Expectations Diverge

Allocation Views explores implications of the broad-based stock rally this year which extended a notable divergence to the views being reflected in bond markets.

Franklin Templeton Multi-Asset Solutions

Preview

The global economy is slowing, trade tensions dominate investor sentiment and inflation in the major economies is subdued. A broad-based stock rally in the early part of this year extended a notable divergence against the less optimistic views being reflected in government bond markets and expressed by central bankers who continue to back away from the planned normalization of monetary policy.

Various markets and their participants appear to be discounting different degrees of monetary support from central banks, some of whom are constrained in their ability to behave proactively. Any failure to manage these expectations could result in a loss of confidence among investors. Bond yields may increase, placing renewed pressure on equity markets. The alternative scenario, where growth continues to disappoint, might lead to additional rate cuts, but this is hardly an optimistic one for stocks.

Major themes driving our views

  • Slower global growth remains a concern
    Growth in the major economies is starting to reflect the impact of trade uncertainties as investors’ sentiment was hit due to suddenly hardened rhetoric and an escalation toward a trade war between the United States and China that seemed more imminent. This is likely to present a headwind for business investment intentions.

  • Subdued inflation in major economies
    Global central banks are struggling to revive inflation expectations which remain close to historical lows. Corporate fundamentals remain relatively strong despite the moderation in global growth. At the same time, their ability to pass costs on to consumers appears limited, putting pressure on margins.

  • Ongoing policy tensions
    The global economy is slowing, trade tensions dominate investor sentiment and inflation in the major economies is subdued. However, perhaps the most important of our investment themes is the fact that policymakers seem unable to plot an easy course through the current environment.

Practical considerations

  • Transition to a range-trading environment
    Over recent months, we have highlighted a return to long-run levels of market volatility rather than the muted levels seen for much of the past 10 years. This indicates that we have entered a new volatility regime. We believed that a change of mindset might be required as markets transition from a momentum-driven to a range-trading environment.

  • Some central banks may not be able to do much
    Most major economies are struggling to generate adequate levels of inflation, but some central banks are more constrained than others in the policy action they can take. The ECB is particularly constrained at this time as Mario Draghi moves toward the end of his term as ECB President and the search for his successor highlights differences of opinion between key nations in the currency union.

  • Bonds remain expensive generally
    We continue to view sovereign bond yields as depressed, reflecting the demographics of an aging population and the demand for matching assets from pension plans. The decline in recent months has been accompanied by a reduction in the term premium to multi-decade lows, reflecting fresh demand for bonds even at these low levels.

 

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The positioning of a specific portfolio may differ from the information presented herein due to various factors, including, but not limited to, allocations from the core portfolio and specific investment objectives, guidelines, strategy and restrictions of a portfolio. There is no assurance any forecast, projection or estimate will be realized. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Derivatives, including currency management strategies, involve costs and can create economic leverage in a portfolio which may result in significant volatility and cause the portfolio to participate in losses (as well as enable gains) on an amount that exceeds the portfolio’s initial investment. A strategy may not achieve the anticipated benefits, and may realize losses, when a counterparty fails to perform as promised. Currency rates may fluctuate significantly over short periods of time and can reduce returns. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector—prices of such securities can be volatile, particularly over the short term.