Uneven Climb Through Recovery

Our CIOs' Global Investment Outlook offers perspective on the investment landscape and the US elections.

Edward D. Perks, CFA

Edward D. Perks, CFA Chief Investment Officer, Franklin Templeton Investment Solutions

Michael Hasenstab, Ph.D.

Michael Hasenstab, Ph.D. Chief Investment Officer, Templeton Global Macro

Sonal Desai, Ph.D.

Sonal Desai, Ph.D. Chief Investment Officer, Franklin Templeton Fixed Income

Stephen H. Dover, CFA

Stephen H. Dover, CFA Head of Equities

Manraj Sekhon, CFA

Manraj Sekhon, CFA Chief Investment Officer, Franklin Templeton Emerging Markets Equity

Introduction

The global economy is still fighting to recover from the ravages of COVID-19, but there are hopeful signs. Many countries, markets and sectors are climbing out of the crisis with the help of centralized policy responses.

While the path to a full recovery may not be smooth—and may take longer than initially anticipated—our senior investment leaders see reasons to be optimistic 2021 will bring brighter days. They offer their view of investment opportunities today and the uncertainties still clouding the outlook, including not only the pandemic but also the US presidential election.

Key Viewpoints

  • It appears that a cyclical recovery is underway. However, we expect the path to remain uneven. Consumer confidence remains vulnerable to virus-related concerns, and the need for ongoing government support is essential for those who have become unemployed, and to drive future business investment.
    —Ed Perks, Gene Podkaminer and Wylie Tollette

  • We continue to model two phases to the global crisis. Financial markets currently remain in the first phase, characterized by a prolonged period of elevated risks and uncertainty, with the potential for additional market shocks that could last for multiple quarters. In the second phase, we expect a more sustainable recovery to eventually take hold, shortly preceded by periods of distorted asset prices and compelling investment opportunities.
    —Michael Hasenstab

  • The US presidential election is adding to market uncertainty. Democrats and Republicans have substantially different economic policy plans, so depending on the outcome, the tax and regulatory environment could be very different for the overall economy and for key sectors like energy, health care, finance and technology, with the associated impact on high-yield and investment-grade corporate credits. We believe high-quality, bottom-up research will remain crucial to successful investing.
    —Sonal Desai

  • Parts of Europe and Asia are ahead of the United States in returning their economies back to pre-COVID-19 norms. In Asia and particularly China, manufacturing and surprisingly, service industries have returned to near normal pre-COVID-19 levels. This contributes to our generally positive global outlook.
    —Stephen Dover

  • The COVID-19 crisis has catalyzed the acceleration of some long-term themes and trends that we have identified and followed in recent years. This trajectory will likely continue into 2021. Emerging markets have shown a continued appetite for structural reforms that could lay the foundation for lasting economic recoveries. China, for example, has stayed true to its longer-term goal of making domestic consumption a major economic engine—and a source of potential ballast during external demand shocks.
    —Manraj Sekhon

A flexible investment approach in the face of an unusually uncertain environment

Ed Perks, CFA
Chief Investment Officer, 
Franklin Templeton Investment Solutions

Gene Podkaminer, CFA
Head of Multi-Asset Research Strategies, Franklin Templeton Investment Solutions

Wylie Tollette
Head of Client Investment Solutions, Franklin Templeton Investment Solutions

Business cycles typically follow a similar arc. Though this recession was unique, caused by a different kind of policy tightening, it appears that a cyclical recovery is underway. However, we expect the path to remain uneven. Does it matter that progress will not be smooth? It probably depends on your perspective. Viewed from high above, the path is clearly climbing, and it’s hard to make out bumps and undulations in the terrain. From the point of view of a hiker climbing out of the valley, it is obvious that we might need to avoid a few boulders, or even descend slightly before making the final ascent.

Similarly, in the big picture, the earnings outlook for stocks is improving. Business sentiment might even be stronger than usual at this stage of the cycle. But the pace of growth is not assured. Consumer confidence remains vulnerable to virus-related concerns, and the need for ongoing government support is essential for those who have become unemployed, and to drive future business investment. The consequences of different approaches— between the US support for individuals who have lost jobs, and the European model of support for companies and to preserve jobs—will play out over the next six to 12 months. It makes the pace of recovery and the relative strength across regions more difficult to predict than normal. This contributes to an environment that remains more than usually uncertain.

Fiscal and monetary policy coordination necessary

Developed market central banks continue to provide stimulus in the form of very low or negative interest rates and have indicated that they will do whatever it takes to support economies back toward full employment. This has included boosting the quantity of money in circulation through buying financial assets. In recent months, central bankers have adopted a more flexible approach to setting policy, with the aim of promoting a healthy level of inflation. However, they have also sounded a little pessimistic over the near-term outlook and argued strongly for additional and ongoing fiscal stimulus to cement the recovery. This has resulted in a degree of policy coordination that would have seemed exceptional just a year or so ago. We expect such coordination to remain necessary and to be delivered.

The ability for emerging markets to follow the same path is less clear. The boulders in their way are larger and could prove insurmountable for some.

Many will be in greater need of fiscal or monetary help in the year ahead and may be slower to benefit from vaccine progress. However, the success of developed economies will help them, and any associated increase in commodity prices or a persistent decline in the US dollar exchange rate would help ease their progress.

Market and economic disconnect

Markets discount the future, not just the present, so it’s common to feel like there’s a disconnect between the markets and the economy, especially at the beginning of a recovery. In addition, the policy reaction that commonly marks the trough was unprecedented in its timeliness, degree, and magnitude in this cycle. As well as supporting activity, the surge in liquidity, or credit growth, has suppressed volatility and reduced the risk premia for assets.

Overall, we see the prospects of more modest returns from all assets in the years ahead and continue to see benefits from remaining flexible in our investment approach. Finding assets that offer natural diversification benefits and offsets to any rise in inflation will be particularly appealing. However, in the longer term, we focus on the return potential for stocks versus bonds. We believe that they should earn their equity risk premium over time, offsetting shorter-term concerns that have tempered our enthusiasm.

COVID-19 accelerating trends

There are a number of trends that we see accelerating in the wake of the COVID-19 pandemic, many of which are likely to continue long term.

We continue to expect environmental, social and governance (ESG) factors to play a growing part in driving investor behavior. Equally, we see a broadening of the consensus that we must integrate a social dimension into government and corporate behavior. The consequences of the current COVID-19 recession may be felt in re-building economies in a greener and more socially inclusive way. This is exemplified by the European Union’s recently agreed stimulus measures, where richer countries support poorer ones. With one-third of the funding due to be raised through issuance of green bonds, it will also help to accelerate the development of this nascent market.

It is also likely that technology trends that started during the economic lockdown will continue, as we have seen an acceleration of secular adoption and investment trends. We have also seen a shift of consumption patterns from services and experiences (e.g., travel) to things (e.g., homes and autos), which is a tailwind for the construction and manufacturing sectors. It is perhaps less clear if this is a permanent change, or just a temporary interruption to broader societal trends.

"Historically, equity markets tend to do well in the year following US elections, regardless of which party wins, although this is not always evident in the short term.”

The US political wildcard

Historically, equity markets tend to do well in the year following US elections, regardless of which party wins, although this is not always evident in the short term. However, there are risk factors that bear monitoring this year, not least that the election results might be delayed, creating uncertainty or chaos in the short term. Or that a Democratic sweep of the US Congress and presidency might usher in a number of broad and sharp changes in policy that could be challenging for businesses. Potential changes might include higher taxes, more regulatory oversight, higher minimum wages, or a reversal of the 2017 Tax Cuts and Jobs Act. Conversely, trade policy might normalize with a return to multilateralism, as we pivot back to traditional norms and international alliances, which could provide a counteractive boost to markets, particularly for Asian and emerging market countries. It does seem like both parties will continue to target trade policies with China, although the Democratic nominee, Joe Biden, is more likely to coordinate this effort with other developed markets. If the Democrats gained much stronger control over government, fiscal stimulus would also likely be much larger and serve as an economic tailwind, although a larger fiscal deficit might have some implications longer term with regard to higher taxes for future generations.

Under a Biden administration or more Democratic-led agenda, aerospace and defense could be impacted given potential cuts to defense spending. The largest technology and media companies could also be impacted through stronger antitrust and content regulation efforts. Banks and financial institutions might also face more regulatory initiatives and headwinds, but they would likely remain intact. On the more positive side, larger infrastructure and new green energy platforms would likely take hold. These would benefit industries with direct ties such as materials and industrials, while hurting traditional energy companies.

Within health care, expansion of the Affordable Care Act would be more likely and benefit hospitals, but a possible strengthening of the Supreme Court along Republican lines might undermine or stall those efforts. Drug pricing reform would likely remain in sharp focus and could gain more traction, depending on the makeup of Congress, which would have negative implications for pharmaceuticals and biotechnology.

If the status quo is maintained with a Trump presidency or a Congressional stalemate, the impacted industries above might rebound, given some pricing-in and bracing for potential changes in either the presidency and/or Congress. However, in the longer term the underlying economic fundamentals tend to be dominant over political orientation. This year, it is perhaps the uncertainty over the electoral process, rather than the policies of the combatants, that causes us greatest concern and leads us to temper our enthusiasm for stocks and other risk assets in what is undoubtedly already an uncertain environment.


Elevated risks for the fall and winter months

Michael Hasenstab, Ph.D.
Chief Investment Officer, Templeton Global Macro

After a surge of summer optimism, global financial markets have appeared to cool with the arrival of fall. Risk-asset rallies in the United States and Europe have recently shown signs of reaching their limits, as equity prices have pulled back from their peaks and credit spreads have widened. We expect those trends to continue in the months ahead as economic hardship persists, leading to greater cost-cutting by businesses and rising insolvencies. Central banks have been effective at maintaining liquidity across financial markets to date, but their interventions do not replace lost revenues or cure insolvencies, they only deepen the debt burdens. Consequently, many risk assets appear detached from underlying economic fundamentals, in our view, and remain vulnerable to a correction as the pandemic persists.

While there are reasons for optimism amid the COVID-19 pandemic, there is also cause for concern. It has been encouraging to see economies around the world strive to remain open under varying precautionary measures. However, we expect the pandemic to continue to have a constraining effect on global aggregate demand until the health crisis is remedied. The headwinds to economic growth remain substantial.

Economic recoveries in many regions have recently shown signs of leveling off, demonstrating that much of the previous improvements in the late spring and summer months were rebounds from the extreme low points in March and April, not growth trends that could be extrapolated through upcoming quarters. We remain concerned that as the pandemic persists through the fall and winter months, business insolvencies will worsen with each month of stifled activity. As the seasons shift to less daylight and colder, increasingly inclement weather, people will be increasingly compelled to spend more time indoors, increasing the risks for rising infections and further suppressing economic activity. A global recovery is likely to remain gradual, in our view, with the potential for multiple stages of relief rallies and corrections in financial markets before a more sustainable growth recovery eventually takes hold.

Adding to the complexity of the globally synchronized crisis is the precarious state of the world that existed before the pandemic. Geopolitical tensions, unorthodox policymaking and political polarizations have made it difficult for countries to find the collective goodwill needed to address both domestic and international challenges during the most profound economic shock in the post-war era. Geopolitical risks remain elevated as the United States heads toward elections in November and the United Kingdom struggles to agree to terms before its end of year deadline for withdrawal from the European Union.

Additionally, deglobalization trends that were already underway before the pandemic erupted have only accelerated during the crisis. As countries increasingly focus internally on health concerns, national security and other domestic issues, global integration has been further cast aside. Potential structural shifts toward domestic production and regional supply chains would have major implications for the global economy and financial markets in the decade ahead.

It also remains unclear how governments that were already burdened with high debt levels will pay for massive pandemic relief programs, as fiscal deficits have deepened significantly throughout the world. Large stimulus measures may be unavoidable in the near term, but responsible fiscal governance will be essential to debt sustainability going forward. Unorthodox policies such as modern monetary theory and debt monetization are likely to see greater political interest in upcoming years, increasing the risks for structural damage by imprudent governments. This makes it ever-more crucial to monitor policy across developed and emerging markets alike, to identify which sovereigns have their fiscal houses in order or the ability to bring them to order, versus those that do not. Environmental, Social and Governance (ESG) factors will be increasingly critical metrics for assessing the stability and economic prospects for countries in the years ahead. Social cohesion and good governance can accelerate a country’s post-crisis recovery, or the lack thereof can stymie it.

"It remains unclear how governments that were already burdened with high debt levels will pay for massive pandemic relief programs, as fiscal deficits have deepened significantly throughout the world. Large stimulus measures may be unavoidable in the near term, but responsible fiscal governance will be essential to debt sustainability going forward.”

Tragically we have seen the consequences of weak ESG factors in specific emerging markets during the pandemic. Countries that were less prepared for a health crisis due to weaker health care systems and less developed infrastructure, and/or less prepared for an economic crisis due to fiscal imbalances, high levels of debt and external dependencies, have suffered greater damage to lives and livelihoods. By contrast, countries that were in stronger fundamental shape before the crisis, with stronger institutions, lower levels of debt and more diversified economies, have generally fared better. As an investor, it remains crucial to be selective—a number of sectors and sovereigns remain highly vulnerable to a market correction, in our view.

In the United States, debt levels are projected to exceed 100% of gross domestic product (GDP) over the next decade with a fiscal deficit heading toward more than 5% of GDP by 2030. Monetary policy is projected to remain loose for the foreseeable future, with the Federal Reserve anticipating near-zero-percent rates through 2023 while it continues to provide unlimited balance sheet support to financial markets. Short-term US Treasury yields are likely to remain anchored by monetary accommodation in the near term, but surging fiscal deficits, massive debt levels and inflation pressures will eventually drive term premiums higher, in our view.

Looking ahead, we continue to model two phases to the global crisis. Financial markets currently remain in the first phase, which is characterized by a prolonged period of elevated risks and uncertainty, with the potential for additional market shocks that could last for multiple quarters. In the second phase, we expect a more sustainable recovery to eventually take hold, shortly preceded by periods of distorted asset prices and compelling investment opportunities.

Similar to the playbook we used heading into and eventually out of the global financial crisis in 2008/2009, we are taking a two-staged investment approach. In phase one, we are maintaining a largely defensive stance that focuses on higher allocations to safe-haven assets, lower duration exposures in select emerging markets, broad risk reductions and optimized liquidity. In phase two, we anticipate pursuing undervalued risk assets, with a particular focus on distressed valuations in higher duration local-currency sovereign bonds, emerging market currencies, and various credit sectors.

We remain confident that these types of phase-two investment opportunities will ultimately arise, but we also recognize that the pandemic may persist for multiple quarters, potentially pushing out the timeline for when certain investment opportunities may become suitable. Until that point, we continue to glean new information and new insights amid the evolving crisis, as we monitor the global economy on a country-by-country basis to uncover current and future investment opportunities.


A strong recovery, many challenges remain

Sonal Desai, Ph.D.
Chief Investment Officer, Franklin Templeton Fixed Income

The US recovery has proved as strong as we expected—and more. The rebounds in spending and employment have exceeded analysts’ expectations, thanks to the timely and decisive fiscal support: while the economy was shut down, stimulus checks and enhanced unemployment benefits boosted personal savings to a record high. As states began to reopen in May, this allowed households to unleash their pent-up demand for goods and services.

The recovery showed resilience when tested by a second wave of contagion in July. The second pulse of our Franklin Templeton–Gallup Economics of Recovery study, conducted in early August, showed that Americans’ willingness to engage in economic activities held up well, and that a majority of Americans intend to keep increasing their savings over the coming months, but not pay down debt, again accumulating spending power to deploy once the uncertainty abates.

The second wave of contagion was relatively more benign: compared to the rise in new cases, hospitalizations, intensive care unit use and deaths increased to a much lesser degree, and policymakers have mostly been able to respond with more localized and targeted restrictions rather than reverting to full-blown lockdowns. But the challenge is far from over; until an effective vaccine is made available at scale, policymakers will need to calibrate restrictions so as to allow the economy to recover while limiting the adverse health consequences of COVID-19.

We expect a strong quarter-on-quarter rebound in third quarter (Q3) US gross domestic product, followed by a slower recovery in the fourth quarter, when election uncertainty will likely act as a brake on business investment, and likely prevent Congress from passing an extension of fiscal support measures before early 2021.

We see a similar picture in the euro area, with fiscal stimulus helping a recovery in consumer spending and business activity, especially in Q3. Europe is also facing a new increase in COVID-19 cases, notably in the United Kingdom, Spain, France and to a lesser extent Germany, but these countries should also be able to respond with localized lockdowns, increased testing and tracing programs, rather than reverting to nationwide lockdowns.

Central bank support still on maximum setting

Global central banks are still offering maximum support. In August, the US Federal Reserve (Fed) switched to average inflation targeting: it will allow inflation to run “moderately” above 2% for some time, to make up for the period of below-target inflation. Since the Fed’s own projections envisage inflation will rise to 2% only in 2023, the Fed should be comfortable keeping interest rates at zero for well over three years, assuming its forecasts are borne out.

The Fed has, however, left itself substantial room for maneuver: it eschewed calendar-based forward guidance (a commitment to keep rates at zero until a specified date), and it has deliberately not indicated what look-back window it will consider for its past inflation undershooting. The Fed has signaled it will maintain a supportive policy stance until it is convinced that inflation has stabilized above 2%; but it has also retained the flexibility to act in case inflation should start rising too quickly. The Fed recognizes that the economy has already demonstrated a healthy capacity to rebound, and given the amount of fiscal and monetary stimulus, an earlier-than-expected rebound in growth and prices cannot be ruled out.

"We expect a strong quarter-on-quarter rebound in third quarter (Q3) US gross domestic product, followed by a slower recovery in the fourth quarter, when election uncertainty will likely act as a brake on business investment, and likely prevent Congress from passing an extension of fiscal support measures before early 2021.”

The European Central Bank (ECB) also remains fully committed to supporting the recovery, with negative interest rates and sizable asset purchases. The ECB’s loose monetary policy stance is complemented by the launch of a €750 billion European Recovery Fund that represents a momentous step forward in terms of fiscal integration, helping reduce borrowing costs for the financially weaker member countries.

Globally accommodative monetary policies are likely to keep yield curves anchored with long-term yields rangebound for the next three to six months. But as the recovery picks up steam, zero interest rates together with quantitative easing and loose fiscal policies should give some more life to inflation, creating potential for yield curves to steepen. The differential pace of economic recoveries will play a determinant role in foreign exchange markets. The Fed’s move to zero interest rates and average inflation targeting eliminated the interest-rate advantage for the US currency. Looking forward, however, the ECB’s sizable asset purchase program and the lingering uncertainty over global economic growth should limit any more persistent and pronounced dollar weakness.

Actively seeking value remains crucial

Financial markets over the past six months have remained substantially insulated from the travails of the real economy. Record-low interest rates and stepped-up central bank asset purchases have provided ample liquidity and reassurance; decisive fiscal stimulus has boosted household savings and markets’ confidence that the real economy will be able to weather the storm and bounce back once the health crisis has been surmounted.

The coming months, however, might prove more challenging. New surges in COVID-19 cases are slowing the pace at which governments reopen business activity, and in some cases leading to restrictions being tightened again. Prolonged limits to business activity are likely to trigger some increase in defaults in the months ahead.

In the United States, this will be compounded by the election’s uncertainty. Democrats and Republicans have substantially different economic policy plans, so depending on the election outcome, the tax and regulatory environment could be very different for the overall economy and for key sectors like energy, health care, finance and technology, with the associated impact on high-yield and investment-grade corporate credits.

More generally, financial asset valuations will therefore likely experience stronger headwinds, while the entrenched zero interest-rate environment underscores the challenge of generating income. We see no obvious areas of undervaluation remaining; to the contrary, some sectors like commercial real estate remain vulnerable. In this climate, we believe active asset selection will become even more important: picking individual countries, asset classes, industries and companies will be crucial to generate performance and manage risk. Importantly, as a number of states will likely need to increase taxes to get their finances on a more sustainable footing, we think the tax-free municipal bonds sector will become an even more valuable source of potential investment opportunities.

I remain optimistic on the prospects for the economy. We will get through the pandemic and the election uncertainty, and in 2021, the US and global economy will likely recover much of the lost ground. However, it will be a gradual process, with a lot of uncertainty and obstacles to surmount; some sectors of economic activity will be challenged for longer, and the pandemic will seed structural changes that we will need time to understand and process. In our view, high-quality, bottom-up research will remain crucial to successful investing.


Economic recovery and global waves of uncertainty

Stephen Dover, CFA
Head of Equities

Overall, we are positive on the global economic recovery continuing, albeit from a low basis. I believe we are not at risk of experiencing the potential economic freefall that could have happened in March and April 2020, with one huge caveat: the great unknown path of the pandemic. If recurring COVID-19 waves or high reinfection rates continue, those would have great social and economic effects. Fiscal and monetary policies in the United States and around the world created an economic backstop, but I think even more stimulus will be necessary if the COVID-19 pandemic continues to prevent economic activity. Recurring COVID-19 infection rates could derail the global economy that had experienced one of the largest and shortest falls and is now recovering better than most economists predicted.

Parts of Europe and Asia are ahead of the United States in returning their economies back to pre-COVID-19 norms. In Asia and particularly China, manufacturing and surprisingly, service industries have returned to near normal pre-COVID-19 levels. This contributes to our generally positive global outlook.

'Fiscal and monetary policies in the United States and around the world created an economic backstop, but I think even more stimulus will be necessary if the COVID-19 pandemic continues to prevent economic activity.”

Consumers and service sectors

Consumer sentiment in every country remains a concern. We have quite a separation between industries and economies because companies that were already innovating toward remote work were better prepared for succeeding through the pandemic, whereas other industries, i.e., those in travel and entertainment, are not enduring. However, there is increased consumption in some countries where recovery has started, and consumers are returning. For example, many restaurants in China are operating nearly at or above normal capacity. So, I believe as the virus dissipates, we will see big boosts in consumer consumption as consumers want to resume to their pre-COVID-19 lifestyles.

The US market is particularly driven by consumption and as global trade changes, other countries are trying to increase consumption as part of their economies, most notably China. As consumption drops globally, it impacts all economies around the world. I think what we are seeing is manufacturing beginning to recover.

Since people cannot be together, service sectors cannot recover in the same way. We should see the service sector recover as it has in other countries, and possibly very robustly, as the virus abates.

Economic dislocation and technology leading the recovery

I have said for a long time I believe stock markets do not reflect any country’s own economy. As I look at all of the stock markets around the globe, I might have thought the US market would reflect its economy more than anywhere else. Clearly what we have seen in the last few years is a huge disconnect between Wall Street and Main Street. Part of that is because there is such a focus on just a few growth stocks. Just eight stocks account for over 25% of the S&P 500 Index market capitalization, which is unprecedented.1 Despite its recent March 2020 pullback, the S&P 500 Index climbed nearly 50% since its March 23, 2020 lows.2

The US equity market’s ascent since March 2020 is very similar to its ascent in 2009; however, this cycle is a shorter period of decline and recovery.3 This is, I believe, a result of the US government’s aggressive fiscal and monetary policy actions. Value and lower-quality stocks normally outpace growth and higher-quality stock prices during recoveries. This has not been the case in the current cycle.4

Historically, technology stocks lead recoveries, they led each of the last three recoveries, and technology stocks continue to lead now.5 But this is not representative of the US economy as a whole. There is a lot of global economic hardship, particularly with smaller companies and with individuals. Although there has been some policy assistance, I believe most small businesses and the economy in general are not reflected in the stock markets. Unfortunately, this is causing the Wall Street and Main Street disconnect, which is amplified even more overseas.

CURRENT REBOUND PACE OF S&P 500 INDEXExhibit 1: Although not unusual, what makes this cycle different is the leadership of high-quality growth stocks. We believe the market’s advance and the recovery is likely to persist. (As of September 13, 2020)

Sources: Franklin Templeton Capital Markets Insights Group, SPDJI, Macrobond. Important data provider notices and terms at www.franklintempletondatasources.com. Comparisons of total returns from the S&P 500 TR Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges.
Past performance is not an indicator or guarantee of future results.

ESG—“S” is for social (and supply chain)

I strongly believe ESG—Environmental, Social and Governance—aware investing will be a powerful component of how many investors compose their portfolios globally, including in the United States as it already is in Europe and Australia. If the outcome of the US November elections results in a US Democratic Party wave (a Democratic President and a Democratically controlled Congress), their proposal to substantially increase spending on environmental infrastructure will likely affect ESG investing. And many more investors and companies are taking the social concerns of ESG investing more seriously. ESG was once thought of as mostly environmentally focused, but all three components are critically important. I believe companies will be held more accountable, or perhaps valued, for their social and societal impacts.

ESG considerations now impact changes in global trade, primarily because of the pandemic. But a knock-on effect, I believe, is that ESG will also impact supply chains moving back or relocating closer to consumers. Companies may want to better manage their supply chains so they can monitor their local and global social impacts, and more closely be aligned with their customers’ ESG purchasing goals.

The US elections and possible tax changes

I believe in the past, US elections did not have a big impact on equity markets because markets are much more influenced by the economy as a whole. However, there are a few different impacts that might happen during this year’s elections’ cycle. First, because of the pandemic and the record number of mail-in ballots, it may take some time to tally election results, creating some uncertainty and possibly some volatility in equity markets, perhaps even to Inauguration Day. Second, a contested election—likely when a losing candidate contests the results of an election—can create great uncertainty. And the third, the possibility of a complete change in US administrations, which would likely be a Democratic wave with the implications of fairly large structural changes in the economy and also in the tax system.

For individual investors, one of the differences to consider are changes in both the capital gains tax rate, which would be potentially eliminated for investors who have more than US$1 million in income, and also the elimination of the step-up basis for estate taxes. Both changes would have significant impacts on how individuals invest, and might be taken into consideration now.


Emerging markets: Just when you think you’ve seen it all

Manraj Sekhon, CFA
Chief Investment Officer, Franklin Templeton Emerging Markets Equity

Progress amid disruption

We are entering the final stretch of what has been an extraordinary year. The COVID-19 crisis has catalyzed the acceleration of some long-term themes that we have identified and followed in recent years. This trajectory will likely continue into 2021. A further marked trend this year has been increased differentiation within emerging markets (EMs) amid rapid changes brought about by various economic, social and exogenous shocks such as the pandemic. We believe the constant flux in EMs underlines the importance of a bottom-up, stock-driven investment approach that is sector- and country-agnostic.

The pandemic has reinforced three key realities in EMs that we have been focusing on. Firstly, the increased institutional resilience in these countries. Secondly, the growth of consumption and technology, resulting in more diversified economies. Thirdly, the growing innovation in EMs—and the capacity of companies to “leapfrog” developed-world competitors. On top of these multiyear themes, three nearer-term issues have our attention: the US-China relationship and deepening bilateral tensions; the impact of COVID-19 on companies and markets; and companies’ readiness to embrace the new normal.

A broadening recovery?

Looking back, EM equities have as a whole been resilient, with the MSCI Emerging Markets Index marginally positive year to date—performing broadly in line with the S&P 500 and MSCI World indices. This does, however, mask wide divergence across countries and sectors. As a region, emerging Asia has outperformed global developed and EM indices, buoyed by China, South Korea, and Taiwan. By contrast, EMs such as Brazil and Russia have lagged, while in developed markets, performance has been concentrated in US mega-capitalization technology stocks, with Europe and the United Kingdom underperforming sharply.

Similar divergence is seen at a sectoral level. While EM equities’ overall valuations have increased, this is largely due to the narrow leadership of internet, technology, consumer and other “new economy” companies that are thriving amid COVID-19. For the MSCI Emerging Markets Index, valuation spreads between the top quartile and median performer are significantly in excess of what has been seen in the last decade, whether measured by price-to-earnings or price-to-book ratios. Similarly, in terms of performance, the top quartile stocks have delivered a 60% return year to date versus the median of –4%, which represents by a considerable margin the widest gap over a 10-year period.6

Unlike many Western countries, much of emerging Asia has thus far successfully managed the pandemic, with the result that business visibility is improving even in “old economy” sectors with relatively attractive valuations. This has the potential to broaden the current equity market rally in the fourth quarter of this year and in 2021. In China, for example, cement producers appear on track for new peaks in profitability, as reviving construction activity post lockdowns and heavy floods drives up demand. In countries that have underperformed, we see further potential. Indian financials, which have slipped amid near-term asset quality concerns, continue to be well-positioned for longer-term growth in an underbanked market, particularly in the vast rural segments. Brazilian financials also appear attractive, while the economy’s reopening could bode well for late recovery plays such as mall operators and education providers.

"While EM equities’ overall valuations have increased, this is largely due to the narrow leadership of internet, technology, consumer and other ‘new economy’ companies that are thriving amid COVID-19.”

Past the trough

On the economic front, EM activity has continued to rebound, albeit at varying speeds across countries. In China, stronger exports and production growth have confirmed a V-shaped economic recovery. Though consumption has been a weak spot, green shoots are appearing, with data on luxury spending and domestic air travel remarkably up year-on-year.

Conditions in India have been mixed. Various states are keen to get economic activity back on track following a nationwide lockdown and most coronavirus-related restrictions have eased. High-frequency indicators such as fuel consumption, travel and credit-card usage have improved to approach pre-pandemic levels. However, areas such as credit growth have been sluggish, with banks remaining wary of a spike in delinquencies amid an economic slowdown. Daily reported COVID-19 cases and fatalities have continued to grow, though the numbers appear to be plateauing.

Brazil’s economy has shown a post-lockdown bounce. Government spending has been critical in backstopping the economy, and better-than-expected data have triggered upgrades in full-year economic forecasts. After a long struggle with the pandemic, Brazil has started to see the number of new COVID-19 cases decline. Paradoxically, the lack of a strict quarantine to contain the virus initially now makes the probability of another wave of outbreak remote, in our view.

Deepening foundations

Meanwhile, EMs have shown a continued appetite for structural reforms that could lay the foundation for lasting economic recoveries. China, for example, has stayed true to its longer-term goal of making domestic consumption a major economic engine—and a source of potential ballast during external demand shocks. The government’s recent moves to boost local luxury consumption tie in with this ambition. Until COVID-19 hobbled international travel, Chinese spending on luxury goods had largely occurred overseas. Eyeing this purchasing power, officials relaxed duty-free shopping rules, igniting a surge in duty-free sales in China. We see China’s domestic travel and duty-free industries heading for a boom in the next few years.

India’s sizable fiscal deficit has limited the government’s ability to spend on shoring up its economy. We expect privatizations and other economic reforms to offer more support by attracting investments. The country’s “Make in India” initiative, aimed at growing the manufacturing sector, appears well placed to benefit from several trends. Global trade tensions and the pandemic have driven countries and companies toward new production locations to enhance supply chain diversity and security. India’s border skirmishes with China have also sparked nationalistic support for local manufacturing.

Brazil has continued to pursue structural reforms despite economic disruptions and political noise. Officials recently passed new rules for the natural gas and sanitation industries in a bid to unlock hefty investments in the coming years. Discussions on tax and administrative reform proposals are underway. The government’s pipeline of infrastructure concessions also remains robust.

Pandemic-proof businesses

EM corporate resilience—especially in industries bolstered by the pandemic—is likely to anchor market sentiment. In China, we have seen companies across the internet, health care, new energy and consumer sectors deliver stronger financial results. Larger corporates have won market share from weaker players in a challenging environment, illustrating their scale advantage. We believe wider technology adoption, increased innovation, accelerated industry consolidation and other pandemic-induced trends could continue to offer growth opportunities for a wide range of companies.

Corporates in India have also shown several bright spots. Technology services providers have regained investors’ attention, helped by improved client traction and greater cost savings driven by a shift toward remote working. Large banks are also likely to see some recovery and benefit when India’s economy begins to normalize, and the corporate sector starts to re-leverage.

In Brazil, monetary easing and record-low interest rates have been a tailwind for capital market-driven companies. Investors seeking better returns have shifted from fixed income to riskier assets such as equities, boosting trading volumes for brokerages and the stock exchange. Agile e-commerce businesses have also outperformed the market during the pandemic. Meanwhile, we view infrastructure and commodity-related companies as potential beneficiaries of improving economic activity, as well as infrastructure concessions in Brazil.

Opportunities versus uncertainties

Our constructive near-term outlook recognizes the potential for bouts of market volatility ahead. Concerns could arise as certain EMs approach policy stimulus limits imposed by prudence or shrinking public coffers. In Brazil, massive spending has undercut the government’s debt stabilization efforts and fueled fiscal worries. The country’s gross debt-to-gross domestic product ratio has risen toward 100%, alongside growing doubts about its commitment to a 20-year public spending cap.

The US-China dispute—which could worsen amid political posturing ahead of the US presidential election—is another potential source of market risk.

We have seen hostility toward China grow across the US political spectrum and we expect bilateral tensions to remain regardless of the election’s outcome.

As long as COVID-19 remains a preoccupation for investors globally, countries and companies that have effectively managed the crisis and seen their businesses deliver are likely to continue doing well. In addition, growing business visibility and recovery in parts of the old economy, coupled with a wide valuation discount, should lead to a broadening of market performance through the end of 2020 and into 2021.

ENDNOTES

  1. Source: FactSet, as of September 30, 2020. The S&P 500 Index‘s eight largest stocks’ share of total market capitalization was 25.5%. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges.

  2. Source: Macrobond, as of September 30, 2020. From the lows on March 23, 2020 through September 30, 2020, the S&P 500 Price Index rose 50.3%. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

  3. Source: Macrobond, as of September 30, 2020. From the lows on March 23, 2020 through September 30, 2020. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

  4. Source: Macrobond, as of September 30, 2020. Comparisons of the S&P 500 Value TR Index, S&P 500 Growth TR Index, S&P 500 Lowest Quintile TR Index, and S&P 500 Quality TR Index illustrate that low quality to quality stocks are sideways since March 23, 2020, while value and growth stocks are down significantly since March 23, 2020. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

  5. Source: Macrobond, as of September 30, 2020. Comparisons of total returns from the S&P 500 TR Index and S&P 500 Information Technology TR Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

  6. Source: MSCI Emerging Markets Index, as of September 17, 2020. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses, or sales charges. Past performance is not an indicator or guarantee of future results.

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 developments. 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. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Diversification does not guarantee profits or protect against risk of loss.

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