Supportive environment for asset returnsDec 11, 2018

2019 CAPITAL MARKETS EXPECTATIONS:

Supportive environment for asset returns

Summary

We believe global stocks have greater performance potential than global bonds, supported by continued global growth. Within both bonds and equities, we continue to forecast stronger return potential for emerging markets, over a seven-year investment horizon. With short-term interest rates and government bond term-premia remaining below historical averages, we see a lower performance potential from government bonds.

Our strongest convictions:

  • Moderate inflation helps sustain global growth
  • Global equities outperform global bonds
  • Emerging markets outperform developed markets

 

2019 Capital Market Expectations

FRANKLIN TEMPLETON THINKSTM CAPITAL MARKET EXPECTATIONS

 

About Capital Market Expectations

Every year we review the data that drive capital markets—current valuation measures, historical risk premia, economic growth and inflation prospects—to help refine our forecasts. We update the models that we use and review their continued appropriateness. Crucially, our models are based on first-principle economic relationships, and reflect seasoned practitioner judgement.

This year we have included as part of every capital market forecast a measure of the expected volatility of that asset class, driven by long-term observed standard deviation of returns and correlations.
Global central banks quantitative easing policies may have repressed both equity and bond market volatility over recent years. Our approach to modeling volatility avoids the recency bias of some alternative approaches and is particularly appropriate at a time when leading central banks are ending or reversing their asset purchase programs.

Our capital market expectations (CME) are designed to provide annualized return expectation over a longer-term horizon, typically viewed as being five to 10 years. Specifically, we calculate geometric mean return expectations over a seven-year period, which approximates the average length of a US business cycle.1 This length of horizon is especially relevant as we proceed towards the latter part of an unusually long economic expansion in the United States.

Our modelling approach is based on a blend of objective inputs, quantitative analysis and fundamental research. We call it “quantamental.” Underpinning these inputs are assumptions on the sustained growth rates that developed and emerging economies can expect to achieve and the level of price inflation that they will likely experience. This approach is forward-looking, rather than being based on historical average returns. This is especially important in an evolving macro-economic environment.

 

1.Since 1945, the National Bureau of Economic Research has defined 11 US business cycles, with an average duration of 69.5 months.

 

Our capital market expectations

Our 2019 Capital Market Expectations are that the expected returns of global equities will be more attractive than the expected returns of global government bonds.

Our geometric mean return expectation over a seven-year period for global equities is fairly close to the historical return; overall, we expect global equities to return 6.3% annualized over the seven-year period, with developed markets returning 6.0% and emerging markets 7.2%.

By comparison, we expect global government bonds to return only 1.3%.

EQUITY EXPECTATIONS
Seven-Year Annualized Return Expectation
Data as at Sep 30, 2018

Asset Class Name
Expected
Return
(Geometric)
Expected
Risk
(Std. Dev.)
Past 20 Yr
Annlzed
Return
GLOBAL EQUITY 6.3% 13.7% 6.5%
Developed Market Equity 6.0% 13.6% 6.4%
US Large Cap 5.7% 15.0% 7.4%
Canada (IMI) 5.7% 16.0% 7.5%
Europe ex UK (IMI) 5.4% 15.5% 5.8%
UK (IMI) 5.5% 18.9% 5.7%
Japan (IMI) 5.2% 18.3% 2.9%
Pacific ex Japan (IMI) 6.2% 21.9% 7.5%
Australia (IMI) 6.7% 18.6% 9.5%
US Small Cap 6.3% 19.2% 8.2%
       
Emerging Market Equity 7.2% 22.1% 9.4%
EM EMEA 5.8% 21.8% 8.3%
EM LatAm 8.4% 25.7% 11.2%
EM Asia 7.6% 19.4% 4.9%
China 4.9% 28.9% 7.5%
       
Specialty Equity
Global Listed Infrastructure 5.8% 14.8% 2.5%
Global REITs 3.7% 19.4% 8.6%

FIXED INCOME EXPECTATIONS
Seven-Year Annualized Return Expectation
Data as at Sep 30, 2018

Asset Class Name
Expected
Return
(Geometric)
Expected
Risk
(Std. Dev.)
Past 20 Yr
Annlzed
Return
GLOBAL GOVERNMENTS
Global Developed Governments 1.3% 3.6% 3.9%
U.S. Government 2.8% 4.8% 4.3%
Canadian Government 2.0% 5.3% 4.7%
Europe ex UK Government 0.9% 4.1% 4.3%
UK Government 1.4% 6.5% 5.8%
Japan Government -0.1% 3.6% 2.0%
Australia Government 2.1% 5.2% 5.7%
       
Emerging Market Governments
Emerging Market Debt-Gov (Hard) 5.2% 13.1% 8.0%
Emerging Market Debt-Gov (Local) 6.4% 4.7% 8.2%
       
US Securitized 2.7% 3.0% 4.6%
US MBS 2.7% 6.2% 4.6%
       
GLOBAL CREDIT
Global Investment Grade Credit 3.4% 6.6% 5.1%
USD 3.8% 6.9% 5.4%
GBP 3.2% 6.2% 5.5%
JPY 0.5% 1.2% 1.0%
EUR 2.5% 3.7% 4.5%
CAD 3.2% 3.0% 5.2%
AUD 3.5% 2.1% 6.3%
       
Global Corporate High Yield 4.0% 8.7% 6.3%
US 4.3% 8.4% 6.6%
Pan-European EUR 2.7% 11.7% 5.8%
Pan-European GBP 4.3% 10.6% 10.5%
       
Emerging Market Corporate Hard 3.5% 12.4% 6.3%
       
US Bank Loans 4.6% 7.2% 4.8%

OTHER EXPECTATIONS
Seven-Year Annualized Return Expectation
Data as at Sep 30, 2018

Asset Class Name
Expected
Return
(Geometric)
Expected
Risk
(Std. Dev.)
Past 20 Yr
Annlzed
Return
COMMODITIES
Commodities 2.5% 16.9% 0.6%
Oil 2.4% 28.9% 4.9%
Precious Metal 7.1% 21.4% 6.0%
Agriculture 4.7% 19.9% -3.4%
       
ALTERNATIVES
Hedge Fund 6.3% 9.1% 6.4%
US Private Equity 7.0% 19.2% 12.9%
US Private Real Estate 6.2% 19.4% 9.1%
US Private Infrastructure 7.4% 14.8% 8.2%
       
LINKERS 1.8% 7.5% 5.7%
US TIPS 2.9% 5.8% 5.3%
Canada RRB 2.3% 7.7% 6.7%
Eurozone 1.4% 4.1% 3.1%
UK Index-Linked Gilt 0.5% 7.7% 7.2%
Japan 0.6% 5.1% 1.6%
Australia 2.5% 5.3% 6.6%

OTHER EXPECTATIONS
Seven-Year Annualized Return Expectation
Data as at Sep 30, 2018

CME
Spot as of 9/28/2018
EXCHANGE RATES
USDCAD 1.26 1.29
EURUSD 1.11 1.16
GBPUSD 1.31 1.30
USDJPY 113.98 113.70
AUDUSD 0.72 0.72

 

CME
Policy Rate as of 9/28/2018
CASH
Short Term (3 month)
Cash Rate
USD Cash 2.4% 2.25
CAD Cash 2.5% 1.50
EUR Cash 1.4% 0.00
GBP Cash 2.0% 0.75
JPY Cash 0.5% -0.10
AUD Cash 2.7% 1.50
Source: Franklin Templeton Multi-Asset Solutions


 

Our strongest convictions

Moderate Inflation Helps Sustain Long-Term Global Growth

We expect continued global growth and moderate inflation over the long-term, but anticipate a volatility regime change in the shorter run. With few imbalances, and signs of a favourable cyclical environment, this is likely to result in less extreme swings in output. We anticipate a gradual, measured, interest rate tightening cycle and an environment of moderate inflation over the next seven years. As a result, we expect global gross domestic product (GDP) to expand at a 3.0% annual rate, with developed markets growing more slowly, at 1.9%. Inflation across the key developed and emerging economies is expected to remain subdued, at 1.9% and 4.2% respec-tively (See Exhibit A).

MODERATE INFLATION WITH STEADY GLOBAL GROWTH
Exhibit A: Table of Economic Assumptions for Seven Years
Data as at September 30, 2018

Exhibit A: MODERATE INFLATION WITH STEADY GLOBAL GROWTH
Source: Franklin Templeton Multi-Asset Solutions

The importance of emerging markets is expected to continue to increase, in terms of Gross Domestic Product (GDP) share and contribution to growth (see Exhibit B).

INCREASING IMPORTANCE OF EMERGING MARKET GROWTH
Exhibit B: Share of Total GDP: Emerging and Developed Markets vs. Rest of World
As of September 30, 2018

Exhibit B: INCREASING IMPORTANCE OF EMERGING MARKET GROWTH
Source: Calculations by Franklin Templeton Capital Market Insights Group using data sourced from International Monetary Fund World Economic Outlook.

 

Global Equities Outperform Global Bonds

The economic environment that we describe above is supportive of asset returns generally. We believe global stocks have greater performance potential than global bonds in an environment of continued global expansion and stimulative fiscal policy, thereby earning the equity risk premium.

Equity markets have appreciated sharply in recent years and valuations, based on price-to-earnings (P/E) ratios, in developed markets, are not cheap relative to their historical averages. In an environment of moderate inflation and subdued real equilibrium interest rates, we believe that equities can continue to trade at significantly higher multiples than was the case in the 1970’s and 1980’s. A comparison with the dotcom era (late 1990s) shows that valuations are not as stretched as was the case at the turn of the millen-nium (see Exhibit C).

LONG TERM EQUITY VALUATIONS ARE BELOW HISTORICAL AVERAGES
Exhibit C: MSCI ACWI P/E Ratio
As of September 30, 2018

Exhibit C: LONG TERM EQUITY VALUATIONS ARE BELOW HISTORICAL AVERAGES
Source: Calculations by Franklin Templeton Capital Market Insights Group using data sourced from Bloomerg, MSCI. The MSCI ACWI is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world. The MSCI ACWI is maintained by Morgan Stanley Capital International (MSCI), and is comprised of stocks from both developed and emerging markets

 

Our view is that earnings growth supports the outlook for stocks. Monetary policy remains stimulative globally, and the relative balance of power remains with corporations. The flip side of modest wage growth and the weakness of labor’s bargaining power has been to support the profit share of GDP, which helps favor the return potential of stocks. This in turn rein-forces the importance of closely monitoring future wage trends, which could put downward pressure on record-high profit margins if wage growth were to accelerate.

Global bonds—especially high credit quality and long-duration issues—appear vulnerable due to low current yields and the desire of devel- oped-market central banks to unwind unconventional policies and normalize interest rates.

The term premia in developed-market government-bond yields are depressed in relation to averages over the last 50 years. The term premium is a measure of the extra yield that owners of bonds demand, in excess of the anticipated average level of short-term interest rates for the life of the bond, to compensate for making a longer-term investment (see Exhibit D). This premium reflects supply and demand factors, including central banks’ quanti-tative easing policies (which have started to reverse) but also the invest-ment behavior of an aging population which will persist. It also likely reflects the re-regulation of financial institu-tions, which has boosted demand for assets perceived as safe (Basel II). This may result in bond yields remaining lower than our historical experience even at the end of this cycle.

BOND TERM PREMIA DEPRESSED IN RELATION TO HISTORICAL RANGE
Exhibit D: Term Premium on 10-Year Zero Coupon Bond
As of September 30, 2018

Exhibit D: BOND TERM PREMIA DEPRESSED IN RELATION TO HISTORICAL RANGE
Source: Calculations by Franklin Templeton Capital Markets Insights Group using data sourced from Bloomberg, Adrian Crump & Moench 10-Year Treasury Term Premium (ACMTP10 Index).

 

Subdued productivity growth has weighed negatively on aggregate demand, even despite improved labor markets. The prospect of continued subdued inflation could potentially keep world government bond yields lower than we have seen over the last 30 years (see Exhibit E). Meanwhile, the current level of nominal yields provides a limited cushion for even modest interest rate increases. Furthermore, given the very large scale and uncon-ventional nature of global monetary policy during and following the 2008–2009 financial crisis, it remains extremely difficult to forecast how these reversals of policy will play out in financial markets. Over the next seven years, the return potential from developed-market government bonds is likely to be less favorable than for stocks, when starting from current depressed yields.

CURRENT LEVEL OF NOMINAL YIELDS PROVIDES LIMITED CUSHION
Exhibit E: ICE BofAML Global Government Bond Index Yield to Maturity
As of September 30, 2018

Exhibit E: CURRENT LEVEL OF NOMINAL YIELDS PROVIDES LIMITED CUSHION
Source: Calculations by Franklin Templeton Capital Market Insights Group using data sourced from FactSet, Bank of America Merrill Lynch. Important data provider notices and terms available at www.franklintempletondatasources.com.

 

Emerging markets outperform Developed markets

In both stocks and bonds, we believe the performance potential in emerging markets will exceed that of developed markets (see Exhibit F).

EXPECTED RETURNS OF EMERGING MARKETS AND DEVELOPED MARKETS (EQUITY & BOND)
Exhibit F: Projected Annualized Returns (7 years forward)
As of September 30, 2018

Exhibit F: EXPECTED RETURNS OF EMERGING MARKETS AND DEVELOPED MARKETS 
(EQUITY & BOND)
Source: Franklin Templeton Multi-Asset Solutions

 

As discussed earlier in this paper, emerging economies have demonstrated a much higher growth potential, notably in China and India. As these countries grow to comprise a larger part of the global economy and contribute a still larger share of global growth, we believe the structural tail-wind is likely to persist over the next seven years. In a world where equity return potential is mainly driven by the growth of earnings, this should see emerging-market stocks outperform.

Emerging market central banks appear to have more flexibility in monetary policy, despite the strains seen during 2018 in certain prominent but idiosyn-cratic cases. Disciplined monetary policy and central bank independence appear to be driving inflation downwards and supporting moves towards market-determined exchange rates and more fully developed domestic capital markets (see Exhibit G). These trends are likely to see both emerging market bonds and currencies benefit from assets flows into these invest-ments from developed markets over the longer term.

INFLATION IN EMERGING-MARKET ECONOMIES IS GENERALLY UNDER CONTROL
Exhibit G: Percent Change in CPI for Emerging Markets
As of September 30, 2018

Exhibit G: INFLATION IN EMERGING-MARKET ECONOMIES IS GENERALLY UNDER CONTROL
Source: Calculations by Franklin Templeton Capital Market Insights Group using data sourced from Bloomberg, Central Bank News.

 

Emerging-market currencies do not appear to be overvalued against most developed-market currencies at the moment. Indeed, over the longer term, we would expect that the Balassa-Samuelson effect, which links increasing productivity with an appreciating real exchange rate, should result in a broad appreciation in emerging-market currencies. This trend supports the return potential of unhedged positions to both bonds and stocks in emerging markets.

Emerging-market bond yields are closer to historical averages than are depressed developed markets yields. Similarly, valuations for emerging market equities are still attractive across a range of measures.

In the longer term, we believe that emerging economies appear better equipped to survive two key global dynamics: the commodity cycle and the Fed tightening cycle. In the past, exces-sive dependence on US dollar financing left emerging economies vulnerable to higher rates and dollar strength. This factor has been used to explain weak-ness in recent months, but we believe emerging markets will display resilience to this and to the inevitable volatility that commodity prices will exhibit over a longer-term horizon.



About Franklin Templeton Multi-Asset Solutions
At Franklin Templeton Multi-Asset Solutions, we translate a wide variety of investor goals into portfolios powered by Franklin Templeton’s best thinking around the globe. We serve a variety of institutional clients, ranging from sovereign wealth funds to public and private pension plans in addition to retail multi-asset clients around the world.

The hallmark of our approach is a central forum—the Investment Strategy & Research Committee—which generates a top-down view across asset classes and regions, and connects and synthesizes the bottom-up sector and regional insights of the global investment teams at Franklin Templeton.

Within our team is a core group of highly specialized quantitative analysts—Franklin SystematicTM—dedicated to the pursuit of new sources of return, strategic diversifi-cation and calibrated volatility management, allowing us to apply the highest level of innovation in our client portfolio solutions. In addition to the quantitative research behind this paper, the team is focused on volatility strategies, smart beta strategies and risk premia strategies.