TIME TO RESET EXPECTATIONS?

Transcription

1 TIME TO RESET EXPECTATIONS? GLOBAL INVESTMENT OUTLOOK SEPTEMBER 2017 Unwinding Quantitative Easing Will It Unwind the Markets? Market Stability or Volatility How Should Investors Prepare? The Elephant in the Investment Room Key Takeaways for Investors FRANKLIN TEMPLETON INVESTMENTS

2 Global markets have been relatively calm this summer despite many uncertainties. Geopolitical risks have continued across the globe, and in some areas, looming monetary policy changes also appear likely. A key question for many investors is whether the sleepy summer period of low volatility will give way to a more turbulent autumn. Franklin Templeton s senior investment leaders offer their perspective on the markets, and discuss where they see opportunities and risks ahead. Contents Unwinding Quantitative Easing Will It Unwind the Markets? 1 Market Stability or Volatility How Should Investors Prepare? 5 The Elephant in the Investment Room 6 Key Takeaways for Investors 7 FEATURED SENIOR INVESTMENT LEADERS Christopher J. Molumphy, CFA Chief Investment Officer Franklin Templeton Fixed Income Group Stephen H. Dover, CFA Head of Equities Edward D. Perks, CFA Chief Investment Officer Franklin Templeton Multi-Asset Solutions Michael Hasenstab, Ph.D. Chief Investment Officer Templeton Global Macro The information provided is not a complete analysis of every material fact regarding any country, region, or market. Comments, opinions and analyses contained herein are those of the speaker and are for informational purposes only. Because market and economic conditions are subject to change, comments, opinions and analyses are rendered as at 29 August 2017 and may change without notice. The analysis and opinions expressed herein may differ or be contrary to those expressed by other business areas, portfolio managers or investment management teams at Franklin Templeton Investments. Opinions are intended to provide insight on macroeconomic issues and commentary is not intended as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. All investments involve risks, including possible loss of principal. Foreign securities involve special risks, including currency fluctuations and economic and political uncertainties. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets smaller size and lesser liquidity. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses. This document summarizes the video content from our panel discussion. 2

3 Unwinding Quantitative Easing Will It Unwind the Markets? Q: Central banks have remained a focus of global markets. Can you give us an update on what different central banks around the world are telegraphing? MICHAEL HASENSTAB: There has been a lot of focus on the speed and extent of interest-rate hikes out of the US Federal Reserve (Fed), but I think there hasn t been enough focus on what happens when the central bank starts to unwind its balance sheet. I think the United States will be the first central bank to unwind, with Europe following suit at some point. Japan isn t really in a position yet to be unwinding though, in my view. Even if the Bank of Japan stops quantitative easing (QE), I believe it will still target the 10-year yield to keep it close to zero. There is a concern that the Fed has never unwound such a large amount of assets before, and the likelihood that there are no disruptions is theoretically possible, but seems pretty unlikely in practice. We just have to be ready for that. And, it s not just what the Fed is doing in terms of its balance sheet that is important. We have a lot of deregulation happening and there could be fiscal spending coming as well. It s a pretty complicated US landscape. CHRISTOPHER MOLUMPHY: To Michael s point, central bankers have quite a task ahead of them. The Fed started with a balance sheet of less than $1 trillion, and now it s up to $4.5 trillion, so it has some work to do to unwind it. I think the Fed has done a reasonably good job recently of trying to telegraph its intentions. In our view, we could see some action as early as the September policy meeting. So far, the market seems receptive it seems to be pricing it in. But as Michael noted, it s a big action in front of us and there are a lot of things that could go wrong. When Central Bankers Purge Their Balance Sheets What Then? Total Assets of Major Central Banks 30 September July 2017 USD Trillion $16 $14 $5.0 Trillion $12 $10 $8 $4.6 Trillion $6 $4 $4.5 Trillion $2 $0 9/06 2/08 6/09 10/10 2/12 7/13 11/14 3/16 7/17 US Federal Reserve Bank of Japan European Central Bank Source: Bloomberg. Most recent data available. FRANKLIN TEMPLETON INVESTMENTS 1

4 Q: So what might you expect to happen when the Fed does normalize, in terms of a potential market reaction? CHRISTOPHER MOLUMPHY: The Fed s primary holdings are US Treasuries and mortgages. So far, those markets have held up reasonably well, but the Fed has also telegraphed a very slow start to the normalization process. In our view, the Fed should move forward while the market is reasonably receptive because market conditions can change, and there are a lot of variables out there. ED PERKS: I think another thing that s relevant is the possible transition we could see at the Fed. Fed Chair Janet Yellen s term is scheduled to end early in 2018, so I think the markets will increasingly be focused on the Fed s potential path under new leadership if it seems likely she won t continue on. CHRISTOPHER MOLUMPHY: While Yellen isn t totally out of the running for a second term, at this point, it seems likely that there could be a new Fed chair. When we think about monetary policy going forward, the impact of that transition is a question mark. As Ed pointed out, we are in the later innings of Yellen s term, so we will need to see some transition communications sooner rather than later. MICHAEL HASENSTAB: In my view, it might be a good thing to have someone from the market side at the Fed s helm. I think one of the challenges for the Fed is policymakers have been in a bit of an ivory tower and the world has changed. So I think it could be encouraging if we saw someone with a markets background. But back to US monetary policy and the implications, I think it s pretty simple. I believe interest rates need to go higher. The United States now has full employment, economic growth is at or above potential and the output gap has closed. Inflation has not come into the picture yet, but it s probably just a matter of time as it s a lagging indicator. All of these factors point to a 10-year US Treasury yield that should be higher than 2%. US Economy Appears to Be Strong with Full Employment US Unemployment Rate 30 June June % 10% 8% 6% 4% 2% 0% 6/10 6/11 6/12 6/13 6/14 6/15 6/16 6/17 Unemployment Rate And Near Potential Growth US Output Gap 1 January April 2017 USD Billion $17,500 $17,000 $16,500 $16,000 $15,500 $15,000 $14,500 $14,000 $13,500 $13,000 1/07 6/08 12/09 5/11 11/12 4/14 10/15 4/17 3/17 Real Potential GDP Real GDP Source: Bloomberg, National Bureau of Economic Research. Most recent data available. Source: US Congressional Budget Office, US Bureau of Economic Analysis. Most recent data available 2 FRANKLIN TEMPLETON INVESTMENTS

5 should investors think about opportunities that are being created Q:How or potentially disappearing? CHRIS MOLUMPHY: We have a more intermediate-to-longerterm investment horizon, so we try to stay long-term focused. We have a reasonably constructive view on the economy globally and on the United States in particular. With that, we are trying to take advantage of some of the shorter-term volatility where it creates potential buying opportunities. The US economy has been growing at about 2% annually, which isn t a great rate of growth, but it s decent from the perspective of a fixed income investor. The United States has been growing at that pace for the entirety of this current cycle s growth phase, which is now into its ninth year. At least over the near term, we see a reasonably constructive corporate environment, and the consumer appears to be in decent shape, too. Our focus has been on asset classes such as corporate credit. We are still reasonably constructive on corporates, as well as mortgage-backed securities, but are staying diversified because we do not see a lot of cheap sectors in the fixed income markets right now. That said, we re willing to take some reasonable level of risk because we think the fundamentals will remain fairly strong in the near-tointermediate term. MICHAEL HASENSTAB: If the Fed moves first and interest rates in the United States start to normalize, then higher US rates combined with stable rates in Japan or Europe should lead to a stronger US dollar, at least temporarily. And we think there are a lot of headwinds for the euro and yen beyond just interest rates. We believe euro strength is probably close to peaking given the issues Europe continues to face with the refugee crisis and terrorism. The situation will probably be a little different against emerging markets because many of those countries have a huge yield advantage over the United States. For example, long-end rates in Brazil are running about 10%, so even if US interest rates go up 100 or 200 basis points, there is still a huge differential. There are some higher-yielding, domestically oriented countries that I think will see their currencies do well if we see the type of constructive economic backdrop Chris just spoke of. Some countries which have very low bond yields might be more vulnerable to a US rate hike. So I think we will see greater bifurcation in emerging-market currencies. When US Interest Rates Start to Normalize, Select Emerging-Market Currencies May Hold Up Better than the Euro and Yen 10-Year Government Bond Yields As at 31 August % 10% 9.99% 8% 6% 4% 2% 0% 2.29% 0.54% 0.08% United States Germany Japan Brazil Source: Bloomberg. FRANKLIN TEMPLETON INVESTMENTS 3

6 STEPHEN DOVER: Corporate earnings have not only been strong but also coordinated around the world, which is the first time that s happened in quite a while. Earnings continue to surprise on the upside, especially in emerging markets, and to some degree in Europe now, too. I think as long as interest rates rise on a measured basis, that s probably priced into the market at this point. The environment is relatively benign, and markets are relatively calm, so the risk is that if there s a shock, I think the markets probably are not really prepared. Ultimately, as long as companies have earnings growth, the market should be able to keep moving higher. In general, we have seen opportunities in Europe, which has had some economic turnaround and some positive political developments. European banks are doing better than many had thought they would. Financials in general still haven t completely recovered from the global financial crisis, providing additional upside potential. So we still see opportunities in that space, to some degree. However, there are some big tail risks in Europe that probably are not priced into the market at this point. We also see a lot of opportunity in emerging markets where there is growth and positive political change or at least select emerging markets such as in Latin America. Ultimately, as long as companies have earnings growth, the market should be able to keep moving higher. Stephen Dover Corporate Earnings Have Improved Across Most Markets Earnings per Share 31 July July /07 7/08 7/09 7/10 7/11 7/12 7/13 7/14 7/15 7/16 7/17 United States Europe Japan Emerging Markets Source: FactSet, MSCI. Data presented is 12-month forward earnings per share indexed to 100 at 31/7/07. 4 FRANKLIN TEMPLETON INVESTMENTS

7 Market Stability or Volatility How Should Investors Prepare? Q: In spite of different risk factors, equity-market volatility remains near historic lows. How should investors think about risk in equity markets right now? ED PERKS: I think it s important to step back beyond just the last months. If you take a longer perspective, just two years ago the markets saw substantially higher volatility. Broader global equity indexes experienced a sharp correction from the middle of 2015 to the early part of That said, I think this current period of low volatility has come with a lot of benefits. In the years since the global financial crisis, the purpose of the Fed s monetary actions, and of global central-bank actions in general, was to bring down volatility in asset classes and more broadly in the economy and we certainly received some benefits from that. We have seen the US and global economy continue to grow at a relatively modest pace. I think the low market volatility we have seen likely had some influence on the relatively strong business and consumer confidence that exists today. For investors, it has enabled more of a focus on fundamentals, which have been strong. However, this period of relatively low I wouldn t say unprecedented, but I would say relatively low volatility is unlikely to persist. From my perspective, the unknowns would be the more significant risks that might lie out there. During the last several years, we have seen a tremendous amount of assets move into passive strategies. So, to what extent will we see algorithmic, indiscriminate selling of equities, of assets in general as volatility moves higher? That s something that we are a bit concerned about and something I think investors need to think about. STEPHEN DOVER: To Ed s point, passive funds are in essence momentum players buying high on appreciating stocks that get progressively larger weightings in an index while selling low on those that depreciate and get progressively smaller in the index, regardless of the stocks future upside potential. The possibility of indiscriminate selling is one of the things we are looking at from a research point of view. We are looking at how much a company is owned by indexes, or by passive investors, because that money could move out very quickly and affect the company. Low-volatility, coordinated market environments, and to some extent, coordinated policies of global central banks can make it difficult to differentiate which stocks might outperform. As we experience the potential for heightened volatility, we think there will be some likely differentiation between the active versus passive space. Market Volatility Has Been Low, But When Will the Tide Turn? CBOE Volatility Index (VIX) and Realized Volatility of S&P 500 Index 31 December July % 20% 15% 10% 5% 0% 0 12/15 3/16 5/16 8/16 10/16 12/16 3/17 5/17 7/17 Three-Month Standard Deviation of S&P 500 Daily Returns (LHS) VIX (RHS) Source: FactSet, Chicago Board of Exchange, S&P. Standard deviation is a measure of the degree to which a portfolio s return varies from the average of its previous returns. The larger the standard deviation, the greater the likelihood (and risk) that a portfolio s performance will fluctuate from the average return. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, measures the market s expectation of 30-day volatility. It is constructed using implied volatilities of S&P 500 index options. Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. Past performance does not guarantee future results FRANKLIN TEMPLETON INVESTMENTS 5

8 The Elephant in the Investment Room Q: How are exogenous political risks influencing your investment thesis? CHRIS MOLUMPHY: From our standpoint as fixed income investors, we think we benefit from our long-term investment approach in that we are fundamentally based and look beyond some of the short-term noise. I think the markets have done a reasonably good job looking through some of these nonfundamental bouts of volatility political, geopolitical and otherwise and have held up reasonably well. But to your question, exogenous risks make things a bit more difficult. At the same time, if you can stick to your main investment thesis, the fundamentals and a longer-term horizon, you can use these events as opportunities. Bouts of market volatility can create buying opportunities. What we try to do is determine whether near-term risks are going to impact longer-term fundamentals. More often than not, they tend to be more transitory in nature. MICHAEL HASENSTAB: The shift in many emerging markets to more orthodox policy has been an area of opportunity for us. In the United States and in Europe, there is a much more charged political environment and, in some cases, the abandonment of orthodox policy. In places like Mexico, for example, policymakers stuck to their guns and hiked interest rates to protect their currency (despite speculative attacks), followed through with fiscal reform and liberalized the energy sector. We have seen a very sharp snapback in the peso. Meanwhile, Brazil has been targeting corruption in a more forceful manner than ever there. I think that is going to lead to some positive political changes. And Argentina has done a 180 degree, aboutface under President Mauricio Macri to re-embrace market principles and get the economy started again. India s Prime Minister Narendra Modi has embarked upon a very rigorous reform of the tax system and has set in place inflation targeting with the central bank. So there have been a lot of positive fundamental changes in emerging markets that I think will pay dividends for years to come. On the flipside, there are places like Venezuela, which is in a crisis. Bad policies have led to a financial and humanitarian crisis there. Currently, Turkey is also facing challenges. So we are seeing the bifurcation I mentioned earlier in our discussion of monetary policy. A lot of that emerging-market bifurcation is also due to changes in a political environment whether it is improving or deteriorating. In Europe, we are a little more cautious medium term. With growth improving, there is unlikely to be a major flashpoint in the short term, in my view. However, we are seeing nationalism grow at levels that it hasn t for decades. The desire for Europe to come together seems to be changing and there s more national identity as opposed to European identity. Longer term, I think that s going to be a big challenge for the eurozone. I think the political environment in Europe has changed more in the last couple of years than it has since For some 60 years, we had one kind of model moving toward integration, and I think this may be the first point in time things are turning in a different direction in Europe. This isn t an immediate flashpoint, but something we see as a potential issue longer term. STEPHEN DOVER: I think sometimes, at least in the equity space, there is so much talk and focus on politics and macroeconomic events. Ultimately, though, companies are valuable based on their discounted earnings stream, so that s why we are fundamentally focused and why we focus on earnings. A lot of what goes on in politics doesn t necessarily affect earnings that much at least in the short term. There are things that do, however, such as the tax plan and tax reform in the United States, which are pretty important and could impact earnings. Overall, I think the political environment hasn t had a huge impact on the equity market because it hasn t actually affected earnings streams. Like Michael, I am pretty enthusiastic about emerging markets that seem to be more progressive than the developed markets are, where politics can make a difference. There is a lot of room for change in those markets. In Brazil, as Michael mentioned, an unpopular government is making dramatic changes that should have been done 20 years ago. These changes are low-hanging fruit in the sense that they are likely to have a very positive economic impact and, ultimately, I think, on the earnings stream for many companies in Brazil. 6 FRANKLIN TEMPLETON INVESTMENTS

9 ED PERKS: At the risk of oversimplifying it, I think diversification is the best rule to follow when you are thinking about a broader portfolio. I think the views that we have shared, relative to equity and fixed income markets are all relevant. It s something that we are specifically looking for in the exposures we have in multiasset portfolios, but ultimately diversification s true test is how it performs when we see a move higher in overall volatility or some kind of market shock. Do markets see a rise in correlation across asset classes? That s something I think investors have to be very mindful of. I think there is a range of strategies investors should consider focusing on. As investors ourselves, ultimately, we need to access as broad and strong a set of building blocks for our portfolios as possible. Generally, with many markets at different levels of valuation in terms of attractiveness, we increasingly want to be very specific with the exposures we might be getting in particular asset classes. Ed Perks At the risk of oversimplifying it, I think diversification is the best rule to follow when you are thinking about a broader portfolio. Key Takeaways for Investors conclude, what s your brief takeaway for investors as we look out Q:To over the course of the next year? CHRIS MOLUMPHY: Within fixed income, there currently are not many cheap asset classes, particularly on a historic basis. But there are still areas within fixed income where we think fundamentals will remain constructive in the year ahead. I previously mentioned US corporate credit as one of those areas, including investment-grade corporates as well as high yield and leveraged bank loans. The fundamentals for municipal bonds also appear reasonably solid (with some outliers) and valuations on a relative basis appear reasonable. In general, I d say it s probably a good time to take a diversified approach to one s fixed income allocation. ED PERKS: I believe some of the conditions that have persisted for a period of time may start to transition to a different environment. There are specific exposures we aim for in our portfolios which are tied to some of the themes we have touched on. For example, in this low-volatility environment, using certain hedging strategies to complement our strategic asset allocation enables us to be a bit more nimble. I think the direction of market volatility is going to be a very important dynamic over the next six-to-12 months. STEPHEN DOVER: I would reiterate the importance of diversification as well. If you were to look back 10 years ago, for example, the United States as a percentage of the global equity market cap was much smaller than it is today as the relative strength of the market over the past decade has led to an increase in its weight. One has to look at the trend and what percentage of global market cap the United States will likely be in the future, and I think there would be a strong argument, at a minimum, for some global diversity and possibly to invest a bit more outside the United States, as countries outside the United States have underperformed over the past few years. There is so much attention paid to the political noise. While some political issues matter, such as tax reform or regulatory reduction in the United States, which could impact corporate after-tax earnings, I wouldn t get too distracted by it. Finally, based on empirical feedback, many if not most investors still seem to be underweight emerging markets in their portfolios. If you are underweight, you are essentially saying they are going to underperform going forward, which I would evaluate and take into consideration when looking at your portfolio. FRANKLIN TEMPLETON INVESTMENTS 7

10 MICHAEL HASENSTAB: We are trying to do three things in our strategy. One is to preserve capital when interest rates go higher, so we achieve that primarily by going negative duration in the United States. The second is to generate a positive return stream. We have attempted to do that via a rifle-shot approach in emerging markets. I think there are still some opportunities to earn a pretty good carry; yield differentials are very favorable in select currencies that we think are fairly valued or undervalued. The third is to limit the beta to the broader market. We can do that by focusing on idiosyncratic ideas. For example, I believe what President Macri does in Argentina will likely have a greater impact on the country s market than global factors will. We are looking for those domestic stories, and we can use certain short strategies to help reduce market beta. For example, shorting the Aussie dollar to limit the beta of risk-on/risk-off effects, or China effects, and isolate the individual country dynamics. It s really those three goals we have in mind: a negative correlation to rates, idiosyncratic return ideas in emerging markets, and limit the market beta. I think there are still some opportunities to earn a pretty good carry; yield differentials are very favorable in select currencies that we think are fairly valued or undervalued. Michael Hasenstab 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. 8 FRANKLIN TEMPLETON INVESTMENTS

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