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Recession: Separating fact from fears

The consequences of monetary policy

Geopolitical risks take center stage

Potential shocks

GLOBAL INVESTMENT OUTLOOKFRANKLIN TEMPLETON THINKSTM

Staying nimble amid an uncertain outlook

OCTOBER 2019

Bouts of volatility hit markets across the globe in

the third quarter of 2019 amid continued

uncertainties about global growth and trade. Central

banks took notice, with the US Federal Reserve

easing interest rates for the first time in more than

a decade and the European Central Bank also

cutting rates and reintroducing quantitative easing.

Against this backdrop, our senior investment

leaders discuss why they do not see a recession in

the near term, but are taking a cautious and

nimble approach.

Discussion topics within:

• Recession: Separating fact from fears

• The consequences of monetary policy

• Geopolitical risks take center stage

• Potential shocks

Stephen H. Dover, CFA Head of Equities

Michael Hasenstab, Ph.D. Chief Investment Officer,

Templeton Global Macro

Edward D. Perks, CFA Chief Investment Officer,

Franklin Templeton

Multi-Asset Solutions

Sonal Desai, Ph.D.Chief Investment Officer,

Franklin Templeton Fixed Income

Featured senior investment leaders

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 develop-ments. 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.

3Staying nimble amid an uncertain outlook

Ed PerksI think we need to look at what causes a recession. When an economy is overheating, monetary policy plays a traditional role to cool it down. This business cycle feels a bit different. We don’t have those classic signs of overheating, but we have a lot of moves that seem to be preemptive—whether that’s US fiscal policy stimulus or actions of central banks globally.

The big issue right now is trade policy uncertainty. Not just from the stand-point of the impact on the real economy, but maybe more importantly, the question of how the situation could be resolved, or how much more could it escalate. The uncertainty about trade has put a bit of a lid on the outlook for equities. That said, I would note US equities are actually near all-time highs.

Stephen DoverI think it’s important to point out the global economy has changed over the past few decades. Gross domestic product growth is less manufacturing- driven and more service-driven—and this is the case not only in most developed countries but in a number of emerging markets, too. Globally, one can argue the manufacturing side is currently in recession, but the service economy is not (see exhibit 1).

Meanwhile, earnings growth hasn’t been what we had hoped for earlier in the year, so there’s also some talk of an earnings recession in the sense that earnings growth has slowed compared with recent years. While predictions still look pretty positive for 2020, earnings could certainly come down a bit (see exhibit 2). We are still relatively positive on our outlook for equities—corporate profits remain high, even if their growth

Q: Recession worries dominated media headlines recently. How do you respond to these concerns?

54

53

52

51

50

55

49

Index

Expanding

Declining

SERVICE ECONOMY REMAINS IN EXPANSION, WHILE MANUFACTURING DECLINES Exhibit 1: Global Purchasing Managers’ Index (PMI) September 2016–August 2019

Sources: Franklin Templeton Capital Market Insights Group, IHS Markit Global Services/Manufacturing PMI, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.

The Global Sector Purchasing Managers’ Index (PMI) tracks variables such as sales, employment, inventories and prices. A reading above 50 indicates that the sector is generally expanding; below 50 indicates that it is generally declining.

Sep 2016 2017 2018 2019 Aug 2019

Service PMI Manufacturing PMI

40%

30%

20%

10%

0

-10%

50%

-20%

US EARNINGS GROWTH EXPECTED TO SLOW IN MOST SECTORSExhibit 2: Year-over-year US corporate earnings-per share (EPS) growth (%) As of August 31, 2019

Sources: Franklin Templeton Capital Market Insights Group, S&P Dow Jones Indices, FactSet. Important data provider notices and terms available at www.franklintepletondatasources.com. For illustrative purposes only and not re�ective of the performance or portfolio composition of any Franklin Templeton fund.

Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. There is no assurances that any estimate, forecast or projection will be realized.

S&P

500

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Disc

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Indu

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Tele

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Fina

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Info

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Stap

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Real

Est

ate

Next 12 months, year-over-year EPS growth Last 12 months, year-over-year EPS growth

Staying nimble amid an uncertain outlook4

is diminishing a bit. We still see a lot of potential opportunities right now but recognize that fears about a reces-sion and negative news can indeed be self-fulfilling prophecies. When busi-nesses are uncertain, they tend to pull back.

Ed PerksI think we should be asking ourselves: “What are the forces that have been holding up market performance?” Going back to the risk of recession versus the fear, if uncertainty rises to a degree where corporations really start to pull back on capital expenditures, that could be a self-fulfilling mechanism that does slow growth.

Stephen DoverOne of those sustaining forces is buybacks—which hit a record of more

than $800 billion in 2018 in the United States.1 I think it’s interesting to look at the difference between the absolute earnings of all companies and earnings per share (EPS), which represent a company’s profit divided by shares it has outstanding. Absolute earnings growth has been less than earnings per share growth due to share buybacks, particularly in the United States. Buybacks can create distortions in the equity market, particularly in terms of valuations. Stock prices tend to appre-ciate more than they would if there were no buybacks, and at least in the United States, buybacks have really been propelling the market. Buybacks can be considered a form of demand for equi-ties—since they involve a purchase of shares. Lastly, money from buybacks that is returned to shareholders wouldn’t be available to investing back into the business to fuel growth.

Sonal DesaiWhen I look at EPS growth because of buybacks, it brings us to a discussion of an unusual quantity of liquidity. It’s essentially financial engineering. But what I find interesting is we are really talking about a possible earnings recession—not a real economic recession. I absolutely agree that firms could start becoming a lot less confident about the outlook and that can impact investment.

On the other hand, we continue to see very robust wage growth (see exhibit 3). So, I would agree that we might see an earnings recession play out if we aren’t already, but I’m not so sure it’s translating near term into a recession in the real economy in the United States.

STRONG US SAVINGS RATE AND WAGE GROWTH TRENDS WITHOUT DEFLATIONExhibit 3: US Bureau of Economic Analysis January 1990–April 2019

Sources: FTI Fixed Income Research, US Bureau of Economic Analysis (BEA), Macrobond.

The core Personal Consumption Expenditures (PCE) excludes food and energy prices from the index.

12.5%

10.0%

7.5%

5.0%

2.5%

0.0%

-2.5%

-5.0%

Savings Rate (% Disposable Income) Nominal Wage Growth (% YoY) Core-PCE (% YoY)

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 Apr2019

Recession period

1. Source: S&P Global press release, March 25, 2019, “S&P 500 Q4 2018 Buybacks Set 4th Consecutive Quarterly Record at $223 Billion; 2018 Sets Record $806 Billion.”

5Staying nimble amid an uncertain outlook

Michael HasenstabIf we were to look back 10 years ago, the thought that central banks would be cutting interest rates when wages were going up, when there is record-low unemployment, decent economic growth and strong budget deficits, would seem pretty unconven-tional. Quantitative easing programs in the wake of the 2008–2009 global financial crisis were unconventional—and they worked really well. So, central banks across the globe are now doubling down on unconventional policy during a different fundamental backdrop—one that is much stronger—and we just don’t know what some of the results of this policy experiment will be. The idea of negative interest rates has become very normal (see exhibit 4). I think we have to question that thinking. Negative rates can be counterproductive.

When you have a lot of savers facing a negative return on their bank accounts and their savings, they tend to save even more and spend less and so it’s counterproductive. We need to consider whether these exceptionally low interest rates are artificially pushing investors seeking better yields into riskier assets at higher valuations and perhaps less liquidity. So, I think policy decisions are where the biggest risks lie because they are creating some distortions, which could trigger a recession.

Sonal DesaiI don’t see how it can end well when central banks—particularly the US Federal Reserve (Fed)—seem to be guarding against a perceived threat of deflation. There’s absolutely no sign of deflation anywhere in the United States, so this complete focus on guarding

against this threat seems strange to me. With record low US unemployment, the Fed seems to be anticipating a deflationary situation that doesn’t seem to exist, and effectively keeps pushing investors towards riskier, less liquid assets. If we look at wage growth combined with the impact of US-China

tariffs, at some stage, we have to actually consider a rise in inflation.

Stephen DoverFrom the equity point of view, while we see many opportunities globally in markets, we are also quite cautious.

Q: What’s your view of monetary policy globally—and the implications for investors?

12%

10%

8%

6%

4%

2%

14%

0%

Yield %

EARNINGS YIELD IS HIGHER THAN THE YIELD ON FIXED INCOME Exhibit 5: Global earnings yield and government bond yield August 2001–August 2019

Sources: Franklin Templeton Capital Market Insights Group, MSCI, Bloomberg, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com. For illustrative purposes only and not re�ective of the performance or portfolio composition of any Franklin Templeton fund.

The MSCI Europe, Australasia and Far East (EAFE) index captures large- and mid-cap representation across 21 developedmarket countries. Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. There is no assurances that any estimate, forecast or projection will be realized. Past performance is not an indicator or guarantee of future results.

Aug-01 2003 2007 2011 2015 Aug-19

Earnings Yield, MSCI EAFE Yield to Maturity—Bloomberg Barclays Global Aggregate Government Index

NEGATIVE-YIELDING DEBT IMPACTING MANY COUNTRIES Exhibit 4: Top 10 countries with negative-yielding debt As of August 30, 2019

Sources: Franklin Templeton Capital Market Insights Group, Bloomberg Barclays Negative Yielding Debt Index. Important data provider notices and terms available at www.franklintempletondatasources.com.

Bloomberg Barclays Negative Yielding Debt Index includes securities in treasury, government-related, corporate and securitized sectors. Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges.

France$2,141

Germany$1,836

CountryPar Outstanding ($Bil)

Japan$6,904

Spain$794

Netherlands$678

Italy$435

Belgium$358

Sweden$317

Switzerland$228

Austria$268

Staying nimble amid an uncertain outlook6

Michael HasenstabWhen we have geopolitical risks such as the current trade frictions between the United States and China, the splin-tering of populations, the growing social divide and the rise of populist economic agendas, we have seen a resulting rise in deficit spending.

In fact, a lot of international organiza-tions—including the International Monetary Fund—have warned that even major countries that had been fiscally sound now are running out of fiscal room.

So, when an economic downturn does eventually come, our question is, what policy tools are left to restart growth? Governments have already spent money and central banks have already lowered interest rates preemptively to react to a potential shock that hasn’t actually materialized, so policymakers are running out of tools.

We’re looking at the world differently today than we have over the past 10 years. We are favoring what the market generally considers “safe-haven” assets. For example, places like Japan or Scandinavia—which have current account surpluses and tend to receive

capital when people panic. We have been de-risking some of our exposure in emerging markets. We are still finding some select opportunities, but are taking a more conservative approach and paring back a bit.

Bottom line, I think it’s time for inves-tors to think about what worked for the last 10 years and realize it probably isn’t going to keep working the same way going forward. We think it’s important for investors to be nimble—that means being actively positioned for greater risks.

Sonal DesaiTo add to Michael’s comments, there has to be a little expectation manage-ment on the part of investors in the sense that we are in a world where fixed income rates are incredibly low. It’s difficult—and unrealistic—to expect to generate the type of returns people have become accustomed to without some risk and volatility. That’s a bit of a sea change. For many years, people became much more comfortable with the idea that yields would just go down, that there is no other direction for them to

Q: Geopolitical risks are taking center stage. How has the investment landscape changed as a result?

I think equities, at this point, are a yield opportunity. The yield on earnings is still much higher than the yield on fixed income (see exhibit 5).

Ed PerksAs central bank activity continues to push investors into riskier assets, the broader drift downwards in global rates has implications for corporate borrowing

costs as well. We have seen a real pickup starting to happen in credit markets; companies have been able to access longer-term capital at incredibly low rates. This ties back into our discussion about the bigger positive drivers for equities—namely share repurchase activity. While we may see a slowdown in earnings growth going forward, corporations do still have

access to capital, so they can sustain share buybacks.

As multi-asset investors, when we look at negative sovereign rates around the world, and very low absolute yields in the broad range of fixed income sectors in the United States, at some point we have to ask where the alternatives are. It’s a challenging time for investors.

25

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15

10

5

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0

P/E Ratio

May 1997 / 18.904

Nov 1998 / 19.75 Sep 1999 / 24.391 Feb 2011 / 15.867

8.65

SOUTH KOREAN EQUITY PRICES AT A RELATIVE LOW, MAY OFFER OPPORTUNITY Exhibit 6: South Korean equity index, trailing price-to-earnings1994–2019

Sources: Franklin Templeton Capital Market Insights Group, MSCI Korea Large Cap Value Index, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.

Trailing price-to-earnings measures the current share price relative to the total EPS earnings over the past 12 months. The price-earnings (P/E) ratio is a valuation multiple de�ned as market price per share divided by annual earnings per share (EPS).

Indexes are unmanaged and one cannot directly invest in an index. They do not include fees, expenses or sales charges. There is no assurances that any estimate, forecast or projection will be realized. Past performance is not an indicator or guarantee of future results.

1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2019

7Staying nimble amid an uncertain outlook

Ed PerksThe one potential shock or variable that I think could have a real impact on financial markets—and change our outlook for equities—would be a deterioration in consumer sentiment. Certainly, there are a lot of things underpinning the consumer, which has been a bastion of strength in the US and global economy. We continue to see job and wage growth. But could trade-related uncertainty weigh on consumer and business sentiment to a degree that causes big cracks? That’s a concern that would challenge the landscape and how assets are allocated, as well as the performance of different asset classes going forward.

Stephen DoverThere are a lot of geopolitical risks coming up that could create even more uncertainty. At a minimum, between now and November of next year, there is expected to be a lot of volatility over political developments around the world—including a US presidential elec-tion. I believe that’s an uncertainty companies don’t know how to deal with.

go, and valuations just got more and more stretched. Because investors are in that frame of mind, at a time of stretched valuations and with height-ened geopolitical risk, I think volatility has to go up.

Stephen DoverI’m always amazed at businesses’ ability to adjust to various environments, but what businesses can’t adjust to is uncertainty. That said, geopolitical risks or changes can also lead to new

Some of the political candidates have stated they favor policies which would negatively impact the profitability of companies; that would have a pretty profound effect on equity markets. If there is a shock, we believe it could manifest as a shortage of market liquidity. That’s something to be concerned about—as active investors, we continuously monitor liquidity within our portfolios on a stock-by-stock basis.

Sonal DesaiMany of the risks we are talking about are, in some regard, related to social populism and political instability. The impact is that there are what I consider to be some scary ideas out there. For example, the idea of Modern Monetary Theory essentially says the central bank should and can keep printing money to finance deficits, and this is supposed to finance universal basic income or anything else. This approach is a slippery slope, in my view. If we see country after country moving in this direction of what I can only consider as sheer recklessness, that to me is a huge worry.

opportunities. For example, around Brexit and the UK market, there are some companies that have adjusted or will be able to adjust, and should do well regardless of what happens. There is also a lot of fear around global trade issues—and some of this fear may be overdone. For example, the South Korean equity market has suffered from some trade-related fallout, and is the cheapest it’s probably been in about 20 years. So, we see some select opportunity in South Korean equities as well (see exhibit 6).

Michael HasenstabWhether it’s stretched valuations, the lack of policy tools that central banks and ministries of finance have to fight an inevitable downdraft, or less liquidity in markets because people are buying riskier assets, we see these conditions as a mounting pile of dry kindling. We don’t know what the spark will be, but we think it’s time to buy more fire extinguishers. There is growing political division globally, and a lack of consensus. In Europe’s case, there is a lack of European identity and with that comes an inability to work together when needed. It’s far left, and far right—with little in between. I think it’s certainly prudent to be building a more cautious portfolio, because when we look to the horizon, it’s hard to imagine a period of geopolitical stability coming—in the near term at least.

Ed PerksI think that certainly tallies with the theme of taking an active approach in a period of potentially high volatility.

There is also a lot of concern about China and slowing growth in its economy. I’ve pounded the table for a long time about how global equity inves-tors really need to look at China in a different way than they have in the past, because its economy has shifted to a different model—one that is more service-based. China’s size and influ-ence are huge in the global economy, and we think investors should not ignore it.

Q: What are the issues or potential shocks that worry you most?

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