Summary
We currently see heightened volatility in fixed income markets as higher energy prices and resilient growth push up bond yields.
This has pressured equity valuations and resulted in an increasingly positive correlation between stocks and bonds, while also highlighting the importance of additional diversifiers within investment portfolios.
In this month’s edition of Allocation Views, we explore how consistently strong economic growth and corporate earnings demand a positive attitude toward risk, even in the face of uncertainties such as geopolitics, persistent inflation and monetary policy tightening.
As our constructive view on equities holds firm, we also see increasing value in government bonds as markets price in multiple interest-rate rises, pushing yields to attractive levels.
Macro Themes
Strong Growth
- Macro growth remains strong, supported by robust corporate earnings power.
- The US economy has proven especially resilient. Estimates of US growth are above trend, while the labor market appears stable.
- Leading economic indicators look healthy and business activity has improved, but we are monitoring the impact of higher rates and input costs.
Complicated Inflation
- The US inflation picture remains challenged by a prolonged period of elevated core readings, despite improvement in recent data.
- We expect limited second-order effects from the energy impulse, as supply-driven inflation reduces real incomes and suppresses consumer spending.
- Core goods inflation has marginally improved. Tariff pressures have waned, but we are monitoring global supply chain tightness.
Tighter Monetary Policy
- Heightened tensions in the Middle East have catalyzed a recalibration of policy expectations, with a tightening bias in all major regions, including the United States.
- The market now expects a more hawkish Federal Open Market Committee (FOMC) as Federal Reserve (Fed) Chair Kevin Warsh focuses on reinforcing the central bank’s credibility.
- US midterm elections should have little impact on fiscal policy or bond yields, although debates on budgets and the debt ceiling may cause some volatility in bond markets.
Portfolio Themes
Cross-Asset: Risk-On
- Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
- Macro growth remains constructive but is offset by a complicated inflation and policy backdrop.
- Sentiment and positioning are becoming more exuberant but, in our view, are not yet at levels of concern.
Equity Diversification
- Our equity exposure is tilted toward artificial intelligence (AI), reflected in overweight exposure to the United States, emerging markets (EMs), and Japan.
- Optimism around US earnings breadth is confined to large-cap stocks, as higher interest rates disproportionately affect small-cap earnings.
- Australian equities remain our least-preferred region due to a mixture of weak domestic growth, unsupportive fiscal policies and tight monetary policy.
Value in Duration
- We expect higher energy prices to create more demand destruction than market pricing suggests, decreasing the chance that major central banks meet market hiking expectations.
- We upgrade our view of US Treasuries as markets have appropriately priced in the US reflationary macro backdrop.
- Excess returns for equities appear more attractive than those for credit, amid strong earnings and tight spreads.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. To the extent a strategy invests in companies in a specific country or region, it may experience greater volatility than a strategy that is more broadly diversified geographically.
Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
Investing in privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity.
Active management does not ensure gains or protect against market declines. Diversification does not guarantee a profit or protect against a loss.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.