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CONTRIBUTORS

Brett Goldstein, CFA

Head of Multi-Asset
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

In this month’s Allocation Views, strong corporate fundamentals and resilient growth fuel our continued optimism toward equities into June, despite persistent inflation and more restrictive monetary policy.

The capital expenditure (capex) super cycle is continuing unabated and benefiting a broad swath of companies involved in the artificial intelligence (AI) build out. 

Investor concern around return on investment from that capex has been suppressed by double-digit earnings expectations, which have held forward price/earnings (PE) ratios at acceptable levels and fueled market momentum.

Restrictive policy is a headwind for risk assets, as are rising input costs, but we believe the ongoing strength of corporate earnings outweighs these concerns.

Within fixed income, a hawkish policy pivot, alongside rising term premia, has pushed US Treasury yields higher. This has closed the valuation gap with international developed market government bonds.

Macro themes

Steady growth

  • Robust earnings expectations fuel an optimistic post-conflict outlook, although earnings breadth has moderated.
  • The US economy has proven resilient, while labor market data has stabilized.
  • Leading economic indicators look healthy, but we are monitoring the impact of higher input costs. Euro-area indicators are weaker than other regions. 

Persistent inflation

  • US inflation dynamics remain challenging. Core inflation is elevated, but some measures show pressures moderating.
  • Core goods inflation is also above trend. Tariff pressures may have peaked but are currently offset by global supply chain tightness.
  • We expect limited second order effects from the energy impulse, as conflict in Iran moves closer to a resolution.

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 a tightening bias in most regions including the United States.
  • Fiscal policy is supporting growth but contributing to expanding deficits. US tax refunds are offsetting tariff headwinds, while energy support packages could also prove influential.

Portfolio positioning themes

Equity optimism

  • Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
  • Conflict in the Middle East is moving toward resolution, and we would expect markets to look through any temporary setbacks.
  • Sentiment and positioning have strengthened, but are not yet exuberant, remaining broadly supportive of risk assets.

Focus on US core equities

  • We retain a preference for US large-cap equities, as artificial intelligence (AI) capital expenditure (capex) continues to drive equity markets.
  • We trim emerging market (EM) equities exposure following recent strong performance but remain optimistic, amid healthy corporate fundamentals and exposure to AI themes.
  • We have reduced exposure to Japanese equities, influenced by rising inflation pressures linked to higher import costs and fiscal stimulus effects.

Balancing duration exposure

  • 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 complicate Fed policy. We have added to US duration but remain underweight amid sustained upward pressure on yields.
  • Excess returns for equities appear more attractive to us 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.

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