European Drama Hasn’t Derailed US Growth

With the Greek debt crisis coming to a head and China’s equity market experiencing a correction, the summer doldrums have not been in effect this year—except in the United States, where relatively calm economic conditions have prevailed. The recent turmoil in the eurozone and China, however, has roused US investors to attention, and many wonder if the relatively healthy US economy will be jolted by some resultant market volatility. Ed Perks, executive vice president and chief investment officer, Franklin Equity Group, provides his views on US markets, and discusses why he thinks, despite challenges facing some parts of the world, the US economy is likely to continue on its growth trajectory.

With US financial news comparatively humdrum this summer, many US market watchers have turned their attention to economic events in other parts of the world, particularly in Europe and China. In doing so, some investors are wondering if any potential volatility arising in the aftermath of the Greek debt crisis could undermine the US economy.

Despite the recent uncertainties surrounding Greece, we remain fairly confident about Europe’s economic prospects in general, and have found opportunities in various segments of the market. We have holdings in European equities in sectors such as health care and energy, and we think the current volatility in the European markets presents an opportunity to take advantage of relative value between European companies and their US-based peers. In fact, we have initiated purchases of many of our foreign holdings during similar market dislocations. That said, we do not take a top-down approach to our region or country allocations. Rather than focusing on a company based on where it’s domiciled, we’re more interested in its underlying valuation, the potential yield opportunities it presents, and if we’re able to take advantage of market dislocations or valuation disparities.

US Economy Sails Along

Turning to the US economy, we believe headwinds to growth have been easing, and what the current leg of the US expansion has perhaps lacked in intensity may very well be made up for by a transition to a more durable or lengthy expansion. We think conditions look favorable for this expansion to continue with a bit more of a tailwind from several important factors.

First, we’ve seen a tremendous decline in unemployment in the United States in recent years. I think what’s particularly positive about that dynamic is that the drop in joblessness has been an accelerating trend. Monthly job growth in the United States has been trending higher, in fact it has been better during the last six to 12 months than it was in the prior six to 12. We’ve also started to see improvement in US wages, which will likely benefit economic activity and economic growth moving forward.

Second, the United States continues to experience persistently low inflation, which we believe is very positive for the economy. We think the Federal Reserve will work to reduce potential inflationary pressures in the future as it transitions to normalizing interest-rate policy and engaging in interest-rate increases.

Third, companies have been increasing their cash flow by using a variety of techniques. Current historically low interest rates have allowed companies to substantially lower their borrowing costs. And we believe companies that have issued long-term debt at very low rates may, in time, come to regard those bonds as the “jewels” of their capital structure. We believe bonds issued under such conditions will likely be out in the market until maturity, which could allow companies to free up cash flow over an extended period. Many companies also have been successful at “creating runway,” meaning they have arranged their debt instruments such that it will be a period of years before substantial liabilities come due.

Searching for Yield

A low-return environment is likely to dominate bond markets for the remainder of 2015, in our view, and the core of our fixed income strategy remains constructively positioning ourselves to navigate what we think will be a rising-rate environment. Managing bond risks will likely require a delicate balancing act.

We believe value still exists in the high-yield sector given the low yields offered in other segments of the fixed income market. Although debt defaults have risen year-to-date in 2015—particularly among select oil companies—we do not expect a major deterioration in the overall default rate. If we do see rising long-term interest rates concurrent with improving economic conditions and business fundamentals, it could actually serve to support many issuers within the high-yield asset class.

Thus far in 2015, US high yield has occasionally seen pronounced investor outflows, but well-regarded and well-capitalized investors have expressed renewed interest in the asset class. Brief periods of challenging performance have historically occurred at monetary policy inflection points, which present a risk to our view. A potentially larger opportunity for us exists in equity-like convertible bonds. Interest in issuing convertible securities seems to have accelerated recently, a trend we are watching closely and believe could present further investment opportunities later in the year.

Dividends on the Rise

In our hybrid portfolios, we remain quite constructive on equities, and we favor them more than other asset classes at the moment. We see upside potential for the US equity market as we reach the one-year anniversary marking the appearance of some of the clouds that have hovered over companies in recent months, including a stronger US dollar. We expect a strengthening currency to become less of a drag on revenue growth going forward. Overall, we see the potential for greater differentiation in sector performance going forward as dynamics such as the stronger dollar may have varying impacts on underlying industries and companies.

An improving outlook for dividend yield from equities across a widening array of US companies and industries has also helped drive our focus on equity market opportunities. As we’ve seen companies deleverage and improve their balance sheets over the past several years, they have been accumulating more cash. And an increasing number of companies have been committing that extra cash to initiating or increasing their dividends.

This has contributed to a breadth of yield opportunities across US equity sectors, which has increased beyond those that have historically been most closely associated with robust yield payouts—telecommunication services, utilities and energy. Generally, we see more companies committing to dividends and dividend growth, particularly in historically non-traditional areas such as information technology and health care.

In recent months, however, investors have stepped away from certain higher-yielding segments of the market, based, in our view, on their expectations for higher interest rates going forward. For example, within the S&P 500, the interest-rate sensitive utility sector underperformed the broader index during the first two quarters of 2015. Some utilities, however, may have been oversold this spring, opening up an opportunity set that may be increasingly driven by companies that are improving their cost structures or that are focusing on areas of higher growth. Some companies also have transitioned their business models away from the purely regulated function that utilities play and are focusing instead on alternative energy products such as wind or solar or on energy infrastructure, which we believe is critically needed in many parts of the United States.

Adjusting to Lower Energy Prices

Equities within the energy sector have also experienced challenging performance during the first half of this year. Despite their recent troubles, we think many energy companies appear well positioned for improvement going forward, and we have been selective buyers when we have seen attractive relative value. As oil prices declined from June 2014 through early 2015, many investors were focused on the price point the commodity would have to reach in order for the industry to continue to be profitable. In our view, many oil companies can adapt and learn how to be profitable under various pricing conditions, and we think many companies are making those adjustments today.

Interestingly, we saw a disconnect between poor-performing energy sector equities and their high-yield corporate bond counterparts during the second quarter. This created some opportunities for us to add to energy equities. Several companies in the sector offer higher dividend yields than one might find in comparable corporate bonds. Combined with the potential upside related to improving commodity prices over the next one to two years, these investments could benefit our shareholders over the long term, in our view. Importantly, we leverage our deep team of fundamental equity and credit analysts to really differentiate and evaluate one company relative to another, taking into consideration the quality of their assets, the positioning of their overall business, the kind of cash flow they can generate, and ultimately their ability to repay lenders or maintain their dividends, in order to identify opportunities for our funds.

On a more thematic note, global merger and acquisition (M&A) activity has been robust thus far this year, and we believe that trend should continue and remain a prominent theme in a highly competitive environment of uncertain growth. We try to identify attractive strategic combinations in light of the highly accommodative financing environment we have been operating in this year. In particular, M&A activity has been on the increase in the information technology, health care and energy sectors.

Regardless of the particular sector in which we invest, we believe in the merit of taking a long-term view, seeking opportunities where market prices seem to deviate from our estimates of potential for income and capital appreciation.

Ed Perks’s comments, opinions and analyses are for informational purposes only and should not be considered Individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

This information is intended for US residents only.

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