Join Fund Library now and get free access to personalized features to help you manage your investments.
Markets have been roiled recently, marked by sharp declines in global equity indexes, bond yields, and commodity prices. The Franklin Templeton Institute is following market conditions and the fundamentals closely. Across all global regions and major asset classes, our teams of strategists and analysts have gathered to assess what all this means for investors. Succinctly, here is our thinking.
All year, we have cautioned that U.S. equity market valuations were excessive and left little margin for disappointment. Our standing year-end S&P 500 Index target has been 5,250, only slightly above where the index opened on August 5. We remain cautious. Based on historical analysis of periods of economic deceleration, we believe that growth styles will outperform value, and that quality is also warranted. We are concerned about earnings disappointments – above all for smaller-capitalization stocks.
That said, we also respect that positioning, momentum and quant-style trading can be decisive when market ructions occur. While implied equity volatility has spiked (the VIX shot up to 65 during the selloff – the highest in four years1), the market moves may not have yet run their course. Opportunity will eventually present itself, but we think it is too early for all but the most long-term investors to seek value.
Non-U.S. markets have been particularly hard-hit, with Japan’s Nikkei shedding over 12% in its second-worst trading day in history. That is a reminder that it is next-to-impossible to diversify equity risk by region (or by sector or style) during major corrections or bear markets. Opportunity will arise, but in our view, it is premature to step in at this point.
In recent months we have been strong proponents of extending duration, particularly in U.S. Treasuries. However, as 10-year Treasury yields have plunged to near 3.7% (from near 4.5% earlier this year), it makes sense to us to take some profit. Corporate spreads have not (yet) widened by as much as declines in equity prices might suggest is warranted, but selective engagement into higher-grade and even higher-yield issuers should eventually make sense.
The outlook for non-U.S. fixed income markets depends (for U.S. investors) to a considerable extent on the outlook for the U.S. dollar. The dollar has slumped against other major currencies in recent days, above all against the Japanese yen as carry trades2 have been unwound. To a considerable extent that reflects expectations of significant Federal Reserve (Fed) easing before year-end (futures markets are now pricing in circa 100 basis points3), with an added “push” from risk aversion. We anticipate the dollar will eventually stabilize and even recover, but that could take time. Therefore, for risk-averse, income-oriented investors, we believe non-U.S. fixed income investments offer poor risk/reward tradeoffs.
For some time, we have been cautious about private equity, with a preference within that class for secondaries. The lack of visibility, particularly during periods of rising fundamental risk, makes us reiterate our caution.
Private credit is slated to be more interesting, particularly if banks become even more reticent to lend. Pricing should improve. Over time, long-term investors should be rewarded by attractive discounts – especially true for investors putting new money to work in this environment.
Above all, we emphasize the importance of manager selection. “Alpha dispersion” (the gap between top managers and the rest) is likely to increase significantly as a result of market dislocations.
Finally, we add a few comments about how we see the fundamentals.
U.S. recession risk is clearly on the rise, as reflected by the sharp swing in market pricing. Rising jobless claims, a poor July employment report, and signs manufacturing may be contracting have changed the narrative.
That said, other indicators are less worrisome, including the latest non-manufacturing Institute for Supply Management survey, the second-quarter U.S. gross domestic product report, and anecdotal evidence from retailers.
It is too soon, in our view, to conclude that the United States is headed toward recession. However, even a more pronounced slowdown can lead to profits disappointments, for which an overvalued equity market was not prepared.
The Fed will surely cut interest rates in September and thereafter. A 50 basis-point cut is now the market expectation for the September meeting, and an inter-meeting (“emergency”) cut cannot be ruled out. Investors will closely follow the Fed’s sessions in August in Jackson Hole, Wyoming, for clues about its policy.
Historically, equity markets have had positive returns in the year after the Fed starts cutting interest rates. This is true whether the economy has dipped into a recession or avoided one. The average return one year after the first rate cut in recessionary periods is 4.98%, versus 16.66% in non-recessionary periods. Drawdowns were magnified in recessionary periods after the first rate cut, with the average max drawdown being 20%, versus 5% in non-recessionary periods.
Globally, there are no “white knights” in the event a recession unfolds. China has shown little inclination to repeat the kind of stimulus it offered 15 years ago during the global financial crisis. Europe and Japan are similarly unwilling or unable to offer “locomotive support” to the world economy. A U.S. election rules out quick fiscal action.
Markets, therefore, may be slower to react to good news via Fed rate cuts, when they happen, in light of those global constraints.
Notes
1. The CBOE Market Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Often called the “fear gauge,” lower readings suggest a perceived low-risk environment, while higher readings suggest a period of higher volatility. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
2. “Carry trade” here refers to borrowing Japanese yen to invest in higher-yielding currencies.
3. Source: CME (Chicago Mercantile Exchange). As of August 5, 2024. There is no assurance that any estimate, forecast or projection will be realized.
4. Source: NBER, Federal Reserve Bank of St. Louis, and DJII. Analysis by Franklin Templeton Institute. January 1, 1972 to July 31, 2024.Indexes are unmanaged and one cannot directly invest in them. Past performance is not an indicator or a guarantee of future results.
5. Ibid.
Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter, Investing This Week. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.
Disclaimer
Content copyright © 2024 by Franklin Templeton. All rights reserved. Used with permission.
What are the risks? All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in foreign securities involve special risks 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. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
Important legal information. This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments (“FTI”) has not independently verified, validated or audited such data. FTI accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton Investments’ U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
Image: iStock.com/Jirapong Manustrong
Join Fund Library now and get free access to personalized features to help you manage your investments.
Fund Library
