CONTRIBUTORS
Wylie Tollette, CFA
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
Key points:
- The current macro backdrop is slightly atypical for an impending Federal Reserve (Fed) easing cycle—growth and labor markets remain strong, while inflation levels are elevated despite progress over the past year.
- The policy backdrop is also notable as Federal Open Market Committee (FOMC) members broadly see current policy levels as restrictive.
- In our opinion, the implications for multi-asset investors remain positive for equities. We believe reflationary macro conditions and a peak in the fed funds rate (our base case) are supportive regimes for risk-taking in portfolios.
Is this time different?
Expectations for a Fed easing cycle have evolved tremendously since the beginning of the year, when the market was pricing in approximately six rate cuts. When will it happen, or will it happen, and what does it mean for asset allocation?
To answer these questions, we start with examining the macro backdrop relative to other Fed easing cycles. The famous question that continually plagues investors bears repeating: “Is this time different?” Through a macro lens, things do appear slightly different—growth and labor are not weakening, and inflation levels remain slightly elevated relative to the previous 30 years despite significant progress since inflation’s peak in 2022 (Exhibit 1).
Exhibit 1: Economic Environment Before, During and After Fed Rate Cuts
1971–Present
All macroeconomic data is lagged by one month. This lag addresses the mismatch between Fed cut dates and the availability of macro data; the Fed has data from the prior month.
*Figures listed under "During First Cut" assume the Fed cuts in March 2024. This did not happen and is not our view; we are showing this for comparison purposes.**We realize there technically was a recession due to COVID-19. Because we find the recession driver unrelated to Fed policy, we consider this period to be non-recessionary.
Sources: Institute for Supply Management (ISM), The Conference Board, Bureau of Economic Analysis, Bloomberg, Macrobond. Growth measured by ISM Manufacturing Index. Inflation measured by Core Personal Consumption Expenditures Index (Core PCE).
The macro backdrop displays some important differences versus history, but what about the policy backdrop? Although there is a debate among market participants around how restrictive Fed policy currently is, there appears to be consensus in the Fed’s interest-rate projections (known as the “dot plot”) that the FOMC views current policy levels as restrictive (Exhibit 2).1
Exhibit 2: Fed DOTS Compared to Fed Funds Rate
Data Begins January 2012; Fed DOTS as of March 20, 2024; Policy Rate as of April 19, 2024
Sources: Federal Reserve, Macrobond. There is no assurance that any estimate, forecast or projection will be realized.
Importantly, market pricing has focused on when Fed rate cuts would begin, rather than if they will begin (Exhibit 3). The expected timing of the first rate cut has increasingly been delayed, although broad market pricing still expects the Fed to begin its easing cycle this year. Our view aligns with the market here—we think Fed policy rates have reached their peak for this cycle.
Exhibit 3: Number of Months Until First Fed Rate Cut
Year-to-Date as of April 23, 2024
Sources: Morgan Stanley, Macrobond. Based on market pricing.
Asset-allocation implications
If we are at peak rates, what does the current macro context mean for asset allocators?
Let’s start with the macro differences. It’s atypical to have reflation—which we define as rising growth and above-average inflation—ahead of Fed rate cuts. If we continue to have reflation, is this a negative backdrop for multi-asset portfolios? Our analysis suggests that it is not. In fact, reflation has been a positive regime for equities, where returns have been positive and slightly above their long-run average (Exhibit 4).
Exhibit 4: Equity Returns in Different Economic Regimes
January 1970–February 2024
Sources: S&P, Organisation for Economic Co-operation and Development (OECD), Bureau of Economic Analysis. Analysis by Franklin Templeton Investment Solutions. Growth rising = positive month-over-month change in OECD composite leading indicator (and vice versa). Inflation high = Core PCE year-over-year % inflation above its 10-year moving average (and vice versa). All returns are measured on S&P 500 price return series, allowing a one-month (1M) lag to incorporate data release lags. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Time series involves monthly frequency beginning in January 1970. Standard deviation measures of the degree to which return varies from the average of previous returns. The larger the standard deviation, the greater the likelihood (and risk) that performance will fluctuate from the average return. Important data provider notices and terms available at www.franklintempletondatasources.com. Past performance is not an indicator or a guarantee of future results.
We also analyze how equities behave following a peak in the fed funds rate (Exhibit 5). We acknowledge the timing of a Fed cut is uncertain, so we focus on equity performance following a peak in the fed funds rate. It turns out that equities have tended to perform well, provided a recession is avoided. For now, with US nonfarm payroll growth averaging 244,000 per month over the last year (and rising), we feel that recession risks remain low.
Exhibit 5: Equity Performance Around Peak Fed Funds Rate
Data Period: 1971–Current
Sources: Federal Reserve, S&P, Macrobond. Equity performance based on the S&P 500 Price 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. Important data provider notices and terms available at www.franklintempletondatasources.com.
Putting it all together leads us to think of the old adage, “history doesn’t repeat itself, but it often rhymes.” We feel this historical analysis has provided a decent guide for how to navigate the current environment. It is understandable that delayed Fed rate cuts have caused some market volatility, especially after equity markets rose 25.1% trough-to-peak in approximately five months.2 Nonetheless, we believe a reflationary macro environment is nothing to fear. In fact, it has historically been a supportive environment for risk-taking in multi-asset portfolios.
Our analysis also plays an important role in how we assess the current Fed rate cycle. While there is a healthy debate around the timing of the Fed easing cycle, we worry less about the delay of Fed rate cuts provided the economy remains strong. Policy is always intended to balance the macro economy, and that’s what we believe is currently taking place. Overall, we continue to remain constructive in our portfolios, with a slight preference for equities versus fixed income.
Endnotes
- Source: Federal Reserve Board of Governors, Summary of Economic Projections (SEP). According to the SEP: The Fed’s dot plot (DOTs) includes “an individual participant’s judgment of the midpoint of the appropriate target range for the federal funds rate or the appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run. One participant did not submit longer run projections for the federal funds rate.”
- Sources: Bloomberg, MSCI. MSCI All Country World Net Total Return USD Index from October 27, 2023, to March 21, 2024. The MSCI All Country World Net Total Return Index is a free float-adjusted, market capitalization-weighted index designed to measure the equity market performance of global developed and emerging markets, including income net of tax withholding when dividends are paid, and expressed in US dollars. 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 of future results.
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.