CONTRIBUTORS
Max Gokhman, CFA
Deputy Chief Investment Officer
Franklin Templeton Investment Solutions
Tom Nelson, CFA, CAIA
Head of Market Strategy
Franklin Templeton Investment Solutions
Miles Sampson, CFA
Head of Asset Allocation Research,
Franklin Templeton Investment Solutions
Summary and themes
In this month’s Allocation Views, we take a more optimistic view of equities in May against a background of waning hostilities in the Middle East and strong corporate earnings.
Open conflict with Iran has given way to tense diplomacy as both sides attempt to find a resolution that meets their objectives. Shipping through the Strait of Hormuz is likely to remain restricted for some time, but de-escalation has stabilized markets, which continue to look past the energy cost shock.
We expect pockets of volatility amid the ebb and flow of conflict resolution, but tail risks have reduced materially in recent weeks, meaning isolated setbacks should have minimal impact as markets trend higher.
Global macro conditions present a mixed picture but remain broadly supportive for risk assets, while earnings growth estimates have strengthened across the world, shrugging off geopolitical tensions and looking through macro uncertainty.
Against this background, we adopt a “risk-on” stance within our cross-asset positioning and improve our view of US core equities and emerging market (EM) equities. Within fixed income, our preference is to diversify international bond exposure while trimming US duration.
Macro themes
Steady growth
- Earnings breadth has moderated, but robust earnings expectations fuel an optimistic post-conflict outlook.
- The US economy has proven resilient, while labor market data is disparate but remains stable.
- Leading economic indicators remain mixed as business activity is crimped by higher input costs and waning confidence.
Moderating inflation
- We expect limited second-order effects from the energy impulse as conflict in Iran moves closer to a resolution.
- US inflation dynamics remain challenging. Core inflation is elevated, but some measures show pressures moderating.
- Core goods inflation remains above trend. Tariff pressures may have peaked but are currently offset by global supply chain tightness.
Policy bifurcation
- There is an increasing bifurcation between supportive fiscal policy and restrictive monetary policy as markets assess the energy price shock.
- The Middle East conflict has catalyzed a recalibration of policy expectations, with multiple hikes now priced in for most regions other than the United States.
- Fiscal policy in major economies is generally supportive of growth. US tax refunds will likely offset tariff headwinds, while energy support packages could also prove influential.
Portfolio positioning themes
Upgrading equities
- Conflict in the Middle East is moving toward resolution, and we would expect markets to look through any temporary setbacks.
- Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
- Sentiment and positioning are not yet overextended, despite the recent strong market rally, supporting risk assets.
Rotating toward US core
- We improve our view of core US large-cap equities, given the conditions for market breadth have weakened in line with slower economic growth.
- Sustained optimism toward EM equities, amid healthy corporate fundamentals and positive exposure to artificial intelligence (AI) capital investment (capex) themes.
- We increase underweight exposure to European and UK equities, influenced by weaker macro backdrops in those regions.
International duration
- We expect demand destruction to have a greater impact on monetary policy decisions than market pricing suggests, decreasing the chance that central banks meet market hiking expectations.
- Resilient US growth and challenging inflation dynamics make Federal Reserve (Fed) easing less likely, in our view. We stay underweight US duration with a preference for international bonds.
- Excess returns for equities appear more attractive than credit, amid strong earnings and tight spreads.
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.
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.
Commodity-related investments are subject to additional risks such as commodity index volatility, investor speculation, interest rates, weather, tax and regulatory developments.
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. The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
Investing in privately held companies presents certain challenges and involves incremental risks as opposed to investments in public companies, such as dealing with the lack of available information about these companies as well as their general lack of liquidity.
Active management does not ensure gains or protect against market declines. Diversification does not guarantee a profit or protect against a loss.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
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