Uncertainty and opportunity

With a sharp deterioration in market sentiment our Allocation Views focus on the macroeconomic backdrop affecting market fundamentals

Franklin Templeton Multi-Asset Solutions

In this issue

In this issue, we describe a framework to help us work through a sharp deterioration in market sentiment. As policymakers are called upon to provide support to the global economy, we focus on how the evolving macroeconomic backdrop is affecting market fundamentals, and adjust our asset allocation views accordingly.

Over a longer-term horizon, we believe global stocks have greater performance potential than global bonds, but that this outlook will not be reached along a smooth path. We have moved to increase our conviction on global equities, though we see this as an incremental move rather than a bold jump into riskier investments.

Major themes driving our views

  • Near-term headwinds to global growth
    The new coronavirus outbreak presents a significant headwind to growth momentum, increasing the risk of recession in a number of economies. Our economic outlook remains cautious, but we look through this to recovery within 12 months. With profit margins having peaked, this is likely to present an ongoing headwind for business investment intentions.

  • Subdued inflation across economies
    Inflation expectations have fallen to historical lows, and various central banks are struggling to engineer a revival. A deficit in demand is likely to be the key driver of disinflation. The ability of corporations to pass costs on to consumers appears limited, increasing pressure on profit margins.

  • Dovish bias to monetary policy
    In responding to the current virus crisis, policymakers are approaching the limits of conventional monetary policy. Major central banks are reviewing their mandates, which could result in more symmetrical inflation targets. We question whether the political will exists to increase the role of fiscal policy.

Practical positioning

  • Nimble management required as opportunities appear
    We believe it is important to maintain diversified portfolios, particularly in times of increasing investment uncertainty. However, even against a backdrop of slower growth, global equities have become cheaper, in our analysis. We have now started to increase our conviction on global equities.

  • Bond valuations are also stretched
    In a multi-asset portfolio, we seek assets that provide the potential for diversification. Bonds traditionally fulfil that role. Global bonds—especially long-duration issues— appear vulnerable due to low term premia. However, slower growth and subdued inflation balance this, leaving us only modestly defensive in our overall levels of conviction.

  • Volatility tends not to persist
    Over recent quarters, we have highlighted a return to long-run levels of market volatility that indicate we have entered a new volatility regime. However, current extreme conditions are unlikely to persist. We continue to believe navigating the challenges the year ahead presents will require nimble management.

Major themes driving our views

Growth will be impacted

Financial markets have been jolted out of a period of growing optimism about the outlook for the global economy. Markets perceive the threat to life and livelihood the new coronavirus (COVID- 19) poses as very real. We anticipate this factor will likely continue to drive news coverage and financial market reaction for weeks, and perhaps months, to come.

As we meet to discuss our outlook for markets and the appropriate course of action we might follow in reviewing our conviction level across a range of available investments, we recognize that uncertainties have grown. We also recognize the limitations of our, or any other financial market participant’s, expertise. We are not virologists, though few of us can resist the compulsion to read voraciously on this topic.

But we cannot ignore the impact of the coronavirus on economies or markets. We have sought a framework to help us work through this. As we published in our recent Beyond Bulls and Bears blog post, we continue to follow a process that resists the temptation to trade around news flow and emotion. Instead, we focus on how the evolving macroeconomic backdrop is affecting market fundamentals, and we adjust our asset allocation views accordingly.

Global economic activity outside of China remains resilient for now and was picking up quite recently (see Exhibit 1), but it is widely expected to deteriorate over the coming weeks. This contributes to the immediate rationale for recent market volatility. We can use the experience of China as a leading indicator of what to expect in other countries— although the extent of containment measures enacted in China might not be repeated in many other political regimes. The ability to “lock down” entire countries, as Italy is now attempting, will challenge the powers of government in liberal democracies.

SIGNS OF STABILIZATION IN GERMANYExhibit 1: Manufacturing and Services Purchasing Managers’ Indexes (PMI) November 2016–February 2020

Sources: Franklin Templeton Capital Market Insights Group, IHS Markit, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. The PMIs represent economic trends in manufacturing and service sectors. A reading above 50 indicates that the sector is generally expanding; below 50 indicates that it is generally declining.

Even as a rolling sequence of supply and demand shocks starts to be applied to the rest of the world, China appears to have passed the trough in its level of corporate activity. However, the ability of China to take advantage of this return to work may be dampened by softer demand in other economies. Similarly, the boost to confidence and spending power from lower interest rates and commodity prices, along with fiscal stimulus measures that are increasingly common across geographies, may be limited. In the first instance, nervous consumers are likely to save rather than spend any windfall. Corporate investment plans may be similarly constrained. Only as the crisis passes would we expect a sustained improvement in activity.

The signals that we are looking for are aligned to the root cause of the current crisis. Examples would be a continuation of better news out of China, with no re-acceleration of COVID-19 cases there. We are also looking at the evolution of the containment and health care response in other countries, hoping to eventually see a peak in the growth of new infections outside of China.

As a base case, after a sharp hit in the next few months, we expect continued but slow global growth and moderate inflation over the long term. With relatively few imbalances prior to this virus threat, the global economy was less vulnerable to a correction. For economies that do succumb to a disproportionate virus and economic hit, we do not foresee deep or lasting recessions. However, reflecting the balance of issues noted above, we are focused on the potential for the risks in the near term to remain skewed to the downside. As a result, this leaves us with a relatively cautious view, encapsulated in our theme that sees “Near-Term Headwinds to Global Growth.”

Inflation expectations remain modest

Over recent months, we have noted that geopolitical risks might present an upside risk to inflation. Indeed, the rise in oil prices earlier this year could have been seen as a textbook example of this effect. Our base case remains that inflationary pressures remain modest. However, heightened coronavirus concerns and the associated weakness in commodity prices have switched the risk to headline inflation to the downside.

Market-based measures of inflation expectations, derived from the yields of nominal and real return bonds, have fallen precipitously. These so-called breakeven inflation rates (where the prospective returns on nominal and real return bonds are equal) responded directly to headline inflation and the sharp decline in oil prices. A breakdown in attempts by the Organization of the Petroleum Exporting Countries (OPEC) to manage production levels and support prices has morphed into a battle for market share. Continued disagreement between Russia and Saudi Arabia, and attempts to put pressure on higher-cost marginal producers, may keep oil prices at current depressed levels, in our opinion.

Looking more deeply, the level of breakeven inflation over the five-year period starting five years from now (the 5-year/5-year forward rate) has been instrumental to this move (see Exhibit 2). This may largely reflect a decline in the risk premium for inflation uncertainty, as government bond yields have also fallen dramatically.

We continue to believe, for now, that the primary drivers of inflation are trends in demand. As a result, the deceleration in global growth that we saw in 2019 is anticipated to cap inflation during 2020. The further interruption to growth that is probable as a result of coronavirus— and its impact on global demand—will reinforce this trend. This effect has been felt broadly, including in emerging markets, reinforcing our theme that sees “Subdued Inflation Across Economies.”

INFLATION EXPECTATIONS ARE DEPRESSEDExhibit 2: Household In Inflation Expectations Follow Market Level Lower (January 2004–March 12, 2020)

Sources: Franklin Templeton Capital Market Insights Group, Bloomberg, Factset, Macrobod, University of Michigan, St. Louis Fed. Important data provider notices and terms available at www.franklintempletondatasources.com.

Policy response will be key

A sharp jump in market volatility occurred in late February, reflecting the threats to global growth the coronavirus poses. Stock markets reversed direction, shortly after some posted new all-time highs, and declines accelerated. In tandem, government bonds rallied, and US Treasury note yields fell below levels that had been reached in late January and before that in summer 2019.

The US Federal Reserve (Fed) reacted to the decline in sentiment and primed market participants to expect a change in policy that was already being discounted in bond yields. In early March, the Fed cut the federal funds target rate by 50 basis points (to a 1% to 1.25% range), easing monetary policy in an unscheduled move between regular meetings for the first time since October 2008.

The Fed’s action was widely anticipated by the time it was delivered, but in the short term it does not seem to have stemmed the flow of negative sentiment. By firing its limited ammunition early, the central bank was hoping to maximize the impact on the economy. However, judged by the market reaction, and anticipation of further sharp cuts, the Fed appears to be reacting to market events rather than leading. However, we have seen a growing list of similar moves, with the Bank of England recently delivering a package of measures to support the economy. Exhibit 3 shows a map of countries that have cut rates this year.

We continue to believe that central banks in the developed world will show a policy response asymmetry more broadly. This reflects a common concern that inflation is undershooting their targets and a fear that inflation expectations might become un-anchored. This may also reflect attempts to calm financial markets and is reflected in our final theme of a “Dovish Bias to Monetary Policy.”

CENTRAL BANKS AROUND THE WORLD ARE PROVIDING MONETARY STIMULUSExhibit 3: Countries Providing Monetary Stimulus in 2020 (As of March 12, 2020)

Sources: Bloomberg. Note: Map shows rate decisions since start of 2020.

We do not believe that monetary policy alone is a sufficient response to the combined supply and demand shocks that the global economy is experiencing. A greater role for fiscal policy in the next downturn was among our Investment Symposium themes, as discussed in our Allocation Views publications over recent months.

In economies with less scope to cut interest rates, such as the eurozone, we expect fiscal policy will need to play a larger role. In general, however, this policy response will struggle to offset the direct effect of economic slowdown, but might simply lessen the second-order effects and aid the eventual recovery when it comes.

Practical positioning

Nimble management required as opportunities appear

As we face near-term uncertainties, it is worth repeating the conclusions that we shared in December, focusing on the longer-term outlook.



“ We incorporate the longer-term themes that we discussed at our Annual Investment Symposium into our research process, helping to set the direction for our portfolios and the benchmarks that we agree with clients.

Over this longer-term horizon, we believe global stocks have greater performance potential than global bonds, supported by continued growth. Within both bonds and equities, we continue to forecast stronger return potential for emerging markets. And with short-term interest rates and government bond term premia remaining below historical averages, we see a lower performance potential from government bonds.”



Our investment approach aims to look through some of the shorter-term noise and retain a clarity of focus. The key conclusion of our last blog post on the coronavirus stressed that we believe it is important to maintain diversified portfolios, particularly in times of increasing investment uncertainty. This approach has proven to be beneficial over the last several weeks as volatility has picked up in equity, fixed income and commodity markets.

However, we also need to balance longer-term economic prospects and the dynamics that drive shorter-term market moves. Uncertainty over policy response, and its efficacy, leaves the outlook more clouded than usual. As we proceed toward the latter part of an unusually long economic expansion in the United States, we need to recognize that our longer-term outlook may not be reached along a smooth path. Although we focus on the longer-term return potential for stocks, and believe that they should earn their equity risk premium over time, we continue to balance this with shorter-term concerns that have tempered our enthusiasm. But, even against a backdrop of slower growth, global equities have become cheaper, in our analysis.

Having scaled back our cautious stance on risk assets last quarter, we have now started to increase our conviction on global equities. This is an incremental move rather than a bold jump into riskier investments. Our view reflects the balance between longer-terms growth attractions and evident concern over the virus threat. In broad terms, bonds have become more highly valued and equity valuations have improved, but we do not yet view them as cheap in a historical context (see Exhibit 4).

EQUITY VALUATIONS HAVE IMPROVED BUT ARE NOT YET CHEAPExhibit 4: MSCI AC World Index Forward P/E Price Bands (July 1994–March 12, 2020)

Sources: Franklin Templeton Capital Market Insights Group, MSCI, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.

Bond valuations are also stretched

One of the most striking features of our longer-term analysis is that the return potential from global bonds, especially government bonds, is depressed. This largely reflects the fact that current yields are at historical lows. However, we note that depressed yields also reflect demographics and demand for matching assets, which are likely to persist. This shows up in the “term premium,” the difference between the current bond yield and the average level for short-term interest rates over the life of the bond (see Exhibit 5).

US TREASURY YIELDS REMAIN EXPENSIVEExhibit 5: 10-Year US Treasury Term Premium (November 2016–March 11, 2020)

Sources: Franklin Templeton Capital Market Insights Group, Federal Reserve Bank of New York, Bloomberg. Important data notices and terms available at www.franklintempletondatasources.com.

In a multi-asset portfolio, we need to hold assets that provide the potential for diversification. Bonds traditionally fulfil that role. Global bonds—especially high credit quality and long-duration issues—appear vulnerable due to low term premia. However, slower growth and subdued inflation balance this in our overall view of the asset class, leaving us only modestly defensive in our overall levels of conviction.

Volatility tends not to persist

When we look at the current market environment, one of the most prominent features has been the rise in volatility. A return to long-run levels of volatility since early 2018, rather than the muted levels seen for much of the previous 10 years, indicates that we have entered a new volatility regime.

However, current extreme conditions are unlikely to persist, and will be resolved one way or another, seeing volatility fall and risk premia validated or reversed. Market expectations for future inflation and for central bank policy responses have an element of this uncertainty embedded within them. As a result, the passage of time will likely see tensions ease, even if the path of growth falters. Markets prefer clarity to uncertainty almost all of the time.

We continue to look for opportunities to take advantage of valuations we regard as attractive while maintaining a broadly diversified portfolio. Periods of dislocation in markets and sharp adjustments to economic expectations often present new opportunities. We continue to believe that navigating the challenges the year ahead presents will require nimble management.



Franklin Templeton Thinks: Allocation Views
Our research process monitors a consistent set of objective indicators and screens them to identify signals that help our analysts to make better recommendations. By doing this we aim to filter out the daily noise to reveal the underlying trend.

Our macro-economic research group aims to challenge the consensus forecasts for growth and inflation by digging deeper into the data. Just as important, we aim not to be swayed unduly by topics that are dominating current market debate.



Editorial review

Ed Perks, CFA Chief Investment Officer,
Franklin Templeton Multi-Asset Solutions

Gene Podkaminer, CFA Head of Multi-Asset Research Strategies,
Chair of Investment Strategy & Research Committee,
Franklin Templeton Multi-Asset Solutions