Investors got a preview of how fixed income markets might respond to a return of inflation when US Treasury yields rose by around 75 basis points and asset prices fell sharply in the March quarter.
Portfolio Manager Brian Kloss at Brandywine Global, a specialist investment manager of Franklin Templeton, said the lesson income investors must learn from the March quarter bond sell-off was that global corporate credit is a good place to strike the right balance between identifying the opportunities from the post-COVID global economic recovery and insulating their portfolios from a pick-up in inflation.
“In the near term, investment grade corporate bond spreads could see another 20 basis points of tightening and below-investment grade corporate bond spreads could tighten by 50 to 100 basis points,” Kloss said.
“We are constructive on corporate credit, especially at the shorter end of the curve, but opportunities will be selective and uneven. Active management will be the key.”
Kloss says that if inflation returns for real, and assuming it is the result of stronger economic growth, longer-duration assets will be repriced across the quality spectrum.
“In this scenario we would expect more equity-like assets, lower-quality securities with shorter maturities and pricing power, to outperform other fixed income segments,” he says.
In terms of industry sectors, Kloss favours commodities and basic materials, which are poised to benefit from the post-pandemic economic reopening.
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“We are also focused on those entities that have pricing power as a potential hedge against rising prices,” he says.
Kloss is part of the team that looks after the Brandywine Global Income Optimiser Fund, which returned 6.19% (net of fees) for the 12 months to the end of July and has produced an average return of 8.34% a year over the past three years.
Kloss said: “Current asset price profiles imply expectations for strong and long-lasting economic growth, a transitory spike in inflation, and a smooth tapering of the Federal Reserve’s balance sheet at some point in the future.
“There are no guarantees surrounding this sanguine view and there is no historical recovery road map for navigating a world full of pandemic-related distortions, along with substantial stimulus measures set to be dialled back at various stages. It is too soon to answer the inflation question.”
