● US Election and its impact on the market

With the contentious upcoming US Presidential election, there are potential risks to financial markets regardless of which candidate wins the election.

Trump, with his lack of experience and depth of knowledge on many key issues, is a wild card. His election would bring more uncertainty, which is not ideal for markets or business investment and may cause some volatility. One area in which he does seem to have conviction, however, is trade protectionism. He supports an anti-trade platform, which could be problematic if he starts undoing NAFTA and other trade pacts, and increases tariffs; however, it is unlikely that his efforts would be supported by Congress. Restaurants, retail, and construction could also be hurt by his potential anti-immigration policies.

If Trump wins, there is also the potential for heightened geopolitical risk, as his personality and "America first" mentality may cause tension in US foreign relations. Although Congress and his more moderate Republican counterparts will likely temper his more extreme campaign proposals should he reach office, we do foresee a US recession if Trump is able to implement his campaign promises, such as building his anti-immigration wall or scrapping trade deals. These actions would lead to weakening fundamentals and higher risk premiums.

Should Clinton win the election, we expect less risk as she is more of a typical presidential candidate. The main market risks with a Clinton presidency are to Financials and Energy, as she took a more leftist stance on those issues to compete with fellow democratic candidate Bernie Sanders. Her campaign platform now includes calls to break up banks and to drive for more environmental policy, both of which if implemented, could be detrimental to those sectors. Clinton favors higher minimum wage, and more unionization, which could impact retail and labor businesses should she implement new policies.

● US Outlook, TIPS, and Emerging Market

In the US, corporate fundamentals have improved slightly due to economic surprises, retail sales, revenue growth, and upward earnings revisions. However, ongoing accommodative monetary policy has disrupted the historic correlation between US equity performance and US GPD, with US equity performance posting higher returns than US GDP levels would suggest based on historical trends. Thus, despite some improving economic indicators, we remain neutral on US equity amidst stretched valuations.

Although the team sees limited upside in US equity, they are very bullish on US TIPs. The main driver behind our bullish view on TIPs is that the market seems to be pricing in an extremely dire inflation situation, despite firming employment data. Current 10-year breakevens suggest 1.5% inflation over the next ten years, which, to us, seems overly pessimistic. We expect inflation to normalize, even if commodity prices trend sideways, as tight labor markets and low productivity in major developed markets provide tailwinds for inflation. Because market expectations are out-of-line with our more optimistic outlook for inflation levels, TIPs are very attractively valued at more than one standard deviation below average levels.

The volatility of the Brexit will likely cause central banks to remain accommodative for a longer period of time. Although the Fed struck a more hawkish tone in its last meeting, and job reports have recovered after a disappointing May, there is a chance it will maintain low rates for longer amidst the global uncertainty. Other developed markets, namely the UK and Japan, have already announced further stimulus measures following the Brexit. This accommodative monetary policy should provide support to emerging markets, particularly if the US delays rate hikes. Asia, in particular, presents an attractive opportunity as economic data and corporate fundamentals, such as profit margins, appear stronger in Asian emerging markets than they do in Latin America or EMEA`s emerging markets. Furthermore, valuations in Asia are more attractive than other emerging markets and are historically cheap based on P/E and P/B ratios. Asia also has limited exposure to UK revenue, so the ongoing Brexit volatility and new trade agreements should have a much smaller negative impact on Asian markets than it will on other emerging market countries with high UK revenue exposure, such as South Africa or Turkey.

By Stephen R. Lingard Senior Vice President Portfolio Manager Franklin Templeton Investments

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