The Rotation Will Continue Until Morale Improves

Macro

Our real gross domestic product (GDP) forecast for 2026 is 2.5% (based on our Global Investment Management Survey) vs. the Federal Reserve’s (Fed's) new forecast of 2.4% and the Wall Street consensus of around 2%. We just got a look at third quarter year-over-year (Y/Y) GDP, which was 3.4% vs. market expectations of 3.2%. The economy remains resilient. The biggest risk to this strong economic backdrop is Fed policy going forward; meaning, the Fed signals the beginning of a prolonged rate-hike cycle. Raising the cost of capital or tighter financial conditions in general (happening now with higher yields) could have a negative impact on the pace of growth. Stay tuned—but in our view, this is not a replay of 2022 in terms of what we expect from the Fed.
On the inflation front, the core Personal Consumption Expenditures (PCE) price index (Y/Y) was 3.1% for September, vs. expectations of 3.1%. The monthly core PCE price index was 0.3%, in line with expectations. Fed Chair Kevin Warsh reiterated the central bank’s goal to engineer a “timely return” to the 2% target.
The US 2-year Treasury note yield is 4.63%, 63 basis points (bps) over the fed funds rate. Remember, the bond market leads the Fed, not the other way around. Two-year yields continue to call for additional rate hikes. We expect one additional rate hike this year. The US 10-year bond yield is currently 4.96%, and the 2-10 curve has flattened to 33 bps, as of this writing.
Breakeven rates have come off the boil but remain elevated vs. the Fed’s 2% target. One-year breakeven rates are 2.58%, 2-year breakeven rates are 2.53%, 5-year breakeven rates are 2.47% and 10-year breakeven rates are 2.59%. These numbers represent the bond market’s pricing of annualized inflation out one, two, and five years. Breakeven rates and the 2-year note are giving the same message—something needs to be done to address inflation.
Meanwhile, the fed funds futures market is indicating a 79% chance of a 25-bps hike in December. The futures market has the 2026 terminal fed funds rate at 4.08%—it believes another hike is coming. We agree and it looks like December. Looking at 2027, there is a 59% chance of a rate hike in March. All other months are below 50% at this point.
On the currency front, we are expecting the US dollar to be essentially flat for the year despite the recent volatility. The US Dollar Index (DXY) is trading at 102, still firmly range-bound as it has been for the past 17 months, but is testing the upper end of that range now. I would note that the DXY has been a consensus short for the last few years, although that has not been our call.

See more: Value Breakout Shows Benefits of Diversification

Equities

We are constructive on US equities and have established a year-end target range of 7400-7800 for the S&P 500, driven by 15+% Y/Y earnings-per-share growth. Consensus expectations for 2026 now sit at $369.03, up 12% Y/Y. For 2027, the consensus earnings estimate is $422.72, representing a 15% Y/Y growth rate versus 2026. Estimates have moved up every single week from Jan 1. This explains the resilience of the tape in the face of higher oil and higher bond yields (see our Global Investment Management Survey for more on earnings and our forecasts).
Midterms are upon us. Please see our paper “The Midterm Market Effect,” on what history tells us about midterm elections and equity returns. History is bullish. I don’t think it’s different this time.
There are two main risks to the stock market, in my view. First is the notion of peak rate of change in earnings growth. We are at or near the peak on a rate-of-change basis right now. This does not mean peak nominal earnings power, however, but it does avail investors to higher levels of volatility. Forward earnings power continues to look robust, as mentioned above. The second risk is Fed policy. If we are the beginning of a protracted rate-hike cycle globally, that will likely put downward pressure on aggregate demand and thus put downward pressure on forward earnings power. Global central banks’ tightening in unison leads earnings power by about 14 months. A protracted hiking cycle is not our base case, but it is a risk to be mindful of.
We expect the rotation to continue. As stated in our paper, “Broadening Delivered. Now Prepare for Volatility,” we expected higher volatility. The earnings bar is high—very high. Any minor misstep has led to punishment, which has led to rotation. Rotation is not a bad thing, and if you are running a diversified equity portfolio, you should be in good shape.
Year-to-date index performance tells the same story. Consider this: Through the October 28 close, the Russell 1000 Value Index is up 24.41%. The Russell 1000 Growth Index is up 4.53%. The Russell 2000 Value Index is up 20.31%, while the Russell 2000 Growth Index is up 10.65%. Similarly, the equal-weight version of the S&P 500 Index is up 15.02%, while the traditional cap-weighted S&P 500 Index is up 14.15%. The “average stock” has been doing fine.
That said, October has been a violent ride. This month, the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 6%. The S&P 500 Equal Weight Index has outperformed the S&P 500 by 3%.
The story is also a global one. The MSCI Japan Index and the MSCI Emerging Markets Index are up 18.29% and 16.57%, respectively, in dollar terms. Both are outperforming the S&P 500.
Bottom line: We think it’s prudent to have a diversified equity playbook that includes US large-, mid- and small-cap exposure with a balance of growth and value. The same can be said for ex-US equity exposure; emerging markets and Japanese stocks look attractive. That involves reducing concentration and spreading one’s bets. We think buying on pullbacks makes sense. Volatility is your friend.

Fixed Income

We expect 10-year US Treasury bonds to yield in the range of 5.00%–5.50% for the year. As of this writing, the last trade was 5.27%. We have shifted our range higher. Franklin Templeton Fixed Income CIO Sonal Desai is of the mind that we are in a higher-for-longer yield regime. When Sonal talks, I listen. Have a game plan to use higher yields to your advantage. Current yield levels generally approximate the forward five-year annualized return stream. The risk/reward is improving with higher yields. We believe a dollar-cost-averaging approach makes sense on ugly days (higher yields with special attention north of 5.50%).
We expect short duration fixed income mandates and corporate credit to outperform cash again this year. All-in yield capture seems to be the play. To that end, investors might consider high-yield exposure to boost total return as a barbell with short duration exposure and core bond exposure. High-yield is the only subsector of fixed income where the coupon is significantly higher than duration risk.
Tax-loss harvesting seems like a good idea. In qualified accounts, investors can take the loss and reposition with a new cost basis and a higher starting yield. Get rid of the red.
Credit spreads remain well behaved in the face of higher yields. Investment-grade spreads, as proxied by the Bloomberg US Corporate 1-3 Year Option-Adjusted Spread (OAS), are now 56 bps over comparable Treasuries. High-yield spreads, as proxied by the Bloomberg US Corporate HY OAS, are now 312 bps over. These are both relatively tight levels from a historical perspective, reflecting a strong fundamental backdrop with corporate profitability being the main driver.
We are bullish on municipal bonds and find taxable-equivalent yields to be attractive, along with robust fundamentals. Importantly, municipal bonds can offer potential diversification benefits in the form of low correlations to various equity markets, relative to most taxable fixed income mandates.

Sentiment

The percentage of bullish investors in the latest AAII survey (the week ending October 28) is 38%, a low reading. The capitulation level is around 20%-25% bulls. The percentage of bearish investors in the AAII survey is 41%. The wall of worry is still in place.
Bull markets peak on euphoria. I don’t think we are there yet.

We will continue to analyze the markets and offer insights again next week.

Source of data (except where noted) is Bloomberg and Franklin Templeton Institute, as of October 29, 2026. Important data provider notices and terms are available at www.franklintempletondatasources.com.

The Franklin Templeton Institute Global Investment Management Survey is a biannual outlook survey designed to give a view across our investment teams. The Franklin Templeton Institute identifies the median across the survey answers and develops the outlook. The survey received responses from around 200 portfolio managers, directors of research and chief investment officers, representing participation across equity, private equity, fixed income, private debt, real estate, digital assets, hedge funds and secondary private markets. Each of our investment teams is independent and has its own views.

Glossary of Terms

The AAII (American Association of Individual Investors) Sentiment Survey: This survey offers insight into the opinions of individual investors by asking them their thoughts on where the market is heading in the next six months.

Breakeven rates: The difference between yields of Treasury bonds and TIPS for issues of the same tenor/maturity, calculated by subtracting TIPS yields from Treasuries; a measure of inflation.

Capital expenditure (capex): Funds that companies spend to acquire, upgrade or maintain physical assets, such as buildings, technology or equipment, with the purpose of maintaining or growing future operations.

Dollar-cost averaging: An investment strategy wherein a fixed amount of money is invested at regular intervals, regardless of the market's price. Periodic investment plans do not ensure a profit and do not protect against investment loss in declining markets. Since dollar-cost averaging involves continuous investment in securities regardless of fluctuating price levels of such securities, an investor should consider his/her financial ability to continue purchasing through periods of low price levels.

Duration: A measure of how much a bond’s price changes relative to changes in interest rates.

Earnings per share (EPS): The portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.

Fed funds (FF) rate: The interest rate that depository institutions such as banks charge other institutions for holding overnight reserves.

Option-adjusted spread (OAS): Measures the spread between a bond's interest rate and the risk-free rate, while adjusting for any embedded options like callable or mortgage-backed securities.

Price/earnings (P/E): A ratio calculated by dividing a company’s share price by its earnings per share, a measure of valuation.

Tape: A reference to broad market performance, based on the ticker tape that transmitted stock prices during the 19th and 20th centuries.

Tax-loss harvesting: A strategy of selling securities at a loss to offset capital gains and reduce an investor’s taxable income.

Taxable-equivalent yield: The yield of a municipal bond investment calculated to reflect the benefits of income tax exemption and to be comparable to the yield of a taxable bond.

Yield spreads/tights: Spreads are the difference between yields on differing debt instruments of varying maturities, credit ratings, issuers or risk levels. “Tight” in reference to spreads indicates small differences in yields.

Indexes

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.

Bloomberg US Corporate High Yield Index: Tracks the performance of the USD-denominated, high-yield, fixed-rate corporate bond market.

Purchasing Managers’ Index (PMI): Produced monthly by the Institute for Supply Management, the Manufacturing PMI tracks activity in the manufacturing sector. The Services PMI tracks activity in the services sector. The Composite PMI combines information from the Manufacturing and Services indices.

Russell 2000® Index: A market capitalization-weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000 Index.

Russell 2000 Growth Index: A market capitalization-weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000 Index with relatively higher price-to-book ratios and higher forecasted growth rates.

Russell 2000 Value Index: A market capitalization-weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000 Index with relatively lower price-to-book ratios and lower forecasted growth rates.

Russell 1000 Growth Index: An unmanaged index of those companies in the large-cap Russell 1000 Index chosen for their growth orientation.

Russell 1000 Value Index: A market capitalization-weighted index that measures the performance of Russell 1000® Index companies with relatively lower price-to-book ratios and lower forecasted growth rates.

MSCI Emerging Markets Index: Captures large- and mid-cap representation across emerging markets countries, covering approximately 85% of the free float-adjusted market capitalization in each country.

MSCI Japan Index: A free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of Japan.

S&P 500 Equal Weight Index: The equal-weight version of the S&P 500 Index. The index includes the same constituents as the capitalization weighted S&P 500, but each company is allocated a fixed weight, or 0.2% of the index total, at each quarterly rebalance.

US Dollar Index: A basket of six foreign currencies (euro, Japanese yen, UK pound sterling, Canadian dollar, Swedish krona and Swiss franc) used to track the relative strength of the US dollar, with a higher index value representing US dollar strength.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal.

The allocation of assets among different strategies, asset classes and investments may not prove beneficial or produce desired results.

Diversification does not guarantee a profit or protect against a loss.

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. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.

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 investment style may become out of favor, which may have a negative impact on performance.

Large-capitalization companies may fall out of favor with investors based on market and economic conditions.

Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.

Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.

Important Information

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

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