Beyond Bulls & Bears Bulletin

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1 January 2017 INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS IN THIS ISSUE: The articles in this issue are as at 30 January Europe s Main Event: Economics vs. Politics: European equities have been in the tank for years, as the region has struggled with lacklustre growth since the financial crisis. But just as it appears that European stocks may be poised to benefit from higher global economic growth levels and an uptick in earnings, potential fallout from national elections both in the region and from abroad may impact their progress. Here, Philippe Brugere-Trelat, executive vice president and portfolio manager, Franklin Mutual Series, discusses the competing forces at work in likely determining how the European economy and its equities fare this year. Driving a Case for Convertibles in 2017: When many people hear the word convertible, carefree driving, sunny roads and wind-blown hair probably come to mind. Franklin Equity Group Portfolio Manager Alan Muschott thinks of convertibles as something entirely different. He sees an investment vehicle, and one that doesn t represent reckless abandon, but rather, one that can offer attractive yields to income-seeking investors as well as an asymmetric risk/reward profile. Here, he makes the case for why investors might consider convertible securities in the coming year, particularly as US interest rates look set to continue rising and many global uncertainties remain MENA Outlook: A Quiet Economic Evolution: After a year fuelled by shocks and political surprises, many investors are probably happy to see the calendar turn to Amidst political upheavals in the United States and Europe (and don t forget Brazil), many investors may have missed an interesting story taking place in many economies in the Gulf Cooperation Council (GCC) one of a quiet economic evolution. Mohieddine (Dino) Kronfol, chief investment officer, Franklin Local Asset Management, examines the rapid structural reforms taking place across the gulf region as it seeks to break away from oil dependency, and how these reforms are altering the investment landscape. Europe s Main Event: Economics vs. Politics Philippe Brugere-Trelat Executive Vice President, Portfolio Manager Franklin Mutual Series After a tumultuous 2016, European equities may be in for a relatively smoother ride in Economically speaking, the outlook for Europe is improving, in my view, and the most recent data show economic confidence is at its highest level since As 2017 unfolds, I believe European equities may benefit from two factors. First, the recent acceleration in global economic growth will likely increase demand for Europe s exports. Exports comprise about 27% of the eurozone s gross domestic product (GDP), 2 and that percentage is even higher for Germany. The second factor, which is likely a consequence of the first, is the inflection point we have seen in European corporate earnings. Corporate profits in Europe have risen since their trough in July 2016, and for the first time in several years, on a year-on-year basis, earnings growth has risen above zero. European earnings had languished for years because, by and large, European companies have been price-takers (companies that have little influence on the prices they charge) rather than price-setters, and were hampered by concerns about deflation and anaemic economic growth in the region. With the pickup in global economic growth, we are even seeing some signs of inflation, which should have a positive impact on pricing and, by extension, on European companies margins. Political Uncertainties Although the economic picture appears brighter, the political outlook has become cloudier. First, there s the fallout from the United Kingdom s vote in June 2016 to leave the European Union (EU). Since the vote took place, the United Kingdom has been in a kind of suspended animation, and very little has happened, although behind-the-scenes positioning has taken place between the United Kingdom and the EU regarding how to pursue future negotiations.

2 Europe s Main Event: Economics vs. Politics continued Even if the plans to implement Brexit start in March, as indicated by UK Prime Minister Theresa May, the process will likely be long and drawn out, which in and of itself generates uncertainty. The negotiations could become acrimonious, which may put the United Kingdom in a difficult situation. I believe the economic impact of a hard Brexit (where the United Kingdom gives up full access to the single market and the customs union with the EU), would be much harsher on the UK economy than on the EU s, but it would not inspire confidence in the rest of Europe. Second, it s possible that national elections occurring this year may propel populist, anti-eu parties to power. I believe the prospect for that in France is limited, and even less so in Germany, but I would not say it does not exist. On the other hand, a populist party may gain traction in the next Netherlands elections, although I doubt that it would get enough votes to form a majority government by itself. In Italy, we still do not know whether there will be an election this year, because the main objective of the current temporary government is to reform the electoral law so that the populist Five Star party cannot benefit from the law s current form. Looking across the Atlantic, it s difficult to predict how US President Donald Trump s policies will affect the world and Europe in particular. Trump s trade policy, for one, is not clear. At the moment, he seems to be focusing his attention on Mexico and China. I believe the concerns Trump has regarding trade relations with Mexico and China would not apply to Europe. Europe is not a low-cost area in terms of wages or taxes (with the possible exception of Ireland, which is already in the crosshairs of the European Commission for lowering its corporate tax rates to attract US multinationals). So, in my view, the European economic structure offers no unfair advantages that would draw the ire of the new administration in Washington. From a different angle, since the United States is the largest market for European exports a far larger one than China, contrary to popular belief tensions that may arise from an aggressive Trump global trade policy could have a negative effect on Europe s economy. However, I believe an important offset exists: Europe already has a very large economic presence in the United States in manufacturing and services, with most of the trade done by European companies through a US domestic platform. will be favoured, while imports will be penalised. This change could have a significant impact on existing US trade relations with the rest of the world. That said, I don t believe we are going to have a trade war, simply because the US Congress would have to vote on any broad trade barriers; Trump cannot act unilaterally, but there could be some tension in Washington, DC. Favouring Financials Continuing on Trump's policies, his call for less regulation and lower tax rates may benefit a sector that we have favoured for quite a while: US banks. We at Mutual Series believe US banks have been successful in resolving most of the challenges that arose from the global financial crisis. The other side of the coin, however, is that US bank shares have generally become fairly valued. Although I wouldn t jump into the sector with both feet at current price levels, I believe that if the economic growth expected under a Trump administration does occur, US bank stocks may still offer attractive upside growth opportunities. We are, however, much more cautious about European banks. Many European banks have not fully addressed and resolved the issues that originated from the global financial crisis, which include a still relatively high level of nonperforming loans, inadequate capital ratios and dilutive fundraising operations. Additionally, European banks operate in a regulatory environment that is unlikely to be as lenient as the one expected in the United States, in our view. European banks also are still feeling the negative side effects of the European Central Bank s protracted negative interest-rate policy. Overall, we prefer insurance companies over banks at the moment because of their generally healthier capital structures, risk-management abilities and the fact that a large number of them have a restructuring story already underway. Ultimately, when we say we favour a certain sector, we don t necessarily like every company in that sector. We are stockpickers bottom-up investors who seek companies that are trading at market prices that are below our assessment of their intrinsic value. Overall, despite potential political volatility and headlines, we maintain a positive view on Europe as 2017 begins. We are not raging bulls, but we are optimistic that the region has entered a phase of accelerating economic growth. Regarding an issue that I don t believe is fully understood by many investors, the Trump administration also has proposed reforms that could transform the way US corporate taxes are calculated. If the ideas being floated become reality, the United States will install an entirely new tax system, which instead of taxing on the point of production will tax on the point of consumption (i.e., will tax US imports and not US exports). Simply put, domestic manufacturing and whatever is exported 2

3 Driving a Case for Convertibles in 2017 Alan Muschott, CFA Vice President, Portfolio Manager Franklin Equity Group Those looking back at 2016 may be surprised to find a lack of volatility as markets generally took in stride both the United Kingdom s vote to leave the EU (known as Brexit) and the surprise election of Donald Trump as the next president of the United States. As equity markets particularly in the United States moved higher, global interest rates remained historically low, with negative government bond yields in Germany, Japan and Switzerland making headlines. This may change in 2017, however. Impact of Rising Rates Even if we do not see a general paradigm shift towards widespread rising interest rates globally, rates can rise suddenly and strongly, taking the markets by surprise. When that happens, traditional government and corporate bonds face losses, and the potential losses are typically higher for bonds with longer maturities. This risk is expressed as duration risk the measure of a fixed income instrument s sensitivity to changes in interest rates. Corporate treasurers have taken the opportunity in recent months and years to refinance and increase debt loads in an environment of low interest rates. Overall, duration risk is significantly higher for conventional bonds compared to convertible bonds. Many convertibles are issued with a maturity of three to five years, either maturing as a traditional bond or converting to equity. Additionally, if the underlying equities are performing well, the associated convertible securities should trade based on their conversion value rather than their bond characteristics. in a majority of the underlying equities upside, and less of the underlying equities downside, offers investors an attractive risk reward investment option. We think the potential advantages of investing in convertibles are compelling: relatively low duration risk, participation in the potential appreciation of the underlying equities (allowing for a built-in inflation adjustment), and potential to mitigate downside movements in equities. We continue to believe numerous secular growth themes offer multiple opportunities. Convertibles Have Performed Relatively Well in Past Rising-Rate Periods Exhibit 1: Comparative Performance: Rising-Rate Periods Convertible Securities and 10-Year US Treasury Notes Annualised Returns 50% 40% 30% 20% 10% In the last few decades, there have been five periods of rising rates and corresponding negative returns for government bonds. These periods differed in length and magnitude, but they had one characteristic in common: Although convertible bond performance was not always positive, convertible bonds performed relatively well compared with government bonds. (See Exhibit 1.) 0% -10% 10-Year US Treasury Notes Convertible Securities 30/9/93 31/12/94 30/9/98 31/1/00 31/5/03 30/6/06 31/12/09 30/4/10 31/7/12 31/1/14 In our view, 2017 could be a year where the properties of convertibles become an increasingly important feature for investors asset allocation. We expect to see an environment supportive of equity markets, driven by a general shift from expansive monetary policy to expansive fiscal policies and not only in the United States. In this environment, we think a wellstructured convertible bond strategy with a goal of participating For illustrative purposes only. Past performance does not guarantee future results. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed. Source: Morningstar. 10-year US Treasury notes are represented by Payden & Rygel s 10-Year US Treasury Index; Convertible Securities are represented by the BofAML All Convertible All Qualities Index. Indexes are unmanaged and one cannot invest directly in an index. They do not reflect any fees, expenses or sales charges. 3

4 Driving a Case for Convertibles in 2017 continued WHAT IS A CONVERTIBLE BOND? Issued by companies looking to raise capital, a convertible bond is a type of bond that the holder can convert into a specified number of shares of common stock in the company under predetermined conditions. Convertible bonds offer a fixed income component in the form of coupon payments (the interest rate paid on a bond) as well as potential to benefit from a rise in the stock s share price through the conversion to equity. If a company s common stock rises, the convertible security should increase in value because of its price relationship with the common stock. If the common stock doesn t perform well, the bond component should help soften the potential downside. We take an active-management approach focused on balanced convertibles that tread the middle ground between equity- and bond-like characteristics, and that offer a moderate level of conversion premium and equity sensitivity. One of their typical primary advantages is an asymmetric risk/return profile, which can result in greater potential for participation in the upside return of the underlying stock and lower participation in the stock s downside. Finding Value At Franklin Equity Group, our portfolio managers and analysts are focused foremost on understanding the fundamentals and financial health of individual companies. This bottom-up research singles out firms that are capitalising on or driving multi-year growth trends, because we believe such business models can foster superior profitability over the long term. Looking at opportunities across sectors, we see technology as increasingly becoming a non-discretionary expense for a wide range of companies and industries. Third-party providers stand to benefit from these trends as firms often lack the expertise, personnel and resources to develop technology in-house. Within global equity markets, bond proxies companies perceived as safe and defensive, offering reliable dividends, and often in sectors like consumer staples and utilities generally became historically expensive in 2016, despite their recent selloffs. We are finding some selectively better values in dynamic sectors like health care and information technology, in which long-term innovation and growth are being undervalued, in our assessment. Navigating Change and Volatility Ultimately, markets may remain driven by monetary policy for some time, amplifying our concern about the dwindling number of rational capital allocators in the global financial system. Capital should flow to where it can expect to achieve the best return; we believe price-insensitive government buyers and fundamentally agnostic index investors are not fulfilling this critical role. The rising share of capital being invested in these ways has contributed to a growing correlation between the returns of different financial assets. Over time, we expect these imbalances to correct, potentially impairing misallocated capital while benefitting investors who have maintained the discipline of investing in fundamentally undervalued securities through the cycle. Navigating changes in financial markets is never easy. While the global financial system today seems to be far better equipped to deal with systemic crisis than it was in 2008, we nevertheless expect periods of instability and volatility as China s economy continues to transition, post-election uncertainty lingers in the United States and the populist forces that drove the Brexit vote struggle for ascendancy in various parts of the world. We are confident that near-term pain could once again pave the way for long-term opportunity. Looking forward, we believe convertible bonds continue to be an appealing option for income-focused investors looking to capture much (but not all) of equities upside potential but with less downside risk. Convertibles can also be attractive in low interestrate environments when sources of income may be scarce. Historically, convertibles have tended to perform well during periods of above-average market volatility, when cautious investors with a generally positive view of the equity markets seek risk-controlled equity exposure to reduce potential downside risk. Rising stock markets also tend to favour convertible securities due to the price linkage with the underlying common stock. We believe this ability to adapt to myriad market conditions makes convertibles an attractive vehicle for potentially increasing a portfolio s level of diversification. It also bears mentioning that within a company s capital structure, convertible securities can be ranked at various levels of seniority, ranging from the most junior preferred stock to senior debt. Most convertibles are issued as senior unsecured debt, which ranks higher than stocks with respect to income distribution or liquidation. Convertibles Gaining Attention Corporations seem to have grown more comfortable issuing convertible securities as an alternative means of financing by taking advantage of global market conditions that can potentially lower their overall cost of capital below what it would be if they issued only one class of debt and common stock. Worldwide, convertible securities are garnering increasing attention from both issuers and investors. The asset class has ample room for expansion, in our view, as companies across the globe look for financing and endeavour to attract investors to 4

5 Driving a Case for Convertibles in 2017 continued their common shares at the lowest possible cost. Compared with a few years ago, issuers have been coming from an increasingly diverse mix of sectors, countries, industries and marketcapitalisation sizes, which has widened our potential investment universe. Because convertible bonds typically carry a lower coupon rate than straight debt due to their conversion option, they can be a more attractive option to companies in higher-rate environments. Should rates increase, we may see an increase in issuance in the convertibles space. Using our consistent process that leverages a deep bench of research analysts who identify opportunities from a bottom-up perspective, we are finding companies with high-quality business models that we believe can capitalise on secular trends to create sustainable growth. As always, we look to invest in convertibles that offer an appealing yield, potentially attractive risk/reward profiles, and the potential for attractive long-term risk-adjusted return MENA Outlook: A Quiet Economic Evolution Mohieddine (Dino) Kronfol Chief Investment Officer, Global Sukuk and MENA Fixed Income Franklin Local Asset Management Looking at the investment landscape at the beginning of 2017 from the perspective of the GCC region, an alliance between six Middle Eastern countries Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates (UAE) two areas come top of mind. One is the price of oil, which for a region that has massive hydrocarbon reserves will clearly have an impact on the finances of many countries, and the other is the trajectory of US interest rates. Of course, investors should also have an eye on the potential for market volatility, as this is something that we expect to persist. For several decades, this region has been trying to diversify away from its dependency on oil. Some countries have been somewhat successful at doing that at a GDP level; in the UAE, for example, oil represents just 30% of GDP. But for the most part, it remains a struggle, and many GCC economies derive the vast majority of their revenues some over 90% from oil. 3 A Changing Fiscal Landscape As the price of oil has fallen over the past couple of years, we ve seen what we would describe as an impressive structural reform agenda unfold, as the region strives to put itself on more sustainable footing. Governments in the region have reduced salaries, cut subsidies and introduced taxation in a bid to tackle deficits and spending. We ve seen more reform happen to the GCC economies in the past 18 months than we ve seen happen over the past 10 years. In our view, these structural reforms have fundamentally altered the fiscal landscape. We think these efforts will start bearing fruit in the next few years, and that is certainly encouraging. Equally important is the change in policy with respect to oil price. At the end of last year, we saw a significant shift from Organization of the Petroleum Exporting Countries (OPEC) members, led by Saudi Arabia, as they moved from a position of defending market share even at the expense of lower oil prices to a new approach designed to pump up the price of oil by cutting supply. As we move forward, we think it s reasonable to assume oil prices will be more range-bound, moving within a tighter range. However, there could be some volatility ahead, as focus will likely fall on which countries stick to the OPEC-agreed quota, and whether the cartel and non-opec members keep to their word and curb supply. No matter how that turns out, we think it is unlikely that we will be in an environment where oil prices can fall precipitously, as they did in early Oil price risks to the downside appear to us to be significantly diminished. In our view, a more stable oil price with upside potential bodes well for many oil exporters in this region, which when coupled with an ongoing structural reform agenda, paints a pretty decent picture not just for the fixed income markets in the region, but arguably even for some equity stories as well. Operating in a Global Context It is important to remember that the GCC region s financial markets operate in the context of global conditions. Even though these markets typically have significantly lower durations than other fixed income sectors bringing the ability to mitigate rising interest rates and the impact of market volatility any fixed income market has to be cognisant of the trajectory of interest rates across the world. 5

6 2017 MENA Outlook: A Quiet Economic Evolution continued The arrival of a Donald Trump-led administration in the United States has implications, we think, for financial markets everywhere, and this part of the world is certainly no different. We think the US Federal Reserve, notwithstanding its decision to raise interest rates at the end of 2016, is likely to continue treading a cautious path, at least until we see a little more clarity about what the Trump administration is going to be doing. And we, like many others, think that is probably warranted. Events of the past few months have, in our eyes, opened up a lot of opportunities. In 2016, we saw a record year for bond issuance in GCC countries, particularly in Saudi Arabia s case, which came to market with one of the largest ever emerging-market sovereign bond deals at US$17.5 billion. This landmark transaction could alter the pace of issuance within the GCC region going forward, not only substantially increasing the amount of debt issued but also changing the composition to be more consistent with the size and scale of the Saudi Arabian economy. We also think Kuwait is likely to issue bonds in early 2017 marking the first time in history all six GCC countries have bonds outstanding, as the region makes tangible progress developing its capital markets. The geopolitical landscape has changed a lot over the past few months, and we think it will be interesting to see how geopolitics and international relations unfold, particularly through the oil market. But we think any new administration brings with it a degree of uncertainty, and in our view, a Trump administration probably has an extra dose of that uncertainty. Overturning Pessimism One of our ambitions for 2017 is to try to overturn some of the misconceptions about the MENA region and the GCC in particular. One of the misconceptions is that the GCC region is in the middle of a conflict zone and is vulnerable to volatility many residents live in thriving GCC economies without the gloomy headlines often seen in the media. When considering the outlook for the GCC region, many commentators focus on the downside, highlighting a lot of the risks that they perceive the region faces. We would argue that a lot of that risk is priced in to many of our markets. Furthermore, we think it s a myth that the markets in this region are closed or inward-looking. We see evidence that regional policy is geared almost entirely towards integrating more with the world, opening up capital markets and in particular, developing bond markets. What those pessimistic commentators may have missed, in our view, is some of the blue sky or the potential opportunities that could be transformational. That could include anything from seeing the effects of markets in Iran and Saudi Arabia opening up Saudi Arabia s market is open only to institutional investors, while investment in Iran is limited to direct investment, or through a local fund and rerating GDP across the region, to some peace and security as many of the region s conflicts are resolved. Despite some negative headlines we have seen over the years, this is a region that we feel could continue to deliver growth that is higher than much of the developed world. We also feel, as we move forward, that investors would do well to pay more attention to the region s markets, the diversification benefits they potentially offer and the expanding opportunity set we see and look to continue to uncover. 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. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in developing markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with their relatively small size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Changes in the financial strength of a bond issuer or in a bond s credit rating may affect its value. Investments in lower-rated, higheryielding instruments include higher risk of default and loss of principal. These securities carry a greater degree of credit risk relative to investment-grade securities. Focusing on particular countries, regions, industries, sectors or types of investment from time to time may subject one to a greater risk of adverse developments in such areas of focus than investing in a wider variety of countries, regions, industries, sectors or investments. Investments in the energy sector involve special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. 6

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