Harnessing the power of duration

THE investment landscape now is very different to 12 months ago, when there really was no alternative to equities, and investors were locked into a desperate search for yield across all asset classes. The US Federal Reserve’s singular focus on controlling inflation in 2022 resulted in an aggressive cycle of rate rises, which in turn tightened financial conditions, leading to a sharp rise in yields and spreads on fixed income assets.

A year ago, yields on high-quality credit did not seem attractive to us, prospects for total returns were poor, and bonds were not acting as a diversifier. Today, we believe the positive correlation with stocks is also breaking down, allowing fixed income to offset equity market volatility. As a result, Franklin Income Investors continues to invest with a preference for fixed income, moving closer to a 60/40 split in favour of bonds over equities.

Moving forward, our allocation decisions will be driven by what happens with interest rates and inflation this year. We believe the move higher in rates is likely almost done, but we expect a long pause from the Fed before any pivot, meaning our attention will be focused on the effect rate hikes have on the economy and inflation. The uncertainty lies in whether the lagged effect of tightening financial conditions and a more challenging growth environment results in a real pullback in fundamentals.