Reflections on Growing Economies and Fading Stimulus

2018 Global Investment Outlook

Long-Term Capital Markets ExpectationsDec 1, 2017

LONG-TERM OUTLOOK: “High levels of policy uncertainty and regional divergences will cause higher dispersion across and within asset classes, in our opinion, which increases the attractiveness of active management in both asset allocation and at the security-selection level.”

Long-Term Capital Market Expectations

Every year, a quantitative group within Franklin Templeton Multi-Asset Solutions reviews the data and themes driving capital markets in order to build asset return expectations for different asset classes for the next five to 10 years. Our long-term forecasts are based on our assessment of current valuation measures, economic growth and inflation prospects, as well as historical risk premiums. The text that follows summarizes our 2018 capital market expectations.

Analysis: Global Growth Has Improved and Inflation Is Likely to Remain Subdued

The global economy has experienced slower growth than was the historical pattern before the 2007–2009 global financial crisis. Productivity growth has been slower and uncertainties have remained high, but activity is picking up in many regions of the world, assisted by reform measures.

We live in an “Age of Reforms,” which in many cases have already supported stronger activity and in others promise improving global growth, in our assessment:

All reforms face criticism and doubt at the beginning. But in the end, they all tend to help the economy. We expect this trend to continue.

The reform agenda in the European Union has been slow and at times painful, but progress has been made since the eurozone sovereign debt crisis. The leading role that Europe now holds among developed economies, in terms of prospective growth, is at least in part due to the greater stability that these reforms have encouraged. The 2017 election of Emmanuel Macron as president of France adds to the prospect of further progress toward reforms.

“Abenomics”—the economic policies of Japanese Prime Minister Shinzo Abe—is already in the category of “proven to have helped.” Ongoing structural reforms in emerging markets generally, and specifically in China, appear to be making good progress, which we see as a big plus for global growth.

Globally, inflation has been persistently below-target and the outlook is mixed, as wage growth has disappointed consensus expectations given the employment growth seen in many economies. Many factors are holding back wage gains, not least being the impact of globalized markets. Technological advances such as artificial intelligence and demographic factors are also important, as aging populations add to excess savings while keeping interest rates low and inflation moderate. We intend to closely monitor nominal wage growth to see if any pickup in it can help boost inflation.

View #1: We Favor Global Equities over Global Bonds

We believe global stocks have greater performance potential than global bonds, over the next five to 10 years, in an environment of reform measures, improving global growth and moderate inflation.

Equity markets have appreciated sharply in recent years, and valuations, based on price-to-earnings ratios, in developed markets were not cheap relative to their historical averages as of late 2017. However, we believe equities can continue to trade at significantly higher multiples than was the case in the 1970s and 1980s. The relative balance of power remains with global corporations, and the weakness of labor’s bargaining power supports the profit share of gross domestic product (GDP). In our analysis, it is earnings growth that supports the outlook for stocks.

Global bonds are vulnerable due to low current yields, depressed term premia1 and the desire of developed-market central banks to unwind unconventional policies. Demographics and subdued productivity growth will likely keep yields low. Despite this, current depressed yields provide a limited cushion for even modest interest-rate increases.

Analysis: Emerging Markets Have Recovered and Become More Resilient

Emerging economies have demonstrated a much higher growth potential, notably in China and India, and their share of global GDP has increased consistently since 2009. Although their growth rates have slowed, their share of GDP has continued to increase and the importance of these countries to the pace of global growth has also increased.

Fortunately, as the importance of the emerging-market economies has increased, so the stability of these countries has improved. Enhanced macroeconomic self-control, increased domestic consumption, reduced dependence on the United States as a trading partner and higher currency reserves have improved their fiscal flexibility. As a result, more countries can issue local-currency denominated bonds, rather than be dependent on “hard-currency” debt. It has also brought greater freedom to their monetary policies, with no need to move in lockstep with the US Federal Reserve.

Growing Importance of Emerging-Market Growth

Relative Nominal GDP of G7 and BRIC Economies

BRC: 38%  G7: 62%

BRC: 45%  G7: 55%

BRC: 51%  G7: 49%

Source: OECD, FTMAS. The G7 comprises seven countries: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. BRIC countries are Brazil, Russia, India and China. Forecast as of 6/30/17. There is no assurance that any forecast will be realized.

View #2: We Favor Emerging Markets over Developed Markets

In both stocks and bonds, we believe the performance potential in emerging markets will exceed that of developed markets over the next five to 10 years.

Emerging markets’ higher productivity growth rates are likely to persist. Conventional monetary policy appears to be controlling inflation. Over the longer term, we expect increasing productivity should also result in a broad appreciation in emerging-market currencies. Such trends support the return potential of unhedged positions to both stocks and bonds in emerging markets and may drive asset flows into these investments.

In contrast, the pressures on developed economies remain acute. Even with unorthodox monetary policy, the developed world is struggling to bring inflation back on track. The “demographic time-bomb” of aging populations is likely to hold down yields and limit the growth that supports stock prices. Intergenerational stresses may be compounded by social imbalances, a middle-income wealth squeeze and the rise of populism.

Risk Considerations and Conclusion

A rising rate cycle and uncertainty about reform measures pose risks to economic growth and financial markets. However, investors appeared well aware of these threats and positioned cautiously in late 2017. Stock valuations will need to be watched closely in the medium term as we remain vigilant against a buildup of financial stability risks.

Going forward, we expect long-term performance potential for numerous asset classes to be positive but subdued. High levels of policy uncertainty and regional divergences will cause higher dispersion across and within asset classes, in our opinion, which increases the attractiveness of active management in both asset allocation and at the security-selection level. The generally low financial market volatility level during 2017 is unlikely to persist. Given our subdued return expectation, we would not be surprised to see volatility rebound down the road.


Michael Hasenstab, Ph.D.

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