Beyond Bulls & Bears Bulletin

Transcription

1 April 2018 Beyond Bulls & Bears Bulletin INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS IN THIS ISSUE: The articles in this issue are as at 27 April Symmetry Policy: How to Adapt to a More Volatile Market Environment: It s easy to understand why the return of equity market volatility in the first quarter of 2018 caused some consternation for investors. But Dylan Ball, head of European Equity Strategies, Templeton Global Equity Group, is largely unfazed. He outlines how he s adapted his approach to what he considers to be more normal levels of volatility, incorporating deep stock research and an eye on risk/return dynamics. Will 2018 Be a Banner Year for US Bank Stocks?: Franklin Equity Group Vice President Matt Quinlan explains why he thinks US banks are starting to benefit from a more favourable economic and regulatory environment. Given this healthy backdrop, he believes select large-cap bank stocks may increase dividends and stock buybacks in the next two years. Who Said the Rules of the Game Could Change Because LIBOR s Going Away?: There s been a lot of discussion in the fixed income world about the end of the London Interbank Offered Rate (LIBOR) and what might replace it. But what hasn t been as widely discussed is an important consequence for investors in this space: changes to LIBOR language in new-issue and amended credit agreements particularly how these changes are implemented. Mark Boyadjian, director of our Floating Rate Debt Group, and Reema Agarwal, vice president and director of research, explain. Symmetry Policy: How to Adapt to a More Volatile Market Environment Dylan Ball, ACA Head of European Equity Strategies Executive Vice President Templeton Global Equity Group Unusually subdued levels of volatility during 2017 possibly lured some investors into a false sense of security. But as precipitous market moves in early February and late March suggested a return to more historically normal levels of volatility, the question for investors now is how to adapt their approach to the new environment. Market Volatility CBOE Market Volatility Index December 1989 April Recession Periods US CBOE Market Volatility Index Average Source: FactSet, CBOE. The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the US stock market, derived from real-time, midquote prices of S&P 500 Index call and put options. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges.

2 Symmetry Policy: How to Adapt to a More Volatile Market Environment continued An Alternative to Derivatives To help address volatility, some equity funds use the derivatives market to hedge against downturns. For example, an investment manager may use put options to limit the downside, and protect returns. Put options give the owner the right, but not the obligation, to sell a specified amount of an underlying security at a specified price within a specified time. Buying a put represents a bearish view on the security since there s an expectation for the market price to decline. But this type of insurance comes at a cost, and while derivatives may offer protection against a decline, they can also erode the potential upside. We think there s another way long-term investors can potentially manage volatility: using fundamental earnings analysis to look for those ideas with what we call an asymmetric upside/downside. Attractive Upside Potential, Limited Downside Potential In general terms, the investment universe is replete with companies offering attractive upside stocks which have the potential to generate outsized returns. The problem is the vast majority of these ideas have a symmetrical downside the equal potential for outsized losses. As we build our portfolios, we re looking for companies where we see asymmetric risks: for example, upside potential that is two or three times greater than the downside risk. Clearly, stocks with that type of risk profile are hard to find. So, we have to roll up our sleeves and apply our analysis to as many stocks as we can. Three Categories of Analysis To do this, we break down our expectation of upside into three categories: earnings growth, valuation rerating and capital return (including dividends). In each case, we take a five-year view. We take a similar approach to downside analysis. We examine the potential for earnings to collapse, valuations to fall to trough levels, or capital erosion though a dividend cut or rights issue over the next 12 months. This analysis shows us whether a stock has an asymmetric upside/downside profile. Jumping on Opportunities as They Arise In our view, 2017 s low volatility was an ideal environment for picking up stocks which we felt could fare relatively well should volatility rise, and which we felt could also potentially reduce the overall risk metrics of our portfolios. We found some opportunities amongst financial companies, including financial exchanges and brokerage firms or securities dealers, that have the ability to prosper even when volatility rises. In addition, we believe companies with inflation-resilient pricing power could potentially offer opportunities to outperform amidst a rising-volatility environment. For example, intellectual property rights and legal patents have traditionally offered support to certain health care names. Lastly, rising commodity prices, particularly oil, have historically tended to be correlated with higher volatility. So, the opportunity to buy large integrated energy companies at discounts to their long-term average price also proved attractive to us in our search for potentially higher returns and lower risk than the benchmark. Incorporating Analysis of a Full Range of Risks Our approach reflects intense research analysis that goes deep into stock selection for our portfolios. In our view, the more risks that an investor factors into their investment case when purchasing a stock, the lower the impact volatility could have on their portfolio as long as those risks have been discounted. Conducting this kind of research can include factoring in thirdparty data where appropriate. For example, while our analysis has traditionally cast an environmental, social and governance (ESG) lens over potential investments, we also use outside analysis to inform our reckoning of ESG considerations that we ve not already factored into our original investment case. If that analysis uncovers a previously unconsidered risk, we may discount our earnings expectation for that stock accordingly. In effect, we re trying to get ahead of any ESG discount that the market might want to price in if a risk manifests itself. We believe that with effective research and analysis, it can potentially reduce the susceptibility to volatility of our portfolios. Compared with the use of derivatives, this use of fundamental analysis is a longer-term approach. It can be labour-intensive and to be most effective, we think it needs to be carried out before volatility strikes. Beyond Bulls & Bears Bulletin 2

3 Will 2018 Be a Banner Year for US Bank Stocks? Matt Quinlan Vice President, Portfolio Manager, Research Analyst Franklin Equity Group Although valuations appear stretched in certain pockets of the US equity market, we see value in specific sectors. In particular, we like the prospects for US banks. In our view, select large-capitalisation US banks are likely to benefit from a growing US economy, higher interest rates and a less-restrictive regulatory environment. As a result, we think they have room to increase dividends and stock buybacks as earnings improve and capital is freed up. Favourable Economic Backdrop At this time, US economic growth appears to be on solid footing, with tailwinds from tax reform as well as some near-term fiscal stimulus. As the US economy continues to grow, we think select banks are likely to see increased loan and capital markets activity. In addition, we think the upward momentum in US interest rates is likely to lead to higher bank net-interest income growth, and as a result, greater profitability potential. The US Federal Reserve (Fed) has said it plans to continue to raise interest rates as the economy improves. At its March monetary policy meeting, the Fed reaffirmed its projection of three interest-rate hikes in 2018, which would put the federal funds rate at 2.1% by the end of the year. Also, the Fed projected the fed funds rate will rise to 2.9% by the end of Improving Regulatory Environment In the past year, the regulatory backdrop for the US financial sector has improved for the first time since the global financial crisis (GFC) a decade ago. President Donald Trump s administration has proposed rule changes that would allow banks to hold less capital, based on how much leverage they hold. US banks have worked to build up their capital ratios since the financial crisis. Now, we think regulators seem generally confident that bank capital ratios are sound. These institutions performed well in government-mandated stress tests last year, which allowed them to return capital to shareholders. We believe they are likely to continue to perform well. As a result, select banks seem prepared to return an increasing amount of profits to shareholders as they generate higher levels of after-tax cash flows. Based on our analysis, these banks are likely to be able to boost buybacks and raise dividend payouts over the next couple of years. And because of the more favourable stress-test results, it appears more likely that the Fed will allow them to do so. Investment Implications We think valuations of select US banks appear attractive relative to the broader market. In our view, these banks have made great strides in becoming more efficient, and they have generated higher levels of capital than required to meet their regulatory requirements. We believe they stand to benefit from a growing economy and a more favourable regulatory environment going forward. That said, if US economic activity slows and the outlook for interest-rate hikes decreases, our view could change. Although we don t see a cause for a slowdown at this time, it is possible a trade war could develop and lead to downward revisions in economic growth. So far, trade tensions have led to bouts of market volatility, but have not signalled that the economy won t be able to continue growing at its current pace. Beyond Bulls & Bears Bulletin 3

4 Who Said the Rules of the Game Could Change Because LIBOR s Going Away? Mark Boyadjian, CFA Director of Floating Rate Debt Group Franklin Templeton Fixed Income Group Reema Agarwal, CFA Vice President, Director of Research, Floating Rate Debt Group Franklin Templeton Fixed Income Group Background For decades, lenders worldwide have used the London Interbank Offered Rate (LIBOR) to set interest rates for a variety of financial products, including interest rate swaps, student loans, mortgages, collateralised loan obligations (CLOs) and syndicated floating rate loans in which a group of lenders known as the syndicate work together to provide funds for a single borrower at a variable interest rate. A panel of leading banks active in London sets the LIBOR rate, which represents the level they have determined they can borrow short-term, unsecured funds in the interbank market. Put simply, LIBOR represents the average interest rate they (banks) would charge each other for a loan, and its widespread use by so many market participants was based on its construction and availability. Hundreds of trillions of dollars worth of interest rate exposure is tied to LIBOR, 1 which until recently was seen as a standard and accurate rate by a wide swath of market participants. LIBOR has been beset with multiple pricing scandals over the past few years, casting doubt on the pricing process and its validity as a reference rate. The result is that LIBOR will eventually be discontinued. The Financial Conduct Authority has confirmed that the future sustainability of LIBOR can t be guaranteed, but 20 of the LIBOR panel banks will continue to support it until Why LIBOR s Fate Matters to Us It remains unclear what benchmark will replace LIBOR in the syndicated floating rate market. Notwithstanding the recent rise in LIBOR (roughly 100 basis points in the last six months) a change would require amendments to the contracts and credit agreements underlying trillions in global assets. The interest rates on many of these financial instruments are currently set based on LIBOR. If an alternative benchmark does not reflect the risk and return signatures provided by LIBOR, such a change will likely result in a resetting of the credit spreads syndicated lenders charge and borrowers are willing to pay for these assets. In situations where there is a syndicate, the lenders participating in this group agree to fund the loan together, which enables them to spread the risk of default across other entities. These loans are typically larger than a single lender could handle, so the role of the syndicate is important. The terms of the loan agreement must be agreeable to all of the lenders, regardless of whether they are known to each other or not. Typically, if a borrower wishes to make a change to a loan agreement, he or she would contact the group of lenders in the syndicate (usually through the agent) to communicate and explain the reason for the proposed change. Amendments to existing credit agreements can represent complex or simple requests. For example, there could be a request for an extension in the deadline to file quarterly financial statements, or to push out the maturity date of a loan. Generally, a borrower would need the affirmative approval of a clear majority of the lenders of record prior to the amendment s changes taking effect. [Changes to more material terms of a loan (e.g., interest rate and maturity) would require the approval of all lenders.] The lenders collectively decide whether to grant, withhold or renegotiate any proposed amendment to the terms of the credit agreement. This would include a change to the interest rate being paid on the loan. Getting back to LIBOR, in most credit agreements, there is backup or contingency language for the temporary replacement of LIBOR. For example, the prime rate is frequently referenced as a substitute, in the event LIBOR is unavailable. However, the prime rate is typically higher than LIBOR, and naturally, the borrower s goal is to minimise their interest payments on the loan. Therefore, the borrower would only be obligated to use a substitute rate if the LIBOR is unavailable and could revert back to LIBOR upon its being available. Now, faced with the likelihood of LIBOR going away permanently, instead of treating the LIBOR change as a typical affirmative amendment which should require the consent and approval of the clear majority of the group of lenders some borrowers are issuing new or amended credit agreements with a Beyond Bulls & Bears Bulletin 4

5 Who Said the Rules of the Game Could Change Because LIBOR s Going Away? continued reference rate of their choosing, and if a certain number of lenders don t reject (or opt out of) this replacement choice, they are automatically accepted. This is a disturbing and unfortunate market dynamic that concerns us as investors. Historically, in the syndicated floating rate leveraged-loan market, LIBOR has been a primary component of the income generated for investors. So, adding new terms to a loan agreement that require lenders not to participate, if they don t like the new interest rate, could negatively impact our investors and jeopardise these traditional sources of income. A Slippery Slope Essentially, the most offensive examples of the LIBOR replacement language allow administrative agents and companies (borrowers) to amend the credit agreements in the future without a lender s affirmative consent, which then changes the future risk profile of the investment. In our view, it s a fundamental rule of lending that each affected lender should affirmatively consent to any proposed reduction or change in the interest rate or benchmark of a loan. In some cases, these new and amended credit agreements state that the changes will become effective unless 50% of lenders object within five business days of notice. This is a significant change from the way these types of changes were traditionally handled. We believe it is not realistic or likely to expect lenders to respond negatively (i.e., to opt out) within five business days, particularly given lenders as part of this syndicate group often are unknown to each other and therefore have no way to engage each other to discuss such a change or what an acceptable alternative would be. We are seeing very little transparency with these changes and it appears intentional as though the borrower or agent bank is seeking the option to unilaterally negotiate better terms in a way that will minimise the lenders taking notice, including their ability to be in a position to constructively negotiate an acceptable alternative. Investor Rights Being Diluted If lenders allow changes to be made to credit agreements that permit the agent or borrower to select a LIBOR replacement without their affirmative acceptance, they are all accepting an erosion of lender protections protections which we think are critical to our asset class and our investors while simultaneously receiving no commensurate compensation for giving this option away. As troubling as this new practice of negative consent for creditagreement amendments on LIBOR replacement is, the language and substance of some are egregious. We have seen provisions in new and modified credit agreements that permit the borrower to change the reference rate from LIBOR without ANY lender approval. Furthermore, in some cases, this language was not in draft documentation sent to investors. It was added to final executed versions of the credit agreements, which raises questions of ethical business practices. The legality and underhandedness of inserting such a provision are debatable, but we are taking a proactive approach in responding to this development. We are watching for this type of language in draft credit agreements of any new-issue transactions and in amended credit agreements of repricings we are considering investing in. As an investor, we do not believe these new or amended forms of credit agreements are in the best interests of our clients. We are seeking to require prior consent and approval of any changes made to the LIBOR or reference benchmark rate in the final credit agreement as a condition of investing. We have also seen several repricing transactions recently with unfavourable replacement language added, and have taken an active decision in some cases to eliminate or dramatically reduce our exposure to those borrowers. We encourage our peers and competitors to seek to protect their clients investments by negotiating unfavourable LIBOR replacement language out of new or amended credit agreements. We believe that any change to the usage of LIBOR should require an affirmative amendment process with >50% consenting lenders approving any replacement index. In other words, a majority of lenders would need to collectively opt in, rather than be pressured to organise quickly to opt out. In our view, there is a simple solution to the issue of determining what will replace the LIBOR benchmark in credit agreements treat this change like a regular amendment that seeks outright majority approval, and let us have a voice in the matter. Beyond Bulls & Bears Bulletin 5

6 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. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Value securities may not increase in price as anticipated, or may decline further in value. To the extent a portfolio focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a portfolio that invests in a wider variety of countries, regions, industries, sectors or investments. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in derivatives involve costs and create economic leverage, which may result in significant volatility and cause losses that significantly exceed the initial investment. Short sales involve the risk that losses may exceed the original amount invested. Liquidity risk exists when securities have become more difficult to sell at the price they have been valued. Convertible securities are subject to the risks of stocks when the underlying stock price is high relative to the conversion price and debt securities when the underlying stock price is low relative to the conversion price. Floating-rate loans and debt securities tend to be rated below investment grade. Investing in higher-yielding, lower-rated, floating-rate loans and debt securities involves greater risk of default, which could result in loss of principal a risk that may be heightened in a slowing economy. Interest earned on floating-rate loans varies with changes in prevailing interest rates. Therefore, while floating-rate loans offer higher interest income when interest rates rise, they will also generate less income when interest rates decline. Changes in the financial strength of a bond issuer or in a bond s credit rating may affect its value. Beyond Bulls & Bears Bulletin 6

7 IMPORTANT LEGAL 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. The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at the publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal. Data from third party sources may have been used in the preparation of this material and Franklin Templeton Investments ( FTI ) has not independently verified, validated or audited such data. 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