CONTRIBUTORS
Max Gokhman, CFA
Deputy Chief Investment Officer
Franklin Templeton Investment Solutions
Miles Sampson, CFA
Head of Asset Allocation Research,
Franklin Templeton Investment Solutions
Initial asset allocation outlook
There are two asset allocation preferences we hold that will be affected by the “Big Beautiful Bill” (BBB) that President Trump signed into law. We still favor international developed government bonds over US Treasuries and US large-cap stocks over small-cap stocks. It is important to consider how the BBB will affect our outlook for these assets.
Preference for international government bonds
One of the primary concerns driving our outlook is the expected rise in US deficits. US debt is already substantial, exceeding US$36 trillion, with net interest payments surpassing $1 trillion annually1—more than what is spent on defense and Medicare. The BBB is projected to exacerbate this situation, according to the Congressional Budget Office (CBO), potentially leading to higher yields demanded by US Treasury buyers.
Exhibit 1: US Debt Outstanding
Data from January 1962–December 2024
CBO Projections Begin January 2025 through January 2055
Sources: Congressional Budget Office (CBO), Macrobond. There is no assurance that any estimate, forecast or projection will be realized. See www. franklintempletondatasources.com for additional data provider information.
A significant percentage2 of US Treasuries are held by “non-economic buyers” such as central banks and other institutions that purchase Treasuries for reasons other than yield. However, should tariffs reduce the US trade deficit with other countries, fewer foreign investment funds will likely be buying US Treasuries. As that vacuum is filled by “economic buyers,” these profit-seekers will likely demand higher yield in response to US fiscal concerns.
The term premium on US 10-year yields (0.64% as measured by the NY Federal Reserve ACM model), which reflects the additional return investors require for holding longer-term bonds, remains below historical levels and below our 1% estimate of fair value.
Exhibit 2: US Yield Curve Term Premium, 10-Year Treasury Yield
January 1990–June 30, 2025
Sources: Federal Reserve Bank of New York, Macrobond. See www. franklintempletondatasources.com for additional data provider information.
Furthermore, leading US economic indicators are improving. The S&P Global US Manufacturing Purchasing Managers Index rose to 52.9 in June. Nonfarm payrolls grew 147,000. Clearly, the Federal Reserve is in no rush to cut interest rates. Instead, it has committed to holding steady as it evaluates the effects of tax cuts and tariffs. We believe there will be one rate cut in 2025, whereas the market is pricing in two.
As a result, we expect that certain international developed government bonds, such as European and Canadian government bonds, may offer better value and stability in the face of rising US yields.
- European government bonds: We believe the European Central Bank will be more dovish as EU inflation falls and downside risks to growth remain. Challenging trade negotiations with the United States are likely to slow eurozone growth further. And any reallocation from US Treasuries could also drive demand for eurozone duration3, supporting our constructive stance.
- Canadian government bonds: Tariff exemptions should support the Canadian economy. Inflation in Canada appears to be relatively subdued, allowing the Bank of Canada to continue with its rate-cutting cycle if required.
Preference for US large-cap stocks over small caps
We anticipate that both large-cap and small-cap US equities will benefit from the 2025 bill, but in different ways and degrees. Large-cap companies get the certainty of a continued low-tax regime and pro-investment incentives, which will bolster their earnings and cash flows. We think the 100% bonus depreciation and research and development expensing will be significant tailwinds. Larger companies also avoid potential new investor taxes, allowing them to keep rewarding shareholders. Yet, large multinationals face new pressures (higher taxes on foreign income, and the loss of some clean energy subsidies) that could mute the net upside.
A number of items in the BBB will also support small caps, and in our view, they will likely benefit more broadly from the bill’s impact on the US domestic economy. While the BBB might boost market sentiment for small caps in the short term, their low valuations are generally justified by the fact that over 40% of the companies in the Russell 2000 have negative earnings. Moreover, these companies are more susceptible to higher borrowing costs given significantly elevated leverage relative to the Russell 1000 constituents, and we think their interest expenses will rise as the BBB pushes yields higher.
Conclusion
The “Big Beautiful Bill” can create some short-term tailwinds for small-cap stocks and more lasting buoyancy for large-cap stocks in the United States, but over the long term its cost is likely to pull up yields to levels that could threaten American exceptionalism. Thus, while nobody will deny that the bill is big, its beauty will ultimately be in the eye of the bondholder.
Endnotes:
- Federal Reserve Economic Data (FRED). Federal Reserve Bank of St. Louis.
- Treasury Bulletin. June 2025. Department of the Treasury. Bureau of the Fiscal Service.
- Duration refers to the interest-rate sensitivity of a bond.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal. Small- andmid-cap stocks involve greater risks and volatility than large-cap stocks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce the desired results. To the extent a strategy invests in companies in a specific country or region, it may experience greater volatility than a strategy that is more broadly diversified geographically.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Active management does not ensure gains or protect against market declines.
WF: 6141668