixed Income. “There's been frustration around the ability for energy products to get off the ground. Some of the some of the housing metrics that we've seen over the last number of years have been so far off the historical averages, the amount of GDP coming from residential investments has been off the charts. Over the last five to six months, there's been no economic growth.”

He adds, “Everything that happens in the US is so important because the US economy is about 10 times that of Canada. Monetary policy is extremely important because Canada is open. And a lot of the economy comes through trades. So, the currencies are a big factor.

“When we think about just fixed income in general, there's been a lot of movement in rates. We're not getting stuck in trying to predict rates and when they're going to cut. But if you just look at the level of inversion in the yield curve, the Canada tenures at about 3.4 percent, it had been well over four. And it traded as much as 100 basis points through the US tenure. So, you can see the markets expect a worse macro outcome here.

“We think it's been a little bit slower in coming because all the things we've talked about in the past about access stimulus, but in our portfolios, diversification is super important. You have a smaller fixed income market, it's less diversified, less breadth. For us when we think about risk adjusted returns, we want that diversification, we want lower correlation, which allows us to generate higher returns with less risk to us. That's the holy grail of our process – better risk adjusted returns over the long term.

“More than ever, investors need security selection, active asset allocation, and extremely robust risk – market risk process and overlay with hedges – to deliver better risk adjusted, returns and less risk, more return.”