Beyond Bulls & Bears

If It Ain’t Broke, Don’t Fix It


  • Chris Molumphy: “The labor markets certainly aren’t in great condition, but the trends seem, in our view, to be positive.”
  • Roger Bayston: “We do not expect any meaningful policy changes regarding the future of Fannie and Freddie until after the U.S. Presidential election this fall.”
  • Michael Hasenstab: “It is absolutely essential that a number of these European policy measures that were started are followed through on.”
  • Eric Takaha: “We have been viewing the financial market gyrations over the past year as longer-term investment opportunities.”
  • Rafael Costas: “By now everybody knows that 2011 was, in the minds of many, a surprisingly strong year for municipal bonds, but it was, however, a pretty uneven year.”

The idea behind fixed income is to have a predictable amount of money coming in at predictable intervals.  Against a market backdrop that’s only predictable in its unpredicatability, the promise of a steady income probably sounds pretty alluring to a lot of investors right now. So, as we emerge from a very volatile 2011 and wade into what may well be a similarly volatile 2012, how’s the fixed income space sitting?  Great question!  We’re glad you asked.

It just so happens that a panel of five of Franklin Templeton’s fixed income elite recently delivered a sort of State of the Asset Class overview.  Below is a sampling of what they shared.

Chris Molumphy
Chris Molumphy

Chris Molumphy, CIO – Franklin Templeton Fixed Income Group®: U.S. Fixed Income Overview

The labor markets certainly aren’t in great condition, but the trends seem, in our view, to be positive.

Partially driven by the improved jobs picture, the consumer, generally speaking, appears to be reasonably healthy.  The corporate sector continues to be a source of strength for the overall economy.  And, of late, we are finally seeing signs of some hiring in the corporate sector.  Our outlook for inflation is that it is likely to generally remain benign in 2012.

Now, having said that, we’re not without challenges.  Real estate certainly remains stubbornly problematic and likely will remain a headwind in the overall U.S. economy.  In our view, though, valuations—broadly speaking—are near their lows.  Despite the downgrade mid-year, we still have not really made much progress on the federal debt level in the United States.  We ended fiscal 2011 with a significant deficit of roughly $1.3 trillion, or approximately 9% of GDP.  And, finally, we continue to work our way through the sovereign debt crisis in Europe.  While volatility could certainly persist as we look through the first half of 2012, we’re cautiously optimistic that we will see some resolution this year. 

In sum, our view is that the fundamental backdrop is reasonably constructive as we enter 2012 and, as the market inevitably trades on these fundamentals, that should bode well for a number of different fixed income sectors in the coming year.

Roger Bayston
Roger Bayston

Roger Bayston, Senior VP – Franklin Templeton Fixed Income Group®: Fannie and Freddie

It’s been over three years since Fannie Mae and Freddie Mac were put into government conservatorship. With their future in doubt—and it should be noted that both organizations have current mandates to shrink their portfolios—the U.S. Federal Reserve has been there to pick up the pieces and try to keep the market-driven mortgage rates low. This was one clear intention of the quantitative easing policy now known as QE-2, announced in the fall of 2010. 

Should the Fed announce further QE measures, we would expect they would continue to focus on attempting to keep mortgage rates low to support U.S. residential real estate. Continuing to buy agency mortgage pass-throughs will likely be one of their tools. In addition, we expect them to continue to help owners deleverage their household balance sheets through refinancing at the very low rates available. This requires working with banks and mortgage servicers to clear current hurdles that are preventing large amounts of refinancing from happening.

We do not expect any meaningful policy changes regarding the future of Fannie and Freddie until after the U.S. Presidential election this fall.  Given the huge debt loads each organization carries, politicians are leery of supporting decisions that might add to the very difficult U.S. fiscal debt position.

Dr. Michael Hasenstab
Dr. Michael Hasenstab

Dr. Michael Hasenstab, Co-Director – International Bond Department: Impact of Eurozone Woes

One of the key challenges in 2012 will be, I think, implementation: it is absolutely essential that a number of these policy measures that were started are followed through on.  There are six key issues with implementation that we need to watch and I expect that, within the next three to six months, we will get clarity on a lot of them.

1) European fiscal union. I think this is the cornerstone of putting Europe on a more sustainable path, and we need to continue to see that followed through. 

2) Budget follow through in Italy.  Italy has passed some very austere and difficult budget measures. We need to see follow through there and make sure there isn’t backsliding, and we need to see some follow-through on the labor market reforms.

3) Greek restructuring. We have always maintained a view that Greek’s debt was insolvent and it was a matter of time. I think that time is quickly approaching and, hopefully, we can have a restructuring and move beyond that.  I think it would be healthy to no longer have that in the headlines, but it could create some short-term volatility. 

4) Will we see ongoing QE out of Europe?  Will they continue to commit their balance sheet to the Central Bank in periods of stress?  So far they’ve indicated a willingness to do this, and I think this will be important to monitor.

5) Emerging market monetary policy. We’ve seen some easing in monetary policy in emerging markets. This has helped cushion those economies against a global slowdown.  One of the strengths that emerging markets have is the ability to actually lower interest rates. But we need to make sure they don’t get behind the curve and ease too much, given that demand conditions are actually pretty reasonable in those markets.

6) U.S. debt dynamics.  In this political year, U.S. debt discussions seem to be completely at an impasse, and that will be important. 

So those issues of implementation, I think, will be important to follow.

Eric Takaha
Eric Takaha

Eric Takaha, Director – Corporate and High-Yield Credit Group: Corporate, Leveraged and High-Yield Debt

If you just focused on the headlines dominating the news in 2011 you could have reasonably assumed that 2011 would’ve been a fairly difficult year for corporate credit. However, when you look at valuations, while they did cheapen, overall returns were actually positive. 

In particular, U.S. corporations posted positive year-over-year earnings growth throughout 2011, even during the more difficult U.S. economic environment experienced earlier in the year. Valuations across the corporate credit markets in 2011 were driven more by the negative headline news stories than by the generally supportive credit fundamentals. Consequently, while total returns were positive, yield spread valuations did cheapen, particularly in the latter half of the year.

Looking at the leveraged loan sector in the investment-grade corporate markets, we see similar trends of cheapening valuations over the course of 2011, diverging from the credit fundamentals that were being reported by many issuers.  Similar to the high-yield sector, the leveraged floating-rate bank loan market has also benefited from supportive fundamental credit trends. 

Finally, as typical, we have been viewing the financial market gyrations over the past year as longer-term investment opportunities.

Rafael Costas
Rafael Costas

Rafael Costas, Co-Director – Municipal Bond Department: Municipal Bond Market Overview
By now everybody knows that 2011 was, in the minds of many, a surprisingly strong year for municipal bonds, but it was, however, a pretty uneven year. If you’ll remember, the first part of the year was filled with negative headlines and underperformance following the tough end of 2010. However, by the end of the 2011, as people started to realize that the worst-case scenario—calling for hundreds of billions of dollars in defaults—was nowhere close to being what actually would happen, demand started coming up. Demand was also fueled by persistent fears about the global equity markets, particularly Europe, that sent more money coming back into the “perceived” safer investments of Treasuries and municipal bonds. We do want to make sure, however, that we temper expectations for 2012.  It was a great year, but to expect double-digit returns in municipal bonds is not realistic, it doesn’t match up with history.

I would caution everybody to be mindful of the really good numbers that some of our leveraged competitors may be posting. The leverage process amplifies returns in the upside, but it also amplifies them on the downside, and so before people get too enticed by double-digit returns, I remind them to look at the performance of any instrument on the down years—and you have plenty of examples recently—so you can see what the downside potential of those instruments is and decide whether you or your client can handle that kind of downside risk before you invest.

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