A Balanced Look at Equity, Fixed Income Fundamentals—and Oil Price Fears
December 10, 2014

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As we approach the final days of the year, major US equity benchmarks appear to be heading toward positive performance for 2014, largely reflecting continued strength in key economic metrics and corporate fundamentals in the United States. Though recent concerns about slowing global growth (particularly in places like China, Japan and the eurozone) amid growing oil and gas supplies have contributed to a downturn in oil prices, Ed Perks, chief investment officer and portfolio manager, Franklin Equity Group®, believes compelling investment opportunities exist in the sector. In the fixed income markets, central bank cross-currents have been a focal point, with speculation about rising interest rates in the United States countered by easing policies and falling rates in other parts of the world. Perks outlines where he’s searching for opportunities in the equity and fixed income markets for his portfolios, with the goal of seeking to provide income and long-term growth potential. He also provides some thoughts on recent volatility in the energy sector, and why he thinks the current bearish trend is not likely to persist over the long term.

Ed Perks

Ed Perks

Ed Perks, CFA®
Chief Investment Officer, Executive Vice President
Portfolio Manager
Franklin Equity Group®

We are reminded almost every day that the world is a complicated place. It’s understandable that some investors have been worried that global crises, such as the ones the Middle East and Ukraine have experienced this year, would spill over from the battlefield to their bottom lines. So far, however, I think these crises, while very troubling and tragic, have had a minimal effect on US equities in 2014 because the US economy’s relatively positive performance has helped to shield US equities from the fallout. Some analysts may feel that the meager returns some areas of fixed income have been experiencing this year may have forced investors to stick with stocks, no matter what’s going on in the rest of the world. While I think there is some truth to that theory, we shouldn’t dismiss the fact that the US economy, especially when compared with those of many other countries, has been performing well.

With long-term interest rates anchored near historical lows in the United States and in many global markets at year-end 2014, our search for securities offering attractive income and long-term growth potential has focused on a mix of equities and equity-linked securities as well as select opportunities in corporate bonds, particularly noninvestment-grade debt securities. While financial markets generally proved favorable in 2014, there were several periods of elevated volatility, driven in part by concerns over slower growth in Europe and many emerging economies including China, Russia and Brazil. Looking to 2015, we believe strength in corporate profits and consumer spending is likely to support continued economic growth in the United States. Amid this favorable outlook, we believe fundamentals can continue to support asset prices and should provide performance potential.

We believe US equity-market fundamentals have continued to look strong, despite what many observers have been calling a late-stage bull market. Even with modest earnings or revenue growth, US companies have been generating tremendous amounts of cash amid strong profitability. While acknowledging the soundness of corporate balance sheets and significant free cash flow, we examine corporate management views on merger-and-acquisition activity, business investment, dividend growth and share buybacks. We seek to understand how managers of companies view capital allocation and how disciplined a process that is for them—key components of our analysis and investment criteria. For example, we think many companies may be poised to grow their dividends at or in excess of their earnings growth rate in 2015. Lately, these observations and our bottom-up strategy have been leading us to what we view as well-run, top-tier companies in the information technology sector, and many of those with strong balance sheets and cash flows have been increasingly emphasizing dividends.

A Selective Case for Fixed Income

Within fixed income, long-term interest rates moved lower in 2014, contrary to most economists’ forecasts at the beginning of the year, leading to continued robust corporate bond issuance. Meanwhile, corporate credit spreads have contracted and hovered around historically tight levels. Volatility increased in the US high-yield corporate bond segment as the year unfolded, with credit risk becoming more of a concern to us, especially at the lower end of the credit-quality spectrum, as significant investor outflows came into play in 2014’s latter half. In part, we believe the selloff may have come in response to elevated geopolitical tensions or uncertainty about the pace of the Federal Reserve’s interest-rate hike cycle that seemed to amplify existing valuation concerns following the asset class’s rally over the past few years. This shift in investor sentiment occurred despite default rates that have remained near historical lows, even for lower-rated noninvestment-grade credits. With flexibility to consider other asset classes, we have been favoring equities in the recent market environment, which reflects our overall outlook for fixed income. However, in our view, the high-yield asset class has been fairly resilient amid bouts of volatility, which can help investors reassess their tolerance for risk, though we do not think periodic pullbacks are necessarily unhealthy for the bond market, and we believe there are still pockets of opportunity in the corporate bond market.

That said, we are being very selective. Strong corporate fundamentals have supported credit markets over time, and from a longer-term perspective, we’ve seen companies take advantage of low interest rates and the great demand for corporate debt securities. Many companies have extended their maturities and have what I would call a “long runway” before maturities start coming due. I think that dynamic offers us the opportunity to still be selective and find investment opportunities in that area of the market.

Energy Outlook: Fundamentals or Fears?

Across asset classes, the energy and materials sectors have suffered from the recent commodities downdraft. More so than materials, energy has been out of favor lately. There are, we think, some valid reasons for the pullback in energy prices as we believe selling in that sector has been more than warranted in some cases, but some of it appeared to be based largely on fear or forced selling. As a result, we have been noticing greater opportunity in select energy firms.

Robust supply additions, combined with uncertain demand levels, have contributed to the weak energy pricing environment, and we saw an acceleration in the decline in oil prices during November. In the near term, we believe further downside in oil prices is possible until we see signs of slowing supply growth or a stronger pickup in demand. However, long term, we don’t believe that lower energy prices are sustainable as supply should decline as spending contracts. Some US-based exploration and production companies have already announced spending reductions for 2015 while others have highlighted flexibility in their spending plans should crude oil prices remain at or below their month-end levels. Although these combined actions may not immediately reduce global supplies to levels that will fully balance the market, we believe they are important signals that supply and demand should become better aligned over the course of 2015. Additionally, lower energy prices may spur demand, which could also positively influence the supply/demand balance.

Our current view is that oil markets will likely stabilize over the next several quarters as demand improves and production growth slows to a more manageable pace. More importantly, however, is that many energy-related securities now appear to discount commodity prices at or below the low end of our estimated long-term intrinsic value ranges. Although sentiment can turn exceedingly negative at times like these and security values can and often do decline more than expected, we believe investments across the capital structure of many energy companies have become more attractive following recent weakness.

Consistent with our opportunistic investment approach, we have been taking a closer look at potential investment opportunities in the sector. Critical to this assessment is conducting in-depth fundamental research to identify companies we believe can continue to generate solid cash flow to support dividend and interest payments during this period of commodity price weakness, and which appear positioned to perform well in a recovery.

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What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Changes in interest rates will affect the value of a portfolio and its yield. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in portfolio adjust to a rise in interest rates, the portfolio’s yield may decline. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value.

Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in the energy sector involve special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector.