Investment Strategy and Allocation Views - January 2019Jan 7, 2019

FRANKLIN TEMPLETON THINKSTM ALLOCATION VIEWS


Allocation Views

Perspective from Franklin Templeton Multi-Asset Solutions

JANUARY 2019


 

Constructive longer-term outlook…
still tempered by shorter-term concerns

Last month we published our longer-term capital market expectations. This came amid increased market volatility, divergent economic performance, and looming trade wars. We asked if we should take solace in a constructive longer-term outlook?

We highlighted shorter-term concerns that tempered our enthusiasm for stocks. Specifically, a return to long-run levels of market volatility, rather than the muted levels seen for much of the past ten years, which indicated a new volatility regime. As we reviewed our conviction levels, we tilted towards a more cautious outlook.

Looking at our score-card of global growth indicators, we continue to see a less positive outlook than was the case in the early part of 2018. A range of indicators are slowing, not just global trade growth. However, our key measures of the health of the US business cycle remain supportive of a continued period of sustained growth.

2018 ended with a bang. Some investors have become concerned that a pause in growth is close enough at hand to justify reducing risk, even if just on a tactical basis. The level of US Treasury yields has fallen sharply which could imply a less optimistic outlook. A year that has already proved challenging for many investors concluded with market concerns for the sustainability of the global economic expansion.

We believe our cautious approach has been justified. However, many concerns remain unchanged or unresolved. As we revisit our convictions, the challenges facing investors persist.

 

Constructive longer-term outlook…
still tempered by shorter-term concerns

Subdued inflation in recent years has been explained in terms of globalization. Even as the fears of deflation have faded, this trend has continued to prevent core traded goods prices from rising. US core inflation has remained stable, even as food, energy and service prices moved higher (See Exhibit A). The impact has been global and has persisted throughout this business cycle. As a result, our central assumption is that inflation pressures will remain modest.

However, the sharp decline in the price of oil, with Brent Crude down more than 40% from its recent peak in early October (See Exhibit B on the next page), had lessened the energy-induced inflationary pressure for now. As one of the key drivers of inflation expectations, global bond yields have fallen partly as a result of this change. We have changed the balance of our convictions among fixed income assets, modestly lowering duration overall, mainly by reversing a positive conviction on eurozone bonds.

CORE INFLATION REMAINS SUBDUED
Exhibit A: US Consumer Price Index (CPI) vs. US Core CPI, YOY Change
October 31, 2008 to November 30, 2018

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


OIL PRICE DECLINE REDUCES THREAT OF INFLATION
Exhibit B: Brent Crude Oil Price ($ per barrel)
January 3, 2014 to January 3, 2019

Exhibit B
Source: Franklin Templeton Capital Market Insights Group, FactSet. Important data provider notices and terms available at www.franklintempletondatasources.com.


Growth divergence remains a concern

Last year, we observed a growing market concern about the desynchronization of global growth, which was reflected in a widening relative performance dispersion between markets. The extent of emerging market underperformance through early October was notable, but not unprecedented (see Exhibit C).

Fears of continued trade conflict have seen largely idiosyncratic concerns in emerging markets broaden out into a more expansive market decline. Political risks are an ever-present concern, but at times of broader uncertainty can act as a driver of investor caution. Indeed, sentiment has been dented more recently. Despite a temporary easing of trade tensions with China, the United States gave up its role as an oasis of relative calm and led global stock markets lower during the close of 2018.

Concerns extended to high yield corporate bonds and other less liquid parts of the credit market. Reflecting this, we lowered our conviction in leveraged loans, but remain constructive given the outlook for the business cycle remains favorable.

A rational desire to expand the “defensible space” within portfolios has seen us increase conviction in US dollar cash and Treasury Bills. However, this pushes against logical calls to avoid becoming a panicked seller as market declines mount. We suggest that a change of mind-set may be required as markets transition from a momentum-driven to a range-trading environment.

The sequencing of further market pain, a potential Fed pause, and likely rebound are uncertain. It will require nimble management to navigate the challenges that 2019 looks set to present.

DIVERGENT EQUITY MARKET PERFORMANCE
Exhibit C: MSCI World vs. MSCI Emerging Markets Performance
January 1, 2004 to December 31, 2018

Exhibit C
Source: Franklin Templeton Capital Market Insights Group, MSCI, FactSet. 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.



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.