Midyear Outlook: Reining In Risk

Our senior CIOs discuss their global investment outlook and how they are looking to play defense in uncertain times.

Equity markets continued to march higher in the first half of 2019, despite trade uncertainties and recessionary fears. An abrupt change to a more dovish stance among central bankers has recently provided fresh tinder to the equity fire. But does a looser policy stance signal there are cracks in the global economy’s foundation?

Our senior investment leaders share their views on investing in uncertain times and how their outlooks have changed from earlier this year. They weigh in on market divergence, whether there is simply too much focus on the US Federal Reserve (Fed), where they see pockets of opportunity and how they are looking to play defense.

Discussion topics within:

  • Market and data disconnects
  • The Fed effect
  • Shifts in global growth
  • Finding defensible space

Q: It’s midyear 2019, and a lot has happened since January. Let’s assess what has impacted your views of investment opportunities and risks in today’s markets.

When I think about what we have experienced so far in 2019, the crosscurrents we are seeing in the markets really stand out to me. There is a real disconnect or disagreement happening between the markets and the data.

As equity markets continued to advance, we are a bit more risk averse because a slight deceleration in global growth has taken place this year, especially in the United States of late. That’s a concern to us. The question is where the slowing is coming from. Is it a lagging effect of the series of US interest-rate hikes we experienced in 2017 and 2018? Or is it a function of other issues globally? But whatever the cause, it’s the uncertainty gripping markets today that is giving us pause.

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Contributors

  • Chief Investment Officer,Franklin Templeton Fixed Income
  • Head of Equities
  • Chief Investment Officer, Templeton Global Macro
  • Chief Investment Officer,Franklin Templeton Multi-Asset Solutions

The last 10 years have seen a unique period of financial returns. We don’t think investors should get accustomed to those dynamics always existing. Interest rates and inflation aren’t always going to be low, and bonds and stocks shouldn’t always make money at the same time. In fact, we have seen some examples of simultaneous declines in both bonds and equities in recent quarters that should highlight the importance of active management.

There’s a need to build portfolios that have idiosyncratic allocations—customized investment ideas that are not correlated to broad market beta. It’s also crucial to recognize how interest-rate risks have become embedded across the asset classes after a decade of extraordinarily loose monetary policy. Interest-rate risks don’t end with US Treasuries; they’re baked in throughout the financial markets.

"There’s a need to build portfolios that have idiosyncratic allocations—customized investment ideas that are not correlated to broad market beta."

- Michael Hasenstab

When we are talking about risks, we have to distinguish between real risks and financial market risks. Because to me, going back to what you were saying, Ed, I have seen a deceleration in economic activity for sure. But if I look around the world at each of the major blocs—the euro area, emerging markets, the United States—yes, there has been a deceleration in growth, but it’s still above potential.

I think it’s almost premature to assume global growth is slowing. On the other hand, the way central banks are reacting—in particular the Fed—worries me. As soon as we are in a position where we are right now—where the equity market actually reacts more positively to bad economic data—it means it is reacting to the potential for interest-rate cuts from the Fed, not based on what the actual data are telling us. That, for me, is a worry—the disconnect.

I’ve heard so many questions around what the Fed is going to do rather than on earnings or corporate fundamentals—the traditional things we look at as equity investors. We saw equities spike up after Fed Chairman Jerome Powell’s comments in January, where he shifted to a more dovish stance, and then again in June. It’s a “Powell put.”1 That is, currently the market is pricing in rate cuts this year, so if there is a cut, the markets will probably react positively. But if there isn’t, we will likely have a temper tantrum. That’s the world we are living in right now.

EQUITY MARKET GAINS HAVE BEEN SUPPORTED BY US FED NEWSExhibit 1: Select Index Performance (Comparison of two-day gains following Fed news and year-to-date gains in 2019)

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Past performance does not guarantee future results.
Sources: Franklin Templeton Capital Market Insights Group, FactSet and S&P Dow Jones. Indices shown in cash USD. Fed events: Jan 4, 2019 Fed chairman indicates it ‘will be patient’ with monetary policy as it watches how economy performs; June 4, 2019 Fed chairman speaks at the “Conference on Monetary Policy Strategy, Tools, and Communications Practices” sponsored by the Federal Reserve, Chicago; and June 19, 2019 Federal Open Market Committee (FOMC) Meeting press release is distributed. For illustrative purposes only; not representative of any Franklin Templeton fund’s portfolio composition or performance. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges.

About 50% of the increase in the US equity market this year happened within the two trading days following Powell’s dovish comments (Jan 4-7, June 4-5 and June 19-20).

And part of that disconnect—if you look at the US equity market—earnings have not expanded, so why is the market up? It’s price-to-earnings multiple expansion,2 and that’s typically linked to interest rates. Obviously, we would prefer the equity market to go up because of earnings growth, not Fed rhetoric.

And as a result of this uncertainty, from a multi-asset perspective, we have actually reined in risk a bit. The most obvious way to do that in a multi-asset portfolio is by pulling back a little on equities.

Q: We started the year anticipating the end of global quantitative easing (QE) and US interest-rate hikes. Now the Fed and other central banks appear to be shifting to a more dovish stance, indicating rate cuts could be on the horizon. What are your thoughts about where global interest rates will go from here?

We shouldn’t focus simply on the rate hikes or cuts, in my view. Yes, there have been a series of US rate hikes over the past few years. But if I look at the size of the Fed’s balance sheet, it’s still about US$4 trillion. That is the asset side. The liability side of the Fed’s balance sheet is essentially sitting as excess reserves. So in a sense, we have a lot of contingent liquidity available. You can have increases in interest rates, but still have fairly liberal credit. These are some of the reasons why I feel that while there is some softening in the US economy, it’s definitely not enough for me to think we are nearing a tipping point.

Another very frequent rationale or reason for recessions historically has been an overexuberant economy, with rising inflation and an over-tightening Fed. We haven’t seen the inflation, and although I think we’ll see more, we probably won’t see an over-tightening Fed. This has to be one of the most dovish Feds out there.

I think we would all agree we prefer the Fed doesn’t act simply to appease markets. We prefer the Fed to act because there is further tangible deceleration in economic activity or if trade tensions escalate to a point where deceleration would be implied for the second half of the year and into 2020.

I would add that while we haven’t seen meaningful inflation in the broader economy, we have seen asset price inflation, which has been spurred on by recent speculation of interest-rate cuts. But if the Fed is also concerned about financial market bubbles, it has more options than it has taken to address that aspect. For example, the Fed could change margin requirements, which allow investors to buy with borrowed money.

The Fed has a dual mandate: to foster stable inflation and maximum sustainable employment. But there seems to be a de facto third mandate: to sustain flourishing financial markets. I find that a little disturbing. Looking at what the Fed has done, I read Powell as a pretty cautious guy. I cannot believe from a financial stability perspective the Fed is comfortable with the equity market rallies we have seen based on pricing in massive quantities of rate cuts. I believe the Fed should have been a lot more preemptive in terms of rate hikes than it has been so far.

"In its attempt to pacify the markets, I believe the Fed keeps trading less volatility today for greater volatility—and financial risks—later down the line."

- Sonal Desai

Q: A lot of investors remain concerned about an impending recession. How do you view the risk of recession now and what should investors consider about the current environment?

I think there has been a bit of a divide between what I would consider economic sentiment indicators and hard data. Absolutely we are getting some easing on some of the hard data, which by the way, I would expect. When you see the level of uncertainty we are seeing about business investment and capital expenditure, it would make sense for GDP growth to draw back a bit. But I am hesitant to call this the beginning of the “the end” because I really don’t see a trigger for a significant downturn.

GLOBAL GROWTH EXPECTED TO EASE IN 2019Exhibit 2: Contribution to global GDP growth (2008–2019F)

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Sources: Franklin Templeton Capital Market Insights Group and International Monetary Fund, as of April 2019. Data based on Purchasing-Power-Parity (PPP). There is no assurance that any projection, estimate or forecast will be realized.

I think we need to see more poor data—beyond just a couple of reports—to actually validate this pessimism about growth. Three months from now, if we are sitting together and we have seen several disappointing non-farm payroll numbers, then our outlook on the economy will look a bit different. And we think if we see tariffs on another US$300 billion of goods coming from China, some price pressures are likely to emerge. To me, that is a part of the reason why, at least in the fixed income space, being defensive does not necessarily mean going long duration,3 certainly not right now.

US economic growth certainly could be decelerating as the impact of prior fiscal stimulus diminishes. So, we have pivoted in terms of our investment strategy. Incrementally, we have moved toward a more defensive tilt, as opposed to where we were in the early part of the year.

Past recessions were largely a function of our industrial economy. Now the US economy is more service-based and less prone to economic cycles. The next recession is likely to come from a policy mistake, in my view. Since the equity markets are at high price-to-earnings ratios, they are sensitive to what the Fed does, which puts more focus on the Fed than in the past.

Q: Let’s sort through the risks from global to regional. Which parts of the global markets are you watching closely?

We have negative rates again in Japan and in Germany, and a lot of uncertainty around Brexit. I’m curious where we all see opportunities and risks in Europe, particularly with fewer opportunities for stimulus than in the United States.

The eurozone project was essentially a political concept with economics bolted on. But the lack of a fiscal union makes the monetary union very difficult to maintain longer term. Now a lot of public sentiment appears to be shifting away from the idea of a common Europe—rising nationalism, rising populism and simmering frustrations over immigration policy. Any pullback on political coordination will only make it harder to keep the monetary union together.

That political cohesion is now being tested by the macro environment; economic activity is slowing, fiscal imbalances are widening and structural issues remain unresolved. That makes the eurozone more vulnerable to a financial shock today than it was eight years ago. There doesn’t appear to be the same political will to bail out countries with fiscal imbalances like there was during the credit crises in 2011. Unresolved structural and political risks across Europe make the euro more vulnerable than its current valuation reflects—we expect it to weaken.

I’m not a part of the camp which thinks that the euro area is necessarily going to go the way of Japan, which has seen prolonged deflation. I do worry about the euro area a fair deal, but it’s not an imminent worry, it’s an ongoing issue. The European Central Bank (ECB) has pursued very easy monetary policy. I would consider the ECB the only adult in the eurozone room, so therefore, it is responsible for preventing another eurozone debt crisis.

I would also add to what Michael said about populism. In parts of Europe we have social populism, and I’m calling it “social” because it’s really very focused on immigration. In the case of Italy and many countries in Europe, there’s this huge tendency for social populism to drift towards economic populism, and we are seeing that in the case of widening budget deficits.

We don’t think Europe is going into recession, although it isn’t booming either. From an equity investor standpoint, we look at European companies that are global companies. It’s very hard to find companies that are truly local in Europe, unless you are looking at really small companies. We look at where their income comes from, but if there’s a slowdown in global growth, that’s going to be hard on global companies as well. For example, if you look at the United Kingdom’s equity market, it looks like a reasonable market and has outperformed many predictions this year. However, you have this hangover of Brexit, and we just really don’t know how that’s going to turn out. So the United Kingdom is a place where we think there’s potential opportunity, but there are also some downside risks there.

Looking at Germany, its economy is actually very tied to China. So, we believe you have to look at the entire global picture when investing in Germany, and it’s struggling right now. We are also worried about the political side, and to Michael’s point, the economic structure of the eurozone. Our team has had conversations about that, in terms of idiosyncratic risks out there that we really can’t predict.

I think if we just look at the eurozone as a single entity, it can be misleading—let’s put it that way. Italy unsurprisingly is one of the places which gives us the most concern. But Spain, for example, has done all the right things coming out of crisis and is one of our preferred spaces as bond investors. Meanwhile, to me, Germany represents a combination of concerns about populism and the weakness of Chancellor Angela Merkel in the current environment. Merkel really drove most of the positive results in terms of defusing the financial crisis in Europe a decade ago, but she doesn’t have that moral authority anymore. There is no clear leader.

In Europe, we think there are countries where populism makes it extremely difficult to be all-in as an investor, and there are other countries which are definitely improving stories. Right now, it’s much harder to talk about complete asset classes or complete regions as being positive or negative; it’s really a country-by-country approach.

Q: How do you think about positioning portfolios defensively to address these tumultuous times?

It’s a very difficult time for investors, because some of the base economic theory that historically has led market cycles is taking a bit of a backseat to things that become very difficult to analyze, predict or prepare for. So we have to think deeply about that and, ultimately, take actions in our portfolios that come back to the question: “How can we manage in a flexible way that lets us be tactical?”

I think that brings it back to the idea of being active and not just buying the market, because I think increasingly there isn’t a single market that I’d want to buy right now. It’s a pretty scary time to be looking at some of these markets if you are just going to go out and buy the entire thing as in a broad market index fund. When we think about spread sectors—if you believe like I do that the underlying asset, which is Treasuries, is vastly overvalued—your absolute return in terms of how much you are being rewarded to carry that risk just starts looking very unattractive.

In my view, if you’re looking at the corporate sector, this is a time to start thinking in terms of keeping your duration short.

I think that’s an important point of discussion, focusing on being tactical in duration exposure, because investors really were rewarded to have duration these last six or seven months.

I would say that is very much the way I would see it. Really focusing a lot on making sure you are not getting locked into positions which are going to be adversely affected by the overvaluation of the underlying asset.

We talk about duration in bond markets, but equity markets have duration as well. So you can attempt to bring in duration by moving more towards dividend stocks, for example. US markets have changed a lot—technology now is a much bigger portion of the US market and, rather ironically, the dividend growth we have seen over the last couple of years has come from technology companies. That wouldn’t have been expected. So, again, you’ve got to be careful just looking back at long-term trends because the makeup of the market has changed. The tech sector does not generally avoid dividends the way it did in the 1990s, when returning capital was essentially an admission of guilt by companies that they did not have a better use of cash. The tech sector typically has a lower dividend yield than the bond proxies, but due to the commitment to dividends by some of its mega-cap constituents, tech is now the biggest contributor to S&P 500 dividends in dollar terms.

TECHNOLOGY HAS BEEN THE BIGGEST CONTRIBUTOR TO DIVIDENDS IN 2019Exhibit 3: Sector dividends as a percentage of S&P500 dividends (January 1–June 21, 2019)

Exhibit 3: Sector dividends as a percent of S&P 500 dividends

Sources: Franklin Templeton Capital Market Insights Group and Ned Davis.

One of the concerns I have about the question of allocation is there is sort of this presumption that people have a pool of money or pension or something to allocate, but I think a lot of our clients are actually accumulators. Their biggest investment is their income stream and their ability to invest over the next 20 or 30 years. If you look out long term, I think equity should be able to perform—at least that’s been the case historically. So if we are asked whether we think it’s a good idea to move to cash and get out of the markets, that historically has been (with a very few exceptions) a really bad move. The way we see it, we could continue systematic investing and perhaps shorten duration. Being defensive within investment categories, instead of taking your money completely off the table.

It’s perhaps a different definition of being defensive than most people have. But to me, at these valuations, being defensive means actually being short duration, but not being entirely in cash. Especially against a backdrop where you don’t see a crisis as imminent, you want to make sure you are in a position of having the flexibility to be nimble when opportunities arise.

ENDNOTES

  1. A "put" is an options-related term. In this sense, a "Powell Put" refers to the point when market participants believe Fed Chairman Jerome Powell would step in with stimulus, should the equity market fall too far.

  2. Multiple expansion: when the price-to-earnings ratio expands, the price for the same amount of earnings increases. The price/earnings ratio is the stock price divided by its earnings per share.

  3. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed income investment to a change in interest rates. Duration is expressed as a number of years.

What Are the Risks?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds adjust to a rise in interest rates, the share price may decline. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries 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. Such investments could experience significant price volatility in any given year. High yields reflect the higher credit risk associated with these lower-rated securities and, in some cases, the lower market prices for these instruments. Interest rate movements may affect the share price and yield. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.