Mid-year update: Staying diversified and income-focused

CONTRIBUTORS

Edward D. Perks, CFA

Chief Investment Officer
Franklin Income Investors

US economic update

The US economy has been experiencing a soft patch recently, with second-quarter gross domestic product (GDP) showing weakness in areas such as personal consumption, capital expenditure and housing. Despite this, unemployment remains relatively low, although underemployment has seen a slight increase. The US Federal Reserve (Fed) has maintained a wait-and-see approach and didn’t cut the federal funds rate at its July Federal Open Market Committee (FOMC) meeting. There was some controversy, though, with two dissenting votes favoring cutting rates. In our opinion, inflation continues to be a little bit of a question mark. Although tariffs haven’t led to higher inflation thus far, the impact of tariffs and trade policies will likely continue to be a source of uncertainty. Additionally, disinflation has stalled.

Mixed market signals

In our analysis, interest rates and equity markets have been providing mixed signals about the economy. Interest rates remain somewhat elevated, but rate volatility has decreased, with the US 10-year Treasury trading in a narrower range.

Exhibit 1: Interest-Rate Volatility Declining

10-Year Treasury Bond Yield
June 1, 2020–June 30, 2025

Source: Bloomberg.

The equity market, as measured by the S&P 500 Index, experienced a bear market correction in early April, followed by a significant rebound by the end of June. We attribute this recent performance to continued “US exceptionalism” and the leadership of US companies in driving the artificial intelligence (AI) revolution.

Exhibit 2: Too Soon to Bet Against US Exceptionalism

Performance Comparison of Select Equity Benchmarks
April 8, 2025–June 30, 2025

Sources: Bloomberg, S&P Dow Indices, MSCI. The MSCI World ex USA Index captures large- and mid-cap representation across 22 of 23 developed markets countries--excluding the United States. The S&P 500 Equal-Weight Index (EWI) includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 EWI is allocated a fixed weight of 0.2%. Past performance is not an indicator or a guarantee of future performance. Indexes are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.

However, there has also been a broadening of sector performance in the US equity market in 2025—moving away from the narrow leadership of the Magnificent Seven¹ that dominated in 2023 and 2024—with industrials, commercial services, utilities and financials showing strength in the first half of the year.

Exhibit 3: Equity Leadership Shifting

Year-to-Date (YTD) Returns by Sector
December 31, 2024–June 30, 2025

Sources: FactSet, S&P Dow Jones Indices, Bloomberg. Sectors based on S&P Dow Jones GICS (Global Industry Classification System) sector classification system. The Bloomberg Magnificent 7 Index (Mag 7) is an equal-dollar weighted equity benchmark consisting of a fixed basket of seven companies classified in the United States and representing the communications, consumer discretionary and technology sectors as defined by the Bloomberg Industry Classification System (BICS).

Credit market volatility

The credit markets experienced significant fluctuations in the first half of 2025, with the Bloomberg US Corporate High Yield Index Yield-to-Worst² initially declining slightly before spiking higher due to policy-driven uncertainty following President Trump’s Liberation Day announcement. There was a moment in the second quarter where we believe there was an opportunity to take advantage of higher yields. However, as rate volatility decreased and corporate earnings have improved, yields have come back down.

Exhibit 4: Opportunities Abound in Dislocations

Bloomberg US Corporate High Yield Index Yield-to-Worst
June 30, 2020–June 30, 2025

Source: Bloomberg. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Yield-to-worst is the lowest possible yield that can be received on a bond without the issuer actually defaulting. Liberation Day was April 2, 2025, and was the day the Trump administration unveiled initial reciprocal tariff rates on countries worldwide.

Balanced investment approach

In our opinion, the ability to be nimble and react to opportunities in the current environment is crucial. We currently favor maintaining a balanced and diversified mix across stocks, bonds and hybrid investments. We also focus on income generation from companies that generate consistent and what we consider attractive monthly income.

Outlook for fixed income and equities

Looking ahead, we believe it is unlikely for the US economy to fall into recession-type conditions as the Fed will likely act to move off of its still moderately restrictive tone. We expect the Fed could potentially cut rates 50 to 100 basis points over the next six to 12 months. This should provide a nice backdrop for the longer end of the yield curve. We expect the US equity market to continue its broadening trend, offering more opportunities in a wider range of sectors.

Endnotes

The Magnificent Seven comprises Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA and Tesla.
Source: Bloomberg. The Bloomberg US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Yield-to-worst is the lowest possible yield that can be received on a bond without the issuer actually defaulting.

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