Anticipating a divided government with a Democratic-led House, Franklin Templeton professionals recently explored how the midterm elections could affect credit and interest rates, as well as the current opportunities in today’s market.
“We are going to see higher volatility over the next three to four weeks. A key reason for that is that the market has been sprinting toward the midterm elections rather than its usual crawl,” Jeff Schulze Franklin Templeton’s head of investment strategy said at a recent gathering.
“With a thin majority in the House and Republican control of the Senate, there’s going to be a higher likelihood of brinkmanship.” he said.
Meanwhile, Michael Salm, senior vice president and portfolio manager for Franklin Templeton Fixed Income, said that the outcome of the midterm elections doesn’t matter for the fiscal situation in the U.S.
“Neither party has a credible policy path to reducing expenses. Even the expenses they have at their disposal are mandatory spending. I don’t imagine they’ll trim that,” he said.
On the policy side, Salm said a major market focus is the capital expenditure in the artificial intelligence (AI) sector. Any policy that delays energized capacity stresses balance sheets and creates market obstacles. The moratorium in the U.S. today is mostly local, not national. These efforts haven’t stalled many projects, but grassroots activity is growing. Much of the bipartisan work tries to address these challenges, but it is not just a Democrat or Republican issue, he said.
Higher interest rates
Markets currently anticipate three Federal Reserve rate hikes over the next 12 months.
“At Franklin Templeton Fixed Income, we’ve held the view that rates are higher. When the Fed was cutting, we always said it wasn’t necessary,” Salm said. “There’s clearly a shift in how equilibrium rates are viewed, which is evident in the Fed’s statement of economic projections.”
All projections still point to higher equilibrium rates, the hypothetical short-term real interest rate where policy is neither stimulative nor restrictive, Salm said. More debt issuance competing for the savings pool is also raising the U.S. equilibrium rates. “At these higher rates, do we still see growth? The answer is yes,” Salm said.
Neither party has a credible policy path to reducing expenses. Even the expenses they have at their disposal are mandatory.
Consumers’ balance sheets are strong, with assets like housing and equities outweighing mortgage liabilities, especially borrowers who have refinanced. As a result, Fed rate moves have limited macro impact. Some vulnerable areas, such as auto loans, show signs of stress, but these are not widespread. Credit card rates remain steady, while lower-rated bonds face more challenges. Still, overall market pricing remains efficient due to solid growth expectations, Salm said.
“We are looking at what would be vulnerable to rates moving even higher, which is the scenario we are planning for next year’s outlook,” Salm said.
Opportunities in the securitization market
While the non-agency market has seen reasonable issuance, Salm said the concern is not consumer refinancing but deal structures with call options. As rates rise, these calls go out of the money, increasing the risk that some participants may not have hedged their positions properly, Salm explained.
Meanwhile, lending to commercial borrowers has improved. As the cost of capital increases, returns must be high enough for financing to make sense. Every rise in the equilibrium rate makes achieving an adequate return more challenging. However, loans on good properties that churn and are occupied could still be underwritten, Salm said.
“For the most part, in securitization, aside from certain issues in autos, the debt structures are so secure that distress rarely appears in prime credit cards and autos,” Salm said. “The main concern is subprime exposure. Otherwise, opportunities are limited, but the risk can be underwritten at a higher rate.”
