The global reset

Stephen Dover, CFA, Chief Market Strategist, Head of Franklin Templeton Institute

Larry Hatheway, Global Investment Strategist, Franklin Templeton Institute

Seemingly, investors ought to be perturbed, unsettled and even rattled given the bewildering change that has unfolded since January 20, 2025.

But that is not what market outcomes tell us. The S&P 500 Index has fully recovered from its “Liberation Day” setbacks. Despite the prospect of massive US budget deficits as far as the eye can see, US Treasury yields are settling in at lower levels. Furthermore, across capital markets implied volatilities are quiescent despite actual and potential conflict in various global hotspots.

Are investors right to be sanguine or are they complacent?

Unhelpfully, perhaps, both cases can be made. Let’s look at both sides of the argument.

The bull case

Encouragingly, despite arbitrary US tariffs, their sudden withdrawal, the Israel-Iran military conflict, and so much else, the global economy remains on a sound footing. Some softness can be detected in leading indicators, manufacturing surveys and in US residential investment, but many more signs point toward resilience, including in US employment, global real household income growth, European monetary and fiscal easing, and Chinese monetary easing.

It seems the world economy can take a punch and keep on going.

Similarly, global corporate profit expectations remain largely unfazed. European profit growth is bouncing back and is expected to top US estimates this year. Indeed, across all major regions analysts expect greater than 10% earnings growth for next year.[1]

Meanwhile, inflation is generally headed lower. It is already below target in Europe and China, and even though it remains stickier in the United States, and is likely to tick higher because of tariffs, underlying US price pressures are softer. That is why market-derived inflation expectations are stable or falling (e.g., one-year Treasury Inflation-Protected Securities measures of inflation have fallen 50 basis points since April).

As a result, fears of tariff- or uncertainty-induced “stagflation” are receding, leading to falling risk premia, lower bond yields and higher equity valuations. Indeed, falling inflation risk accompanied by a likely modest slowing of US growth has restored market confidence that the Federal Reserve (Fed) can ease at least twice before year-end.

In short, we believe the near-term outlook warrants optimism.

Reasons to remain vigilant

That happy assessment, however, is incomplete. In our opinion, investors must remain vigilant.

Tariffs, erratic US policy implementation and geopolitical risk will likely dampen “animal spirits.” As a result, we believe US and global capital expenditures are unlikely to boom despite promising new innovations, the prospect of bigger US tax cuts and a more business-friendly regulatory approach. There are, in the parlance, too many “known unknowns.”

Moreover, US consumers may balk at attempts to pass along tariff costs to final prices, leading either to weaker final demand, margin compression or both.

Meanwhile, US equities are increasingly “priced to perfection.” Today’s valuations already anticipate soft landings for the US economy and inflation, Fed rate cuts, as well as stronger global growth (spurred by European fiscal and monetary easing). Presumably, valuations also reflect confidence that genuinely dislocating global conflict can be avoided.

That may be how things go, but today’s lofty US equity valuations leave little latitude for disappointment should things turn out differently, in our analysis.

Moreover, beneath the seemingly calm surface various unaddressed challenges and open questions are ever present. Among them are:

• How and when will the United States address large fiscal deficits?

• Who will replace Fed Chairman Powell when his term ends, and will the Fed’s independence come into question?

• How can trade-dependent emerging economies cope with falling commercial globalization and doubts about the durability of open and free global capital markets?

• Can conflicts in the Middle East remain contained, or will they spread?

• Does the United States remain sufficiently engaged as the primary pillar supporting global conflict resolution, free trade, the free movement of capital and the rule of law and, if not, how might things evolve from here?

Summary

In sum, investors are presently rejoicing economic and corporate resilience, and well they should. But the risk is that short-term Panglossian[2] enthusiasm could blind investors to deeper flaws and risks to the global economic and financial system. We believe vigilance should never be sacrificed to exuberance.

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.

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. Investments in companies in a specific country or region may experience greater volatility than those that are more broadly diversified geographically. 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.

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[1] There is no assurance that any estimate, forecast or projection will be realized.

[2] Panglossian describes someone excessively optimistic, even to the point of naivete or delusion, especially when faced with adversity.