New Year's Vantage Point: Christopher Molumphy

For a view on the U.S. and global fixed income market and potential opportunities therein, we turn to Christopher Molumphy, CFA, chief investment officer of Franklin Templeton Fixed Income Group© .

We entered 2012 cautiously optimistic about U.S. economic growth even though the U.S. economy experienced stagnant wage levels and stubborn unemployment levels coupled with struggling residential housing and commercial real estate markets. Given the severe recession, combined with the financial crisis, from which the U.S. has been recovering, expectations for growth both today and going forward continue to be appropriately muted.

As we enter 2013, however, we remain reasonably constructive on the U.S. economy. Overall, the U.S. consumer has made progress in reducing debt balances, the unemployment rate has continued to decline, corporations have remained healthy, and we think the housing sector has likely bottomed and should continue to improve gradually. However, headwinds do remain. When we look at the U.S. debt situation, it very much concerns us that going into this fourth post-recession year, we simply do not see any credible plan to reduce this deficit on a go-forward basis. While we don’t necessarily see this as being an immediate issue, we are very much concerned that the lack of ability to manage a very serious debt problem will negatively impact the markets. Many were closely monitoring the fiscal cliff negotiations for some sign of progress in this area. While Congressional action on January 1 provided a temporary patch and time for further negotiation, a more definitive resolution could still be some time away. In the meantime, much remains unknown about the impact of future fiscal and tax policies on investor sentiment.

Europe’s economy, on the other hand, is anemic at best, and we don’t see much growth potential there over the next couple of years as it struggles through a deleveraging cycle. China, in contrast, has been a tremendous success story, in our view, and has grown by double-digit rates for many years to the point where it is now one of the largest economies in the world. Given how large the economy has gotten, expecting it to continue to grow at double-digit rates is probably a bit unrealistic. Quite frankly, we think growth rates in the mid-to-high single digits on a percentage basis, particularly in this anemic global growth environment, would be extremely healthy.

In this environment of sluggish growth, we think a number of fixed income sectors still hold some potential for investors. For example, global fixed income sectors continue to look attractive to us. Outside the U.S., many regions and countries with better fiscal conditions have continued to issue debt with higher yields than the debt of their peers. We believe the corporate fixed income sector, including high-yield debt, bank loans and investment-grade debt, continue to hold reasonable valuations. Municipal bonds have also held up well, as many municipalities have made progress in reducing costs and managing their debt. In an environment in which tax rates look likely to rise in the near future, we think municipal securities are likely to hold even greater appeal than in the past.

All investments involve risk, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. When interest rates rise, bond prices fall, and the converse is true. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. In general, an investor is paid a higher yield to assume a greater degree of credit risk.

Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets involve heightened risks related to the same factors, in addition to those associated with their relatively small size and lesser liquidity.

For municipal bond investors subject to the alternative minimum tax, dividends may be taxable. Distributions of capital gains are generally taxable.

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© Franklin Templeton Investments

© Franklin Templeton Investments

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