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
Preview
Equity valuations are top of mind among investors as we move into February, amid stretched sentiment and positioning and challenging corporate earnings expectations.
While we recognize these concerns as valid, we believe strong macro and corporate fundamentals should continue to support markets. Deeper analysis of growth, inflation and earnings gives us confidence that current optimism draws from solid foundations rather than irrational exuberance.
We believe rich valuations are justified by above-trend growth, which has combined with ongoing disinflation to create a “goldilocks” environment for equities. We also expect fiscal and monetary policy to be broadly supportive, dependent on the impact of political crosswinds. Beyond macro considerations, we view a healthy corporate earnings environment as bullish for risk assets.
Stretched sentiment and positioning is a contrarian indicator that supports a more bearish approach to risk, but in our view, strong fundamentals outweigh this.
Against this background, in this month’s Allocation Views, we remain modestly overweight equities within our policy portfolio, balanced by an underweight to fixed income. We also allocate to commodities and alternatives for diversification and hedging purposes.
Macro themes
A resilient growth story
- Leading economic indicators have strengthened, fueled by artificial intelligence (AI) capex (capital expenditure) and high-end consumers.
- Corporate sentiment appears strong, as evidenced by positive earnings revisions and guidance for calendar year 2026.
- The US economy has proven robust. Labor market data has softened from a strong position but is stabilizing and currently shows no signs of collapsing.
Moderating inflation trends
- Inflation remains above central-bank targets in most developed economies, although the trends are broadly disinflationary.
- Tariffs have been absorbed by both consumer prices and business margins. Core goods inflation could persist, but pressures have likely peaked.
- Services inflation has eased due to lower housing costs and wages, helping counteract higher goods inflation.
Policy leans supportive
- Economic crosswinds may prevent the Federal Reserve (Fed) from cutting rates again in the near term, but we expect moderate easing over the next year.
- Several major central banks remain in easing cycles, but the global policy environment has become more complex and is increasingly bifurcated.
- Fiscal policy in major economies is an increasingly influential driver of asset prices. We believe US tax refunds will likely offset tariff headwinds, while stimulus measures in Japan and Germany could also prove supportive.
Portfolio positioning themes
Responsibly bullish
- Positive earnings revisions and guidance support equity market momentum, outweighing valuation concerns, in our view.
- Leading and current indicators of economic strength remain broadly positive and support risk assets.
- Sentiment and positioning have become more stretched. We believe this is a slight headwind for risk assets and feeds into the ongoing valuations debate.
Opportunity in emerging markets (EMs)
- Earnings expectations are rising rapidly across EM ex China, influencing our more constructive view on the region. Macro conditions are also supportive.
- We retain our optimistic view of US large-capitalization stocks, relative to small caps and regional equities. Robust earnings and a supportive macro backdrop guide our thinking.
- We remain broadly pessimistic toward international-developed market equities.
Underweight government bonds
- Strong growth is challenging longer-term market expectations for Fed easing, in our view. Elsewhere, central bank rhetoric has become more hawkish recently.
- Fiscal deficits are widening in major economies, as governments increase spending or cut taxes to stimulate growth. Consequent yield effects make us selective on duration.
- Tight spreads diminish the risk-adjusted returns available from credit. Earnings growth leads us to favor equities.
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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