MARCH 2019 Slower growth— equity caution · 2 Slower growth—equity caution In this Issue Major...

For Institutional Investor and Consultant Use Only. Not for Distribution to the General Public.

MARCH 2019

ALLOCATION VIEWSFRANKLIN TEMPLETON THINKSTM

Slower growth—equity caution


2 Slower growth—equity caution

In this Issue

Major themes driving our views• Slower global growth remains a concern

Global growth has slowed, reflecting the impact of trade uncertainties. New export orders have been falling sharply for the past year and we should expect a continued period of economic slowdown through the middle of the year. As a result, we have started to scale back riskier assets, reducing our conviction in equities and high-yield corporate bonds, in favor of defensive assets, where diversification benefits might accrue.

• Subdued inflation in major economies Corporate fundamentals remain relatively strong despite the moderation in global growth, but the broad inflationary environment remains benign. This combination of factors may start to weigh on profit margins and is likely to slow the pace of earnings growth.

• Central bank policy dilemmas In addition, a lower oil price that remains below recent peaks has fed into a decline in broad inflation, and core measures remain subdued. While it is too early to rule out further interest rate increases this cycle, the impact on market sentiment, if the US Federal Reserve (Fed) were to return to tightening policy, may be significant.

Practical considerations• Transition to a range-trading environment

A return to long-run levels of market volatility since early 2018, indicates that we have entered a new volatility regime. More generally, we believed a change of mind-set might be required as markets transition from a momen-tum-driven to a range-trading environment.

• We are finding the best prospects in emerging markets We remain positive on the longer-term growth potential of emerging markets. We are increasingly comfortable in taking solace from the longer-term attractions of these markets.

• Fewer attractions in Japan Japanese stocks are vulnerable to Japan’s position as an open economy and its perceived role as the “canary in the coal mine” of global trade.

We do not hold an apocalyptic view or see a high probability of imminent global recession.

We still recognize the longer-term attractions of stocks and the value in certain segments.

However, we believe it will require nimble management to navigate the challenges that

2019 present.


Slower growth—equity caution 3

Major themes driving our views

Slower global growth remains a concernThe global outlook remains clouded. Growth in the major economies has already slowed, and the impact of trade uncertainties is yet to be fully captured in official statistics. We are monitoring indicators such as new export orders, which have been falling sharply for the past year. They typically foretell the level of trade activity in the following three to six months. As they have yet to show any sign of rebound, we should expect a continued period of economic slowdown through the middle of the year. As a result, we have started to scale back riskier assets, reducing our conviction in equities and high-yield corporate bonds, in favor of defensive assets, where diversification benefits might accrue.

Much of this weakness can be traced back to China and regional trading partners that have felt this weakness most acutely. Japan has suffered a sharp deterioration in exports, and a closely watched indicator of new orders for industrial machinery (see Exhibit 1) has fallen to new lows. As a result, we have seen continued pressure on Japanese stocks, which are more exposed to global trade than most developed markets.

The outlook for Europe is impacted by similar structural sensitivities to global trade. Although the immediate concerns over US-China tariffs might pass, the hit to confidence is likely to take longer to dissipate (see Exhibit 2). Similarly, regional politics remain a concern, with Brexit yet to be resolved and upcoming European Parliament elections high-lighting the threat of a rise in populism.

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JAPAN FACING SHARP DECLINES IN INDUSTRIAL MACHINERY EXPORTSExhibit 1: Japan machine tool orders (year-over-year)January 2013–January 2019

Source: Franklin Templeton Capital Market Insights Group, Macrobond, Japan Machine Tool Builders' Association.

Jan 2013 Jan 2014 Jan 2015 Jan 2016 Jan 2017 Jan 2018 Jan 2019

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EUROPE AFFECTED BOTH BY GLOBAL TRADE AND REGIONAL ISSUESExhibit 2: Markit Eurozone Manufacturing PMI IndexMarch 2016–February 2019

Source: Franklin Templeton Capital Market Insights Group, Bloomberg, IHSMarkit.

Mar2016

Jun2016

Sep2016

Dec2016

Mar2017

Jun2017

Sep2017

Dec2017

Mar2018

Jun2018

Sep2018

Feb2019



3%

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1%

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% Change

CORE INFLATION REMAINS SUBDUEDExhibit 3: US Consumer Price Index (CPI) vs. Core CPI, year-over-year changeOctober 2008–January 2019

Source: Franklin Templeton Capital Market Insights Group, FactSet, Bureau of Labor Statistics. Important data provider notices and terms available at www.franklintempletondatasources.com.

Oct2008

Oct2009

Oct2010

Oct2011

Oct2012

Oct2013

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Jan2019

All items Total excluding food and energy

Although the current economic expan-sion is moving into its latter stages, and stimulus from earlier fiscal measures will soon fade, we do not view the US as being at significant risk of an imminent recession. However, global headwinds are a risk to this assessment.

Subdued inflation in major economiesCorporate fundamentals remain rela-tively strong despite the moderation in global growth. This is likely to help validate global equity valuations. However, with labor markets tight in many leading economies, wage growth appears to be picking up, to an extent, but the broad inflationary envi-ronment remains benign. This combination of factors may start to weigh on profit margins and is likely to slow the pace of earnings growth. To reflect this, we trimmed our convic-tion in US stocks earlier this year.

In addition, a lower oil price that remains below recent peaks has fed into a decline in broad inflation, and core measures remain subdued (see Exhibit 3). As a result of our muted inflation outlook, we maintain a more neutral view of real assets such as commodities and inflation-linked bonds (Treasury Inflation-Protected Securities, or TIPS).

Central bank policy dilemmasThe major central banks are facing a policy dilemma: they are struggling to find a clear direction, buffeted by global trade concerns and a loss of confidence in their ability to target even the modest levels of inflation that they desire.

This dilemma has been ongoing in Japan for many years but appears to be growing in Europe and returning in the United States. Since the turn of the

year, the Fed has successfully engineered a pivot to a more patient approach and a data-dependent response function. The market no longer expects any monetary policy action in the next few quarters and is moving toward discounting interest-rate cuts as the next move. We would question whether the economic outlook justifies such a clear change of direction, but it is evident that the central bank does not want to take unnecessary risks with the health of the economy (and markets) while inflation is subdued.

Even in key emerging markets, clearly stated long-term policy objectives are being overtaken by the need to support short-term activity. This is particularly true in China, where efforts to control the expansion of household debt have been superseded by a need to stabilize growth. However, we expect that a reluctance to flood the economy with

liquidity will leave more of the “heavy lifting” to be done by infrastructure spending and fiscal policy. Action thus far has already helped to lift markets in China and improve global investor sentiment.

By the summer, we may have greater clarity on both the extent of global economic weakness and the US central bank’s approach to its inflation target. While it is too early to rule out further interest rate increases this cycle, the impact on market sentiment, if the Fed were to return to tightening policy, may be significant.



Transition to a range-trading environmentOver recent months, we have high-lighted continued uncertainties in markets and the global economy. Although we recognized the longer-term return potential for stocks, we continued to point to shorter-term concerns that tempered our enthusiasm. A return to long-run levels of market volatility since early 2018, rather than the muted levels seen for much of the past 10 years, indicates that we have entered a new volatility regime.

More generally, a rational desire to expand the “defensible space” within portfolios has seen many inves-tors shift toward cash and higher-grade bonds and away from equities. We believe a change of mind-set might be required as markets transition from a momentum-driven to a range-trading environment.

The strong rebound in global equity markets since the start of 2019 has been driven by a recovery in sentiment. Investors have taken solace in the longer-term attractions of risk assets more broadly and comfort from the response of global central banks (see Exhibit 4). The Fed (with support from the Peoples Bank of China) has been able to control a sharp bout of market-induced nervousness. However, from here, it is unclear how much further support a “data-driven” Fed can provide.

If growth stabilizes, the fear of a tight labor market leading to a pickup of inflation may prompt the need for renewed monetary policy tightening. This would likely dent sentiment. The alternative scenario, where growth

continues to disappoint and profitability starts to dip, might lead to an eventual cut in rates, but this is hardly an opti-mistic one for stocks.

We have started to scale back our conviction in equity investments as a result of the points presented above and reflecting the change in mind-set that we highlighted. We do not hold an apoc-alyptic view or see a high probability of imminent global recession—although certain European economies are getting closer to that point. We still recognize the longer-term attractions of stocks and the value in certain segments, notably emerging markets. However, global equities as a whole are not cheap (see Exhibit 5), and the risk is that we are getting closer to peak profitability. We believe it will require nimble management to navigate the challenges that 2019 presents.

We Are Finding the Best Prospects in Emerging MarketsFinancial conditions indexes are a good measure of the headwinds that investors face when buying riskier assets such as high-yield corporate bonds or equities. The tightening of conditions seen in the final quarter of 2018 was a notable impediment to global markets. The subsequent easing supported the rebound we have seen in the early months of this year. However, more specific headwinds for emerging markets appeared to ease late last year, as a softer US dollar allowed a recovery in emerging-market currencies and prompted investors to redeploy assets into these markets.

The longer-term arguments in favor of emerging-market investments over their

Practical positioning

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SHARP REBOUND IN NON-INVESTMENT-GRADE CREDITExhibit 4: ICE BAML (US) High Yield IndexJanuary 2018–February 2019

Source: Franklin Templeton Capital Market Insights Group, Bloomberg. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future performance.

Jan01 2018

Jan30

Feb27

Mar27

Apr24

May22

Jun19

Jul17

Aug14

Sep11

Oct09

Nov06

Dec04

Jan 012019

Jan29

Feb26



developed-market peers were detailed in our Capital Market Expectations (CME) report. The latest review of our seven-year-horizon forecasts was published in December and highlighted attractions that centered around productivity gains from development and higher rates of gross domestic product growth. These are intrinsically secular arguments.

In addition to the “CME-horizon” outlook, emerging-market stocks continue to offer more attractive valua-tions, in our opinion. When measured on the basis of price-to-earnings, -sales and -book value, emerging-market stocks appear cheaper than alternative investments. These metrics show attrac-tions relative to their own history (see Exhibit 6), as well as when compared to developed markets today. Return on equity has been somewhat depressed but has continued to improve and is nearing longer-term averages.

We remain positive on the longer-term growth potential of emerging markets. Diminished concerns over trade tensions, rate hikes from the Fed and an appreciating US dollar have allowed the valuation attractions of emerg-ing-market stocks to shine through. We are increasingly comfortable in taking solace from the longer-term attractions of these markets and increased our conviction in both bonds and stocks in emerging markets earlier in the quarter.

Fewer Attractions in JapanAs the outlook for global growth slows, we have seen signs the Japanese economy remains particularly vulnerable as it sits at the crossroads of global trade and has particular sensitivity to any weakness in China.

Japanese stocks are vulnerable. They are sensitive to Japan’s position as an

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GLOBAL EQUITY VALUATIONS REMAIN ELEVATEDExhibit 5: MSCI World Index Forward Price-to-Earnings Price BandsJanuary 2016–February 2019

July 12016

Jan 12016

July 12017

Jan 12017

July 12018

Jan 12018

Feb 282019

PricePrice at 12.5X Price at 13.5X Price at 14.5X Price at 15.5X Price at 16.5X

Source: Franklin Templeton Capital Market Insights Group, Bloomberg, MSCI. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.

2.10

1.90

1.70

1.50

1.30

1.10

2.30

0.90

Index price/sales ratio

Source: Franklin Templeton Capital Market Insights Group, Bloomberg, MSCI. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.

Emerging Markets Valuation at Attractive LevelsExhibit 6: MSCI Emerging Markets Index LTM Price-to-Sales RatioDecember 2003–February 2019

12-312003

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02-282019

P/S–LTM 1 StDev Above 1 StDev Below Average



Pendulums explainedIn Allocation settings, we are presenting a new graphical representation of our allocation views and the extent of conviction being expressed.

The central two segments of these pendulum charts both represent a neutral overall conviction toward the asset in question. We have split it into two segments to represent nuanced views. On the left, “reasons for concern, but not bearish” and on the right “reasons for optimism, but not bullish.” These can indicate a direction of travel or underlying longer-term view. For truly neutral views, we high-light both segments.

Where we hold a stronger conviction, we “light-up” more of the segments, working out from the mid-line to the left or right respectively. Two segments for moderate conviction, all three for full conviction.

We show black arrows below the pendulum to show changes over the last month. Green arrows represent quarter-over-quarter change.

These images support a clearer representation of our views and are less prone to ambiguity about how strong a view is being shown. We show our views in three allocation tiers—working down from a top tier that reflects “risk-on” or “risk-off.” Secondly, the top-level allocation, equities, bonds, alternatives and cash along with the rationale for each position. In the third tier, we highlight global, regional or sector preferences, aiming to show those where we have a view. This last tier will evolve appropriately over time but is unlikely to have many neutral views.

open economy and its perceived role as the “canary in the coal mine” of global trade. Also, corporate Japan has a higher level of operational leverage, in aggregate, than its European peers and about twice the level of companies in the US market.

In addition, the market has been buffeted by flows into and out of the Japanese yen. Since the start of the year, investors have diverted funds away from the perceived relative

safe-haven appeal of the yen, re-initi-ating trades that utilize low-cost funding in Japanese yen to buy higher yielding assets elsewhere. Were tensions to return, it is likely the Japanese yen might again appreciate, potentially hampering the profitability of companies in this market.

Finally, later this year, the Japanese government will implement a long-planned increase in its domestic sales tax. Previous increases in this

tax have had a negative impact on consumption growth. Although the authorities are aware of this risk and the Bank of Japan will be ready to offset any impact, the risk to markets is non-trivial and warrants some caution in the short term. We retain a lower level of conviction in this market, despite evident valuation attractions.



These scores are on a scale of 1 to 6, with 3/4 being neutral. The black arrow represents month-over-month change. The green arrow represents quarter-over-quarter change. No arrow = no change from previous.

Allocation settings—March 2019

Global equities are still supported by corporate earnings and strong profit margins, although

concerns remain over growth momentum and pressure on profit margins, given strong labor

markets. We are carefully monitoring the potential for renewed market volatility and have moved

to reflect these concerns but are not bearish.

Continued global growth leads us to prefer lower exposure to government bonds and duration.

Long-term valuations have remained expensive, reflecting low term premiums. The economic envi-

ronment remains somewhat supportive of corporate bonds.

The inflation that was feared, as the economic cycle entered its later stages, has not appeared.

We see better prospects in naturally diversifying assets, rather than passing any comment on the

level of inflation discounted in inflation-linked securities. However, we have moved to a truly

neutral view, reflecting the balance between reasons for optimism and market-driven concerns

that we continue to monitor.

Cash yields have increased, with short-term US Treasury bill yields reflecting greater supply and

progress toward monetary policy normalization. Cash is no longer a significant drag on portfolio

yield, boosting its attractions to us generally.

We anticipate slower global growth and subdued inflation. As a result, we have started to scale

back our conviction in riskier assets. However, with few imbalances, and remaining signs of a late-

stage favorable cyclical environment, we are less likely to see extreme swings in output. Growth

remains strong enough to support risk assets over a longer-term horizon. Our view reflects reasons

for concern over the sustainability of recent gains but is not bearish.

Equities

Risk Off/On

RISK TIER

HIGH LEVEL ALLOCATION TIER

Bonds

Alternatives

Cash

1 62 53 4

To better understand the graphical representation of our allocation views refer to the “Pendulums explained” description on the previous page.



Asset Class Conviction Our Viewpoint

Equity RegionsDeveloped

The constructive economic growth story in developed markets, still strongest in the United States,

remains intact despite slowing momentum around the world. Corporate fundamentals are

currently on par with historical norms, with above-average margins and return-on-equity ratios.

United States Despite elevated geopolitical headlines and trade tensions, growth fundamentals continue to be

positive, with tax reforms still providing a tailwind for earnings and margins. In a higher volatility

regime, the market’s attention will focus on both corporate earnings growth and Fed policy moves.

Europe ex UK Economic activity has disappointed as declining global trade growth and domestic activity have

led to negative sentiment. With the European Central Bank not yet close to embarking on a rate-

hiking cycle, we see banks acting as a drag along with fears of populism ahead of European

Parliament elections.

United Kingdom UK equity market uncertainty has been driven by domestic economic headwinds. Political tension

and uncertainty over Brexit have dominated market sentiment. However, corporate profit remains

high, and with a reduced risk of a no-deal Brexit we have moved to a truly neutral view.

Japan Equity valuations, particularly on a price-to-book value basis, have remained attractive to us rela-

tive to other markets. However, declining global growth and a late-cycle environment is typically

poor for companies with higher operational leverage and for the Japanese market.

Canada We see select opportunities in Canada, with earnings growth expectations providing room for posi-

tive surprises. However, Canadian banks remain burdened by the Fed pause and domestic housing

concerns, and we have moved to a truly neutral view.

Emerging Emerging markets have seen return on equity continue to rise, and valuations are attractive to us

relative to developed-market peers. Although the risk of an escalating trade war remains, head-

winds from Fed policy normalization and a strong US dollar have abated. We see reasons for

optimism, reflecting the longer-term attractions of emerging markets.

Fixed Income SectorsUS Treasuries

The Fed has shifted its stance to emphasize patience and a more data-dependent response func-

tion. However, the economic backdrop remains positive and unemployment is at multi-decade

lows, suggesting further hikes may still occur. We remain concerned about decreased support

from global central banks through quantitative easing and supply-demand dynamics. We prefer

short duration and exposure to Treasury bills for now.

Eurozone

Government

Bonds

Valuations appear full in the eurozone, where term premiums are the lowest among government

bonds. However, with growth slowing, any rate hikes remain a distant prospect, supporting hedged

yields to an extent.

High Yield The economic backdrop remains supportive of riskier fixed income sectors such as high yield.

However, valuations have eroded, and we have moved to a truly neutral view. We believe bank

loans can be an attractive alternative to high yield, given less sensitivity to interest rates, but they

are also vulnerable due to the previous relaxation of covenants.

EM Debt Improved sentiment in the asset class and valuations we view as attractive, particularly among

hard-currency bonds. With continued fears over protectionism and geopolitics, selective posi-

tioning is important, in our view. Some countries are more exposed to any rise in the cost of

capital. Exchange rate risks may hold back local-currency bonds.

Alternative AssetsInflation-Linked

Bonds

The expected inflation that was feared as the economic cycle entered its later stages has not

appeared, and the level of inflation discounted in inflation-linked securities has fallen. However,

with muted inflation risks we maintain a more neutral view of assets that benefit directly from

rising prices, such as inflation-linked bonds.

ALLOCATION TIER



Investment Strategy Research Committee

Senior leadership

Ed Perks, CFAChief Investment Officer

Franklin Templeton Multi-Asset Solutions

Gene Podkaminer, CFAHead of Multi-Asset Research Strategies

Chair of Investment Strategy & Research Committee

Franklin Templeton Multi-Asset Solutions

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.

Stephanie Chan, CFA

Senior Research Analyst Michael Dayan

Lead Portfolio Analyst Mike Greenberg, CFA, CAIA

Portfolio Manager Mia Franklin

Quantitative Research Analyst

Dominik Hoffman

Portfolio Analyst Matthias Hoppe

Portfolio Manager Richard Hsu, CFA

Portfolio Manager, Research Analyst Michael Kerwin, CFA

Research Analyst

Joyce Lang, CFA

Senior Research Analyst Hao Li, CFA

Senior Portfolio Analyst Melissa Mayorga

Senior Research Analyst Chris Ratkovsky

Senior Research Analyst

Miles Sampson, CFA

Senior Research Analyst Chandra Seethamraju, Ph.D.

Head of Quantitative Strategies Kent Shepherd, CFA, CIC

Senior Client Portfolio Manager

Participation in this committee may change periodically and without notice.



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 fore-cast, 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 portfo-lio’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, particu-larly over the short term.

Copyright © 2019 Franklin Templeton Investments. All rights reserved. FTALL_1QIS_0319


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This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at the publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.

All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verifi ed, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.

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MARCH 2019 Slower growth— equity caution · 2 Slower growth—equity caution In this Issue Major...

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