Caution heralds opportunity With concerns about inflation and rising interest rates, market participants have become very cautious on global interest rates.
However, the Franklin Templeton Fixed Income Group is using the current market conditions to add exposure where markets are pricing in higher interest rates than are likely to materialise. In this analysis, we believe it is important to remember that not all inflation is equal.
Energy and food costs driving inflation in Mexico and Chile
Some inflation is dominated by supply-side shocks in countries with credible central banks, at the same time as growth is slowing. In these cases, a sell-off of fixed income markets could actually present opportunities. Take the example of Mexico and Chile, where higher inflation is almost entirely due to higher energy and food costs. These are short-term supply shocks that do not seem to have impacted the broader price level of the economy. We are diligently monitoring data releases for evidence of contamination of overall inflation, including wage increases and prices for non-tradable goods. But, so far, such increases have been limited.
The central banks in both countries have been raising target interest rates to manage inflation expectations. We believe this tightening of monetary policy, combined with the global slowdown and progressive weakness of their own economies, will likely allow central banks in countries like Mexico and Chile to reverse these rate rises at some stage over the next 18 months. Therefore, given our belief that these countries are facing a temporary supply-side shock, we are of the opinion that increasing yields provide a good opportunity to add duration exposure in local bond markets. In short, in countries where inflation is mostly supply driven, we believe that current market volatility presents attractive buying opportunities.
Defensive positioning in face of demand-driven inflation
Other countries face a build-up in inflation due to domestic demand, as well as supply shocks tied to commodity prices. Our job has been to identify economies where capacity is constrained, inflation is domestically driven and supply shocks threaten to de-anchor inflation expectations. China and Singapore are good examples here. These countries are not only feeling the effect of high energy and food prices, but also of growth rates beyond their real potential growth. In these situations, rate hikes and other forms of monetary tightening, such as currency appreciation, are likely to be larger and more durable.
In such cases, our global bond strategy has been to adopt a defensive interest rate position, while adding currency exposure in countries with strong domestic growth and solid external balances. Higher shortened interest rates should be supportive for many currencies, particularly those in Asia. While higher commodity prices are putting a strain on many economies, Asia's generally strong fiscal conditions and healthy external accounts provide a greater cushion in dealing with such shocks.
Separating interest rate potential from currency potential
In Singapore, for example, we have little interest rate exposure, although we have currency exposure. The Singapore dollar is an excellent inflation hedge, because it is the primary tool of local monetary authorities as they move the official exchange rate bands, according to price pressures. In other words, the Singapore dollar is appreciated when inflationary concerns rise and is weakened when price pressures lessen. This explains why the Singapore dollar is currently one of the largest currency exposures in our global bond portfolios.
Too many rate hikes priced in?
Finally, even with rising inflation, there are opportunities at different points of the yield curve. Recent rate movements have occurred across the curve. However, in many cases, the market has already priced in more rate hikes than we expect to materialise, and long-term real yields look attractive given a pending slowdown in growth and the ability of these central banks to maintain medium- to long-term credibility. To the extent that inflation expectations can be managed, long-term rates can be less volatile and provide protection from short term inflation swings.
Dr Michael Hasenstab is Co-Manager of the Templeton Global Total Return Bond Fund. The Templeton Global Total Return Bond Fund was launched on 2 June 2008 and has a flexible mandate allowing the fund managers to invest wherever they see the best potential, through different countries, sectors and currencies, to access to the best fixed income opportunities globally. For more information, visit www.franklintempleton.co.uk/fi.
Issued by Franklin Templeton Investments, authorised and regulated in the UK by the Financial Services Authority. The views of Dr Hasenstab were as at June 2008. This report is intended to be of general interest only, and does not constitute professional advice. Franklin Templeton Investments makes no representations or warranties with respect to the accuracy of this information. Franklin Templeton Investments shall not be liable to any user of this information or to any other person or entity for the inaccuracy of information contained in this document or for any errors or omissions in its contents, regardless of the cause of such inaccuracy, error or omission. Please note that past performance is not a guide to future performance. The value of shares and income from them may fall as well as rise and investors may not get back the full amount invested. Currency fluctuations may cause values to change.
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