2018 GLOBAL INVESTMENT OUTLOOK. Reflections on Growing Economies and Fading Stimulus

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1 2018 GLOBAL INVESTMENT OUTLOOK Reflections on Growing Economies and Fading Stimulus

2 2018 GLOBAL INVESTMENT OUTLOOK WHAT S INSIDE 2 GLOBAL MACRO OUTLOOK Identifying Value and Avoiding Price Distortions in the Post-QE Era Michael Hasenstab, Ph.D. 5 MULTI-SECTOR FIXED INCOME OUTLOOK Constructive but Cautious for 2018 Christopher J. Molumphy, CFA 8 GLOBAL EQUITY OUTLOOK As the Era of Cheap Money Comes to an End, Non-US Markets Look Poised to Stand Out in 2018 Stephen H. Dover, CFA 10 MULTI-ASSET INVESTING OUTLOOK Optimism and Selectivity in 2018: Business Fundamentals in Focus as Stimulus Fades from Financial Markets Edward D. Perks, CFA 13 LONG-TERM CAPITAL MARKETS OUTLOOK Chandra Seethamraju, Ph.D. 15 MORE INVESTMENT INSIGHTS ONLINE WHAT ARE THE RISKS? All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Stocks historically have outperformed other asset classes over the long term, but tend to fluctuate more dramatically over the short term. 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. 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 portfolio s value may decline. Changes in the financial strength of a bond issuer or in a bond s credit rating may affect its value. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal a risk that may be heightened in a slowing economy. 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 portfolio s initial investment. Not FDIC Insured May Lose Value No Bank Guarantee

3 December 2017 Franklin Templeton Investments marked its 70th anniversary as an organization in Throughout our history, we have experienced perhaps every conceivable market environment none so fresh in our minds than the events of a decade ago. What started as a contained subprime mortgage situation in the United States ended as a full-blown global financial crisis. Bank lending around the world seized up, and the fallout impacted venerable firms alongside broader stock and bond indexes. Greg Johnson Chairman of the Board, Chief Executive Officer Franklin Resources, Inc. Over the next 10 years, we saw global monetary policies of epic proportions implemented to address the crisis. Clear signs of recovery have taken hold since then, leading in 2017 to strong advances in many types of financial assets this year, along with positive and strengthening growth across the global economy. The year ahead is now set to see key central banks cut back on their crisis-born programs. It s an ongoing example of a key lesson from the post-crisis period: the importance of continually adapting to change. It s also an environment we think calls for active management based on disciplined, fundamental research. At Franklin Templeton, the strength of our firm is the strength of our people. This strength is on display in the pages that follow, which spotlight our investment expertise in key areas. We ve titled our global investment teams outlook on 2018 particularly the opportunities and challenges at this stage of the economic cycle as Reflections on Growing Economies and Fading Stimulus. We hope these insights will be valuable to you as you prepare to make important decisions about your portfolios. On behalf of the firm s more than 9,000 employees around the world, I d like to thank you for the trust you place in us and extend my very best wishes for a prosperous Greg Johnson 2018 GLOBAL INVESTMENT OUTLOOK 1

4 Global Macro Outlook Identifying Value and Avoiding Price Distortions in the Post-QE Era 2018 OUTLOOK: We expect the reversal of quantitative easing, rate hikes and rising inflation pressures in the US to be among the most impactful factors for global financial markets in the upcoming year. For nearly a decade, financial markets have surfed a wave of low-cost money in the US, courtesy of the US Federal Reserve s (Fed s) massive quantitative easing (QE) programs that were launched after the global financial crisis (GFC) of The expansion of the Fed s balance sheet from around US$900 billion in 2008 to nearly US$4.5 trillion today has arguably been the most dominant force shaping global financial markets. QE has driven down yields and pushed up asset prices, steering many investors toward riskier assets while keeping the costs of capital artificially suppressed. This has distorted valuations in bonds and in equities. In short, the era of QE has created a seemingly complacent market that views persistently low yields as a permanent condition. However, these conditions are neither normal nor permanent, in our assessment, and we expect the reversal of QE by the Fed to meaningfully impact financial markets in 2018 and beyond. Rising US Treasury Yields Present Multiple Risks A number of factors are poised to pressure US Treasury (UST) yields higher, in our view, including the aforementioned reversal of QE as the Fed unwinds its balance sheet, but also the exceptional strength in US labor markets, rising wage and inflation pressures, ongoing resiliency in the US economy, and a structural shift toward deregulation by both the Trump administration and potentially a Jerome Powell Fed. The Fed is projected to unwind US$1.5 trillion from its balance sheet over the next three years. At the same time, major foreign buyers of USTs from prior years have notably stopped acquiring USTs over the last few years. China has reduced its foreign reserves by around US$1 trillion, while oil exporting nations like Saudi Arabia have similarly become net borrowers instead of lenders, no longer buying massive levels of USTs. Now the Fed will also be departing that market, further driving down the supply of UST buyers. At the same time, overall UST borrowing remains on an upward trend. This leaves price-sensitive domestic US investors to predominantly fill the void. We expect those dynamics to put upward pressure on UST yields. Investors who are not prepared for the shift from the recovery era of monetary accommodation to the expansionary Michael Hasenstab, Ph.D. Chief Investment Officer Templeton Global Macro post-qe era may be exposed to significant risks, in our view. Markets could see sharp corrections to UST yields in upcoming quarters, similar to the magnitude and speed of adjustments that occurred during the fourth quarter of We think it is critical not only to defend against current UST risks but to structure portfolios to potentially benefit as rates rise. The challenge for investors in 2018 will be that the traditional diversifying relationship between bonds and risk assets may not hold true in this new cycle of UST declines. It s quite possible to see risk assets also decline as the risk-free rate (yield on USTs) ratchets higher. Markets have become accustomed to exceptionally low discount rates a shift higher would materially impact how those valuations are calculated. Additionally, we ve seen a sense of complacency develop across the asset classes as UST returns and risk asset returns have often had positive correlations, along with positive Continued GLOBAL INVESTMENT OUTLOOK

5 GLOBAL MACRO OUTLOOK Domestic Private Investors Projected to Sharply Raise Their Share of US Treasuries Net Borrowing from the Public (Projected) USD Billions $6,000 $5,000 $4,000 $3,000 $2,000 $1,000 $0 -$1,000 -$2,000 33% 30% (Projected) Foreign Official Other Foreign Domestic Investors Fed Other US Government Source: Calculations by Templeton Global Macro using data sourced from Congressional Budget Office, US Bureau of the Fiscal Service, US Treasury Department, US Federal Reserve. There is no assurance that any projection will be realized. performance. However, the positive outcomes achieved under the benefit of extraordinary monetary accommodation can mask the actual underlying risks in those asset categories. As monetary accommodation unwinds, those positive correlations could continue but with the opposite effect simultaneous declines across bonds, equities and global risk assets as we exit an unprecedented era of financial market distortions. These are the types of correlations and risks we are aiming to avoid in % 78% correlated to broad-based beta (market) risks. Countries that are more domestically driven and less reliant on global trade often have those idiosyncratic qualities along with inherent resiliencies to global shocks. A select few have already demonstrated that resilience in recent years, notably Indonesia. For others, economic risks are related to the reforms underway within their country, rather than what happens externally, such as in Brazil or Argentina. Higher rate differentials are also crucial in a rising-rate environment. Brazil and Mexico have short-term yields around 7%, India and Indonesia around 6%, and Argentina around 25% (as of November 2017). If US rates rise by 100 or 200 basis points, these countries have more cushion to absorb rate pressures. By contrast, emerging markets with macro imbalances or low rate environments should be impacted harder by rising rates. Countries like Turkey or Venezuela remain fundamentally vulnerable to a rate shock, in our view. Another group of potentially vulnerable countries are those with lower rates, such as South Korea or Singapore, which despite strong macro fundamentals could also be vulnerable to currency depreciation as the yield differential with the US flips. Thus we think the key to emerging-market allocations in 2018 will be to avoid the broad beta risks and find those idiosyncratic sources of alpha (performance above the market return) that can withstand rising rates. In the major developed economies, we continue to see unattractive bond markets, particularly the low to negative yields in the eurozone and Japan. As rates rise in the US, we expect the widening rate differentials with the eurozone and Japan to weaken the euro and yen against the US dollar. Specific Emerging Markets Offer Idiosyncratic Value The impact of Fed policy tightening on emerging markets should vary from country to country in the upcoming year. There are still attractive valuations in specific countries, but not all emerging markets will fare well as rates rise, in our assessment. It s important to identify countries with idiosyncratic value that may be less The impact of Fed policy tightening on emerging markets should vary from country to country in the upcoming year. Continued 2018 GLOBAL INVESTMENT OUTLOOK 3

6 GLOBAL MACRO OUTLOOK 12.0% 10.5% Higher Yields Available in Select Emerging Markets Government Bond Yields: Two- and 10-Year Yields As of November 1, % 9.3% 9.0% 7.5% 7.2% 6.7% 6.9% 6.7% 6.0% 4.5% 3.0% 1.5% 0.0% -1.5% 4.0% 8.3% 7.6% 7.0% 6.1% 6.4% 5.1% 3.3% 2.8% 1.6% 1.8% 2.1% 1.6% 1.4% 0.2 Brazil South Africa 4.5% 3.5% 2.6% 2.5% Mexico Indonesia India Colombia Malaysia Chile Poland Australia South Korea Two-Year Yields Source: Bloomberg. Past performance does not guarantee future results. 10-Year Yields 2.3% 2.0% 1.3% 0.4% 0.1% 0.4% -0.2% -0.8% US Canada UK Japan Germany We Expect Inflation and US Treasury Yields to Rise in 2018 As we look ahead in 2018, we expect the reversal of QE, rate hikes and rising inflation pressures in the US to be among the most impactful factors for global financial markets in the upcoming year. When the first rounds of QE were initially deployed by the Fed nearly a decade ago, many skeptics argued that pumping money into the financial system would cause high inflation. But inflation never accelerated, in part because banks and financial companies stockpiled cash while credit activity remained constrained by post-gfc regulations, such as the Dodd-Frank Act. However, the factors that previously limited inflation and money creation over the last decade are also now approaching their end. Deregulation efforts through executive action are already underway, while credit activity has been accelerating. In short, the credit expansion and money velocity 1 that did not materialize over the last decade is just beginning to take shape. This potential acceleration in money velocity combined with existing inflation pressures in the US economy and labor markets leads us to expect higher inflation and higher UST yields in the upcoming year. We think investors need to consider preparing for these risks. The factors that previously limited inflation and money creation over the last decade are also now approaching their end GLOBAL INVESTMENT OUTLOOK

7 Multi-Sector Fixed Income Outlook Constructive but Cautious for OUTLOOK: Against a backdrop of a generally healthy global economy, one could argue that many fixed income sectors looked fully valued as of late However, we believe value can still be found in an approach that moves past headlines and focuses on discrimination and underlying fundamentals. Global Growth Is Healthy but Many Believe Fixed Income Valuations Look Full Our view of the coming year is informed by the backdrop of a global economy that has been performing quite well, particularly in the United States. The consumer-led US economy has continued to show strength aided by continuing improvement in employment and rising household wealth. Moreover, consumer sentiment also has indicated optimism over economic prospects. Measures of corporate wellbeing add to this picture, as revenue and profitability growth suggest a generally steady outlook. And while we continue to carefully observe the potential for political developments in Europe to disrupt economic growth, there has been an uptick in economic activity in the region that bodes well for Overall, we are reasonably optimistic that this backdrop could remain intact over the coming year. At the same time, we cannot ignore the tremendous amount of liquidity that has been injected into the global financial system during the last decade, nor the view of many market participants that fixed income markets appeared fully valued on a number of traditional metrics as of late Inflation, Monetary Policy and an Aging Business Cycle Bear Watching With this framework as a starting point, there are a number of key issues that we believe will prove important in determining investment outcomes in Perhaps most important among these is inflation, given its status as a driver of Fed policy, interest rates and other key variables. While persistently high core inflation could spur rates to climb faster than anticipated, we think the more likely scenario is a modest uptick in inflation, particularly over the coming year. We believe inflation has been persistently low as a consequence of several factors, primarily globalization and technology. Globalization has made a vast pool of labor available that has helped keep a lid on wage growth globally. At the same time, improvements in technology have resulted in the automation of various traditionally manual tasks. While the pace of globalization may have slowed recently, technology has not. If anything, further advancements in artificial intelligence have made even some non-repetitive tasks and occupations additional candidates for disruption. We do not see these impacts easing materially over the near term, so while core inflation may tick up, we think it unlikely to increase in dramatic fashion within this timeframe. Christopher J. Molumphy, CFA Chief Investment Officer Franklin Templeton Fixed Income Group Along with inflation, the Fed s efforts to reduce its balance sheet (even as it continues to hike short-term interest rates) also bear close watching. It is the first time anything of this scale has been attempted, so care must be taken by policymakers not to unintentionally trigger an adverse reaction. While the Fed has just started this normalization process, the European Central Bank (ECB) has announced that it will continue buying assets for a longer period than originally planned (albeit at a reduced pace) while the Bank of Japan (BOJ) has continued its QE program unabated. Nonetheless, we think the Fed and other central banks have done a reasonably good job communicating their intentions to market participants, although we recognize they are still in the early stages of what promises to be a long campaign. For these reasons, we believe that while interest rates are biased to rise, they are likely to do so at a generally measured pace over an extended period. Continued 2018 GLOBAL INVESTMENT OUTLOOK 5

8 MULTI-SECTOR FIXED INCOME OUTLOOK Global Central Banks Have Injected an Unprecedented Amount of Liquidity into Financial Markets Global Liquidity: Total Assets of Major Central Banks August 2005 August 2017 USD Trillion $20 $16 $12 $8 $4 $0 8/05 8/08 8/11 8/14 8/17 Fed BOJ ECB People s Bank of China Source: Bloomberg. Dotted line shows approximate rate of increase prior to recession and approximate rate of increase post-recession. For illustrative and discussion purposes only. Globalization and Technology Have Kept a Lid on US Inflation Inflation Secular Downtrend, Core Personal Consumption Expenditures (PCE) January 1980 September 2017 YOY 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Recession Core PCE Cycle Average Source: FactSet, US Bureau of Economic Analysis. For illustrative and discussion purposes only. We also remain cognizant of the age of the current economic cycle. This cycle is notable in the lack of excesses that normally accompany a late stage cycle. For instance, we would expect somewhat higher levels of US inflation with unemployment at current levels, or somewhat higher levels of corporate leverage that could be interpreted as the first indications of excess. Instead, while we continue to believe that the cycle will end eventually, we have found little evidence so far that is suggestive of broadbased excess. A Time for Discrimination Within specific sectors, corporate credit continues to be an area bolstered by reasonable levels of growth and generally healthy levels of cash flow. Though credit spreads as of late 2017 were skewed toward the tighter side of their historical averages, we would also note that these conditions could persist for some time. In past cycles, conditions permitting, spreads have managed to maintain such levels and have even narrowed further. As a result, we believe reasonable risk-adjusted opportunities remain in all corporate sectors, including investment-grade and high-yield bonds as well as floating rate bank loans. Historically, we would be seeing some reflection of increasing credit risk this late in the economic cycle in metrics like corporate leverage levels, debt service coverage and credit quality. By and large, however, while we have seen a slight pickup in some of these metrics, the indicators we look at show little to incite concern. Nonetheless, given the age of the current cycle, credit quality remains an issue we will monitor closely and could present a headwind were conditions to meaningfully deteriorate. The housing-related sectors are another area where economic fundamentals have remained generally supportive. They offer a broad set of opportunities from the perspective of sectors, such as commercial and residential, as well as credit quality. Diversity also extends to each sector s Continued GLOBAL INVESTMENT OUTLOOK

9 MULTI-SECTOR FIXED INCOME OUTLOOK economic cycle, with certain ones more notably mature than others. The range of available investment opportunities provides a broad variety of potentially attractive assets, in our view. However, even a buoyant economy has winners and losers, and not all credits within these asset classes will benefit equally. As a result, we believe it will be important to differentiate between sectors exposed to some sort of fundamental disruption, such as many retail-related names, versus those that may be undergoing more cyclically dependent shifts, such as many commodity-related credits. The former is an area that we would strive to avoid absent more clarity, while the latter may or may not represent an opportunity. When a sector such as retail is disrupted, the knock-on effects could extend past sector issuers to service providers, such as certain segments of the commercial mortgagebacked securities market. The principle of discrimination extends to other sectors where we think value can still be found, such as US municipal bonds and emerging-market debt. Within emerging markets, we note that problem areas like Venezuela remain localized and generally idiosyncratic while garnering the lion s share of headlines. Likewise, state governments and other municipal bond market issuers in the United States have done a generally solid job of managing their liabilities. While there are always a number of issuers that garner the bulk of headlines for their problems, they represent a very small percentage of overall credits. In short, we believe moving past headlines and focusing on the underlying fundamentals is a sound approach for identifying value in the current bond market climate. Lessons Learned Since the Global Financial Crisis Ten years have passed since the global financial crisis began, and it seems appropriate to mention a few thoughts. As an investment team, our emphasis has always been on identifying where excesses or bubbles are likely to arise and how they might manifest themselves as problems in the global financial system. In retrospect, we think we did a good job of pinpointing these issues in the run-up to the crisis and managed to steer clear of the major trouble spots. As we cast a glance to the coming year, we continue to be concerned with bubbles and excesses no more so than within certain areas of the sovereign debt markets. Of all the distortions or bubble-like conditions caused directly or indirectly by unconventional monetary policy, sovereign bond markets exhibiting negative interest rates would certainly be close to the top of our list. We believe it will be important to differentiate between sectors exposed to some sort of fundamental disruption, such as many retail-related names, versus those that may be undergoing more cyclically dependent shifts, such as many commodity-related credits GLOBAL INVESTMENT OUTLOOK 7

10 Global Equity Outlook As the Era of Cheap Money Comes to an End, Non-US Markets Look Poised to Stand Out in OUTLOOK: Despite robust global economic growth, we anticipate greater uncertainty in 2018 as central bank policy begins to tighten. We see better opportunities outside the United States, with emerging-market technology and consumer names particularly interesting areas. We expect 2018 to be a potentially pivotal year for global equity markets. The global economy should continue to hum along, with both developed and emerging markets maintaining their momentum. However, we expect the era of cheap money will slowly draw to a close, bringing with it new uncertainties. Global equity markets broadly appear to be pricing in significant earnings growth, but we believe some regions such as Europe and Asian emerging markets were more attractively valued than their US counterparts as of late 2017, making it increasingly important for investors to focus on individual company fundamentals. A Goldilocks Macroeconomic Scenario The synchronized expansion we have seen around the world over the course of 2017 looks set to continue unimpeded in After being narrowly driven by a few countries like the United States and China, we have seen the expansion broaden out, with greater participation from Europe, Japan and various emerging markets, suggesting to us that the cycle has further to run. Still ample liquidity, potentially more supportive fiscal policy in a number of major economies and easing lending conditions should all help underpin global growth over the course of the coming year. Inflationary pressures have remained subdued, but we think they should pick up as the recovery advances. With this more durable economic recovery has come a simultaneous move by certain central banks to begin to tighten monetary policy. We see two reasons for this. First, economic conditions have improved in a number of regions to the point that tighter policy is warranted. Second, we believe Falling Market Correlations May Create More Individual Opportunities One-Year Rolling Correlation in Weekly Price Change of 45 Markets against the MSCI All Country World Index As of November 3, 2017 Average R-Squared Source: Calculations by Franklin Templeton s Global Research Library using data sourced from FactSet and MSCI. R- squared is a measurement of how closely the price change correlates with the performance of a benchmark index and is a measurement of what portion of its performance can be explained by the performance of the overall market or index. Values for r-squared range from 0 to 1, where 0 indicates no correlation and 1 indicates perfect correlation. Past performance does not guarantee future results. Stephen H. Dover, CFA Head of Equities Franklin Templeton Investments central banks need to begin to give themselves greater leeway to act in the future to provide stimulus should economic growth weaken over the medium term. With the recovery in the United States the most entrenched, the Fed is already farthest down the path toward policy normalization. We anticipate a gradual rise in interest rates over the year, along with a continued unwinding of the Fed s massive balance sheet as the economic recovery continues and the labor market remains relatively tight. In Europe, policy is likely to tighten more gradually as the recovery builds steam and inflationary pressures remain subdued. Although the effects of these moves will bear watching, we would point out that central bank-driven liquidity remains significant and should continue to buttress global growth. The balance sheets at the ECB and BOJ are bigger than the Fed s as a percentage of gross domestic product (GDP) and should continue to support global equities. So long as rate hikes and Continued GLOBAL INVESTMENT OUTLOOK

11 GLOBAL EQUITY OUTLOOK Emerging-Market Equity Valuations Have Risen, but Have Been Higher in the Past Emerging Markets Relative to Developed Markets: Price-to-Earnings As of October 31, Source: FactSet, MSCI. Emerging markets are represented by the MSCI Emerging Markets Index, and developed markets are represented by the MSCI World Index. Past performance does not guarantee future results. policy changes are gradual and well communicated, we believe markets can take the moves in stride. Even emerging markets need not necessarily fear tighter Fed policy and a potentially stronger US dollar so long as the dollar moves steadily. We believe the positive economic forces currently present in the global economy will remain strong enough to overcome the potentially negative impact tighter policy will have, but we could see some shortterm volatility as markets adjust. Better Opportunities outside the United States Corporate earnings and relative valuations also to some degree have mirrored where the major economies are in their recoveries as of November And we believe positive economic and earnings visibility has been behind equity market returns during 2017, a trend that can continue in 2018 so long as earnings growth maintains momentum. US earnings have recovered strongly and are now past their prior peaks, but with corporate earnings beginning to show increasing strength outside the United States, we believe an opportunity exists for those stock markets to lead global equities over the coming year. Additionally, market correlations have declined substantially, creating greater opportunity to differentiate between markets and focus on individual stock selection. In Europe, we expect earnings to recover alongside a pickup in inflation over time. Modestly higher interest rates can benefit earnings in the financials sector, while rising commodity prices would tend to benefit energy and materials companies. We do remain somewhat cautious on the broader developed markets in general, however, as equities may be priced to perfection any disappointment in earnings or rapid increase in interest rates could prove disruptive. In Europe and Japan, equity valuations as of October 2017 were still below their post-crisis peak in 2015, though close to their long-term historical averages. In Asia, we expect strong economic growth in China and India to feed through to better corporate profits across the region. Already, we are seeing many emerging markets trade more on corporate and sector fundamentals than on broader macroeconomic trends, something we anticipate should continue in Furthermore, China s emphasis on consumption over government investment and India s ongoing structural reform efforts may create conditions for continued economic and corporate earnings growth over both the short and longer terms. Growth in Disruptive Companies In this environment of modestly rising interest rates and fuller valuations, we believe innovative companies with the potential to disrupt existing industries, including in emerging markets, could fare particularly well. We see opportunity not only in disruptive technology companies, but also in companies that are using technology to change entire industries. And unlike during past runs in technology stocks, many of these companies have actual earnings and cash flows that can support reinvestment in their businesses, which in turn makes them less reliant on raising capital in the markets at a time when interest rates are climbing. Emerging markets are particularly attractive to us in this regard. We are at a tipping point in many emerging markets where resources and exports are no longer the primary drivers of growth and of the equity markets. Technology companies now make up a sizable portion of emerging-market stock markets, and these companies have the opportunity to drastically improve economic productivity through things like mobile banking that are hard to replicate in developed economies. The rising middle class should also continue to foster these trends. Emergingmarket consumers are not only demanding goods, but also services such as banking, health care and entertainment. These technological advances and rising consumption should also help reinforce the ongoing structural trends we are seeing in China, India, Indonesia, the Philippines and elsewhere. As growth improves and access to technology increases, we see the rise of urbanization and the burgeoning middle classes consuming more products, further driving growth over the longer term GLOBAL INVESTMENT OUTLOOK 9

12 Multi-Asset Investing Outlook Optimism and Selectivity in 2018: Business Fundamentals in Focus as Stimulus Fades from Financial Markets 2018 OUTLOOK: We re expecting a return to normal volatility in financial markets in 2018, the kind that we think is best-suited to a nimble, tactical approach toward portfolio construction. We regard 2018 as a critical juncture for global financial markets and economies. Ten years on from the GFC of , the response of key central banks to it namely the massive printing of money through QE programs has supported, in broad terms, an environment of synchronized global growth and resilient corporate profitability. It has also accomplished its goal of guiding many investors into riskier financial assets. Stock market gauges across developed and emerging markets have recovered significantly since the depths of the GFC; in the United States, for example, we ve experienced the country s second-longest bull market on record, and bond markets across the globe have likewise posted impressive gains. At the same time, the march higher in US and global equity indexes has seen implied volatility fall to multi-year and in some cases multidecade lows. However, the Fed is now shifting toward a monetarytightening phase as it gradually raises interest rates and unwinds its balance sheet, and certain other central banks may likewise begin to do so in the year ahead. We will see how the extended influence of QE on financial markets evolves as its gradual removal gathers strength. Various global political situations also have the power to ratchet up volatility. Overall, we face the coming year with a balanced assessment of the opportunities and potential headwinds, and this furthers our conviction that a nimble Edward D. Perks, CFA Chief Investment Officer Franklin Templeton Multi-Asset Solutions and tactical approach to multi-asset investing is the best posture to navigate this uncertain outlook. Synchronized Global Growth with Scope to Persist After a slow-burning but sustained recovery, the global economy has largely repaired the damage of the GFC and the ensuing recession. In October 2017, the International Monetary Fund (IMF) lifted its forecasts for global growth and employment in 2017 and The IMF expects all G20 countries 2 to grow in 2017 the first such synchronized expansion since We believe the ongoing global economic recovery has the potential to continue for a few more years at least. Global trade has picked up since the latter half of 2016, and it could accelerate marginally over the next couple of years. The extended period of generally low interest rates globally has also supported corporate profit margins that were still improving in late The sustainability of corporate profits has been the foundation for rising global equity markets in Though US corporations have demonstrated a generally subdued approach toward capital spending since the GFC, we believe many companies are now more focused on positive capital allocation decision making and policies. The lack of significant investment to date has likely dampened excesses that might contribute to economic challenges, and an acceleration in business investment could give economic growth a second wind by, for example, reviving productivity growth. Continued GLOBAL INVESTMENT OUTLOOK

13 MULTI-ASSET INVESTING OUTLOOK Corporate Profit Resiliency amid Low Interest Rates Net Income Margins, United States and Worldwide January 1, 2005 November 1, % 10% 9% 8% 7% 6% of corporate profits. This, in turn, could encourage US companies to reinvest more of their profits domestically based on favorable tax treatment of future earnings. It would also be supportive of higher future US economic and earnings growth. Elsewhere, the latest push for Catalonian independence in Spain was a reminder that Europe s economic recovery is not necessarily synonymous with political tranquility, and thus faces potential future disruption. Similarly, geopolitical outliers such as North Korea could linger as a source of uncertainty and headline risk. With that in mind, we think investors should consider preparing for rising volatility following an unusually quiet period for global financial markets. 5% S&P 500 Index Potential Return of Normal Volatility as Extraordinary Support Measures Are Removed This backdrop leads us to believe the normalizing of monetary policy in 2018 could mean a return to normal market volatility. Many investors seem to expect that reversing QE will have little impact, if any. We disagree, though we think the Fed has signaled its policy intentions clearly enough that a disorderly debt-market decline similar to 2013 s taper tantrum appears unlikely. However, we see greater potential for volatility in 2018, simply as markets adjust to an environment in which business fundamentals look set to continue powering up, monetary policy will begin powering down, and fiscal policy and economic growth could be increasingly influential as they are taken off standby mode. MSCI World Index Source: Thomson Reuters Datastream. Indexes are unmanaged and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. Past performance does not guarantee future results. Any resurgence in market volatility could also be driven by various geopolitical factors. The US political environment remains a challenge, and several of the pro-growth economic policies touted by the current presidential administration have been slow to develop. With tax policy maneuvering alongside Fed balance-sheet unwinding on the horizon, US equities may become more prone to volatility and sector rotation. Nonetheless, we still see potential for eventual US corporate tax reform, which may smooth the way for repatriation We Think 2018 Calls for a Selective Approach to Multi- Asset Investing Given that central bank monetary policy is set to provide incrementally less support for a wide range of risk assets as financial markets evolve in 2018, we think this is a time to be agile in our portfolios and adapt to changes that may be coming. For all of our multi-asset portfolios, their construction begins with our longer-term capital market expectations. However, we also leverage the knowledge and expertise that exists in the Franklin Templeton investment teams to drive tactical moves. Based on the teams fundamental research, we believe our multi-asset portfolios will likely be best served by being tilted toward equities. We regard equities We think investors should consider preparing for rising volatility following an unusually quiet period for global financial markets. Continued 2018 GLOBAL INVESTMENT OUTLOOK 11

14 MULTI-ASSET INVESTING OUTLOOK Global Equity Market Volatility in 2017 Has Been Abnormally Low MSCI World Index, Returns and Drawdowns December 31, 1983 October 31, % 37% 39% 30% 19% 20% 10% 0% 2% -10% -5% -5% -8% -12% -20% -30% -40% 21% 14% 15% -23% -8% -5% -19% -21% 16% 20% 3% 23% 24% 19% 12% 14% -5% -4% -8% -7% -7% -6% -11% -9% -21% -7% -14% -14% -19%-18% -21% -31% -31% Source: MSCI. A drawdown is the peak-to-trough decline during a specific period on the index. A drawdown is usually quoted as the percentage between the peak and the subsequent trough. Those tracking the entity measure from the time a retrenchment begins to when it reaches a new high. Past performance does not guarantee future results. 31% 18% 13% 8% 7% -8% -7% -12%-11% 27% 10% -8% 13% -13% -17% -23% -28% 24% 3% 5% 16% -3% -2% -8% -10% -14% -12% -42% -50% -51% -60% Calendar Year Return Largest Drawdown as fairly attractive compared to more interest rate-sensitive asset classes, given the potential for eventual higher interest rates and the risk this entails for fixed income markets. Heading into 2018, valuations appeared stretched in certain pockets of the global equity markets but not in others, and we have continued to find compelling ideas across sectors. In particular, we are most interested in stocks that appear currently undervalued relative to long-term business fundamentals. We also favor stocks that offer some degree of counter-cyclical or contrarian defensive characteristics should the central bankfueled bull market eventually run out of steam. In our view, corporate earnings and cash flow generation will matter most for the performance potential of global equities going forward. Moreover, we believe rising rates globally should increase the opportunity set for investors. In terms of fixed income, we remain cautious regarding developed-market government bonds and retain our bias toward short duration to help us navigate some of the risks of this market environment. A combination of improving growth and favorable fiscal policies in select emerging markets along with the prospect for higher yields presents opportunity in both hard currency and local currency emerging-market debt. Ultralow interest rates and massive bond-buying by central banks have pushed down financing costs for corporate borrowers who have raised money in the world s bond markets. While corporate credit conditions appeared healthy as we headed toward 2018, we also think potential shifts in these markets could cause problems for investors holding bonds that are more susceptible to price declines or defaults should credit conditions turn. Essentially, our efforts within fixed income markets are now more tilted toward deemphasizing asset allocation risk in favor of more idiosyncratic risk exposures, with targeted and concentrated exposures to specific government and corporate bond opportunities GLOBAL INVESTMENT OUTLOOK

15 Long-Term Capital Markets Outlook LONG-TERM OUTLOOK: We expect long-term performance potential for numerous asset classes to be positive but subdued. High levels of policy uncertainty and regional divergences will cause higher dispersion across and within asset classes, in our opinion. Additionally, the generally low financial market volatility level during 2017 is unlikely to persist. Over the five to 10-year timeframe of our analysis, we favor global equities, particularly those in emerging markets. LONG-TERM CAPITAL MARKET EXPECTATIONS Every year, a quantitative group within Franklin Templeton Multi-Asset Solutions reviews the data and themes driving capital markets in order to build asset return expectations for different asset classes for the next five to 10 years. Our longterm forecasts are based on our assessment of current valuation measures, economic growth and inflation prospects, as well as historical risk premiums. The text that follows summarizes our 2018 capital market expectations. Analysis: Global Growth Has Improved and Inflation Is Likely to Remain Subdued The global economy has experienced slower growth than was the historical pattern before the global financial crisis. Productivity growth has been slower and uncertainties have remained high, but activity is picking up in many regions of the world, assisted by reform measures. We live in an Age of Reforms, which in many cases have already supported stronger activity and in others promise improving global growth, in our assessment. All reforms face criticism and doubt at the beginning. But in the end, they all tend to help the economy. We expect this trend to continue. The reform agenda in the European Union has been slow and at times painful, but progress has been made since the eurozone sovereign debt crisis. The leading role that Europe now holds among developed economies, in terms of prospective growth, is at least in part due to the greater stability that these reforms have encouraged. The 2017 election of Emmanuel Macron as president of France adds to the prospect of further progress toward reforms. Abenomics the economic policies of Japanese Prime Minister Shinzo Abe is already in the category of proven to have helped. Ongoing structural reforms in emerging markets generally, and specifically in China, appear to be making good progress, which we see as a big plus for global growth. Globally, inflation has been persistently below-target and the outlook is mixed, as wage growth has disappointed consensus expectations given the employment growth seen in many economies. Many factors are holding back wage gains, not least being the impact of globalized markets. Technological advances such as artificial intelligence and demographic factors are Chandra Seethamraju, Ph.D. Senior Vice President Franklin SystematiQ Franklin Templeton Multi-Asset Solutions also important, as aging populations add to excess savings while keeping interest rates low and inflation moderate. We intend to closely monitor nominal wage growth to see if any pickup in it can help boost inflation. View #1: We Favor Global Equities over Global Bonds We believe global stocks have greater performance potential than global bonds, over the next five to 10 years, in an environment of reform measures, improving global growth and moderate inflation. Equity markets have appreciated sharply in recent years, and valuations, based on price-to-earnings ratios, in developed markets were not cheap relative to their historical averages as of late However, we believe equities can continue to trade at significantly higher multiples than was the case in the 1970s and 1980s. The relative balance of power remains with Continued 2018 GLOBAL INVESTMENT OUTLOOK 13

16 LONG-TERM CAPITAL MARKETS OUTLOOK global corporations, and the weakness of labor s bargaining power supports the profit share of GDP. In our analysis, it is earnings growth that supports the outlook for stocks. Global bonds are vulnerable due to low current yields, depressed term premia 3 and the desire of developed-market central banks to unwind unconventional policies. Demographics and subdued productivity growth will likely keep yields low. Despite this, current depressed yields provide a limited cushion for even modest interestrate increases. Analysis: Emerging Markets Have Recovered and Become More Resilient Emerging economies have demonstrated a much higher growth potential, notably in China and India, and their share of global GDP has increased consistently since Although their growth rates have slowed, their share of GDP has continued to increase and the importance of these countries to the pace of global growth has also increased. Fortunately, as the importance of the emerging-market economies has increased, so the stability of these countries has improved. Enhanced macroeconomic self-control, increased domestic consumption, reduced dependence on the United States as a trading partner and higher currency reserves have improved their fiscal flexibility. As a result, more countries can issue local-currency denominated bonds, rather than be dependent on hardcurrency debt. It has also brought greater freedom to their monetary policies, with no need to move in lockstep with the Fed. View #2: We Favor Emerging Markets over Developed Markets In both stocks and bonds, we believe the performance potential in emerging markets will exceed that of developed markets over the next five to 10 years. Emerging markets higher productivity growth rates are likely to persist. Conventional monetary policy appears to be controlling inflation. Over the longer term, we expect increasing productivity should also result in a broad appreciation in emerging-market currencies. Such trends support the return potential of unhedged positions to both stocks and bonds in emerging markets and may drive asset flows into these investments. In contrast, the pressures on developed economies remain acute. Even with unorthodox monetary policy, the developed world is struggling to bring inflation back on track. The demographic time-bomb of aging populations is likely to hold down yields and limit the growth that supports stock prices. Intergenerational stresses may be compounded by social imbalances, a middle-income wealth squeeze and the rise of populism. Risk Considerations and Conclusion A rising rate cycle and uncertainty about reform measures pose risks to economic growth and financial markets. However, investors appeared well aware of these threats and positioned cautiously in late Stock valuations will need to be watched closely in the medium term as we remain vigilant against a buildup of financial stability risks. Going forward, we expect long-term performance potential for numerous asset classes to be positive but subdued. High levels of policy uncertainty and regional divergences will cause higher dispersion across and within asset classes, in our opinion, which increases the attractiveness of active management in both asset allocation and at the security-selection level. The generally low financial market volatility level during 2017 is unlikely to persist. Given our subdued return expectation, we would not be surprised to see volatility rebound down the road. Growing Importance of Emerging-Market Growth Relative Nominal GDP of G7 and BRIC Economies (OECD Forecast) BRIC.38% G7.62% BRIC..45% G7..55% BRIC..51% G7..49% Source: Organisation for Economic Co-operation and Development (OECD), FTMAS. The G7 comprises seven countries: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States. BRIC countries are Brazil, Russia, India and China. Forecast as of 6/30/17. There is no assurance that any forecast will be realized GLOBAL INVESTMENT OUTLOOK

17 GO ONLINE TO FIND > MORE INVESTMENT INSIGHTS Visit our website to learn more about how our multiple world-class investment teams view the complex, interconnected global financial markets they invest in. The portfolio managers listed below describe what they foresee as investment opportunities in Read more at franklintempleton.com/outlook2018. FIXED INCOME US Municipal Bond Investing Sheila Amoroso & Rafael Costas Franklin Templeton Fixed Income Group European Fixed Income Investing David Zahn, CFA, FRM Franklin Templeton Fixed Income Group Global Fixed Income Investing John W. Beck Franklin Templeton Fixed Income Group EQUITY Global Value Investing Norman J. Boersma, CFA, Heather Arnold, CFA & Tony Docal, CFA Templeton Global Equity Group Global Value Investing Peter A. Langerman & Christian Correa, CFA Franklin Mutual Series US Growth Investing Grant Bowers & Matthew J. Moberg, CPA Franklin Equity Group Sector Investing: Biotech Evan McCulloch, CFA Franklin Equity Group Sector Investing: Technology Jonathan Curtis Franklin Equity Group European Equity Investing Dylan Ball, ACA Templeton Global Equity Group Emerging Markets Equity Investing Carlos Hardenberg & Chetan Sehgal, CFA Templeton Emerging Markets Group MULTI ASSETS Managing Volatility through Portfolio Construction Thomas A. Nelson, CFA Franklin Templeton Multi-Asset Solutions ALTERNATIVES Hedge Fund Strategy Investing David C. Saunders, Brooks Ritchey & Robert Christian K2 Advisors Real Estate and Infrastructure Investing Wilson Magee Franklin Real Asset Advisors 2018 GLOBAL INVESTMENT OUTLOOK 15

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Phone: +46 (0) , Fax: +46 (0) FTIML is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is authorized to conduct certain investment services in Denmark, in Sweden, in Norway and in Finland. Offshore Americas: In the U.S., this publication is made available only to financial intermediaries by Templeton/Franklin Investment Services, 100 Fountain Parkway, St. Petersburg, Florida Tel: (800) (USA Toll- Free), (877) (Canada Toll-Free), and Fax: (727) Investments are not FDIC insured; may lose value; and are not bank guaranteed. Distribution outside the U.S. may be made by Templeton Global Advisors Limited or other sub-distributors, intermediaries, dealers or professional investors that have been engaged by Templeton Global Advisors Limited to distribute shares of Franklin Templeton funds in certain jurisdictions. This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. CFA and Chartered Financial Analyst are trademarks owned by CFA Institute. 1. Money velocity measures the rate at which money is circulated through an economy. 2. The G20 (Group of 20) is an international forum for the governments and central bank governors from Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, the Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, the United Kingdom, the United States and the European Union. 3. Term premia refer to the extra return buyers of bonds demand to hold longer-term securities instead of investing in a series of short-term issues. 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 GLOBAL INVESTMENT OUTLOOK

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