Beyond Bulls & Bears Bulletin

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1 December 2018 INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS IN THIS ISSUE: The articles in this issue are as at 27 December A Dovish Fed Rate Hike: The US Federal Reserve raised interest rates for the fourth time this year, but with critics starting to question the central bank s actions, will it take a tightening pause in 2019? Franklin Templeton Fixed Income Group s Michael Materasso weighs in. An Integrated Approach to Managing ESG Risks and Opportunities: Information, data and research are the fuel for investment decisions. Over the years, as new information has emerged and evolved, investors have found innovative means to harness new insights to help inform their decisions. Today, some forward-looking investors are deepening their focus on environmental, social and governance (ESG) analysis to provide additional perspectives to complement existing research efforts. Julie Moret, Franklin Templeton s head of ESG, explains how ESG contributes to an evolved investment evaluation framework and serves as a tool to assess broader holistic risks. Who s Who in the ETF Ecosystem: Understanding the functions of all participants in a trade is a vital part of exchange-traded fund (ETF) investing. Two roles that are often confused, even by experienced investors, are Market Maker and Authorised Participant. Jason Xavier, head of EMEA ETF Capital Markets at Franklin Templeton Investments, offers a simple explanation of what each role plays in ETF trading. A Dovish Fed Rate Hike Michael Materasso Senior Vice President, Head of Insurance Portfolio Management Co-Chair, Fixed Income Policy Committee Franklin Templeton Fixed Income Group The US Federal Reserve (Fed) continued on its path of monetary policy tightening, raising its benchmark short-term interest rate, the fed funds rate, 25 basis points at its December US monetary policy meeting. It was the fourth rate hike this year and the ninth in its current tightening cycle, which dates back to This hike brings the fed funds rate to a range of 2.25% to 2.50%, which is still quite low historically. The Fed also updated its monetary policy and economic forecasts, which saw a few changes from the projections made in September. Here are some highlights of the latest projections: The Fed lowered its 2018 US growth forecast to 3.0% from its prior forecast of 3.1%, and lowered its 2019 forecast to 2.3% from 2.5% prior. The 2019 inflation projection (based on core personal consumption expenditures) was lowered to 1.9% from 2.0% previously. The projection for the unemployment rate remained at 3.7% for 2018 and 3.5% for The Fed lowered its interest-rate hike projections for 2019, putting the federal funds rate at 2.9%. It projects a rate of 3.1% in In discussing the outlook for the US economy, Fed Chairman Jerome Powell said it was a reasonably positive forecast and did not seem terribly concerned about a global growth slowdown, despite market fears. We would agree. US Economy Looks Fundamentally Sound While there have been a few areas of concern, overall the US economic landscape still looks very positive. The job market has been strong, with labour participation rates holding steady. Average hourly earnings have been moving up but are still relatively low when compared with similar cyclical periods of a full-employment economy. Consumer spending accounts for roughly two-thirds of US gross domestic product (GDP), and the consumer remains on solid footing with reasonable debt levels and savings. We believe the consumer should have the wherewithal to keep spending. Fiscal policy primarily tax reforms and tax cuts for both consumers and businesses has been a growth driver in There has been talk that fiscal policy has run its course, but we disagree. The tax package was significant, and in the first half of 2019, many individuals will benefit from larger tax refunds. In addition, the enacted tax reforms will stay with the economy for quarters to come. Given this backdrop, it seems likely to us that the US economy can continue to grow at an above-trend pace in the first quarter

2 A Dovish Fed Rate Hike continued of 2019 and beyond. Our view is that while inflation is not a problem, it will likely edge upwards, so it is also likely the Fed will continue to raise rates in Whether it winds up being one or two rate hikes isn t all that important in our view. Taking everything into consideration, the Fed made what we d call a dovish rate hike. Plotting the Dots The Fed updated its dot plot chart, which presents a picture of where the central bank sees rates headed. What seems rather interesting to us in looking at the dot plot versus the prior meeting in September is that the Fed doves became less dovish, and the Fed hawks became less hawkish. The hawks softened their stance to the extent that the high end of the new range is now part of the central tendency which excludes the three highest and three lowest projections. That said, Powell reiterated that policy decisions are not on a pre-set course and there was still a fairly high degree of uncertainty in terms of the path and destination of further rate hikes. 4.5% 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% Fed Projections vs. Market Expectations 0.5% Dec-2018 Dec-2019 Dec-2020 Dec-2021 Longer FOMC Members' (19/12/2018) Projections FOMC Median Market (Fed Funds Futures) Sources: Federal Reserve, Bloomberg, as at 19 December OIS (overnight index swap)/market consensus. Participants judgements of the appropriate level of the target federal funds rate (rounded to the nearest 1/8 percentage point) at the end of the specified calendar year. FOMC=Federal Open Market Committee. Each shaded circle indicates the value (rounded to the nearest 1/8 percentage point) of an individual participant s judgment of the midpoint of the appropriate target range for the federal funds rate. There is no assurance that any projection, estimate or forecast will be realised. For illustrative purposes only. At the press conference following the Federal Open Market Committee s announcement, Powell fielded some questions about inflation and whether the Fed really needed to continue tightening next year. We have seen a repricing of risk in the markets, and therefore many people think the Fed has to pause, but Fed policymakers focus on fundamentals of the economy, not market fears. In a full-employment economy, it s natural for wage pressures to rise, even though increases so far have been rather muted. However, the output gap the difference between the actual and potential output of an economy closed a while ago, so now there are capacity constraints, and some raw materials costs are increasing. With above-trend GDP growth projected, we think it s more likely manufacturers will be able to pass those increased costs to consumers. Bottom line, we don t think this hike is the last hike in the cycle, unless things change dramatically in the economy in the near term. It s worth noting that one of the goals of tax reform is to increase capital spending, which typically leads to higher productivity. When productivity increases, the economy s trend rate of growth will typically increase as well. That being the case, one could argue the Fed s neutral rate should probably move up, too. Higher productivity accompanied by low inflation could allow for a higher fed funds rate, because the neutral rate should rise with rising productivity. There s been some talk recently about what the neutral rate should be in October, Powell said the Fed was still a long way from neutral but then in November said rates were just below neutral. At this latest policy meeting, Powell said he thinks rates have reached the bottom end of the range of what the committee estimates as neutral. A No-Win Situation for Powell? As noted, we have seen a more risk-off type of environment, and the immediate market reaction in the wake of the Fed s announcement seemed to reflect a continuation of that risk aversion, both on the equity and fixed income side. It seems to me that from a market standpoint, it was almost a no-win situation for Powell. If he communicated the Fed was finished tightening, it could be interpreted as a signal the economic picture is deteriorating. If he were to be more hawkish in tone, the markets probably wouldn t like that, either. We believe the US economy has broad-based strength to weather another rate hike or two in the coming year. There is a concern about slowing global growth particularly in China that will cause the United States to slow down as well. However, the United States is a largely insulated economy and our monetary and fiscal policy is significantly different than China or Europe. The US economy has and can continue to grow, even if China and Europe are slowing. 2

3 A Dovish Fed Rate Hike continued In sum, we think the United States can continue to grow above trend as fiscal policy and employment trends are large positives that bode well for strong growth. In that type of environment, we see potential opportunities to increase exposures to certain credit sectors. An Integrated Approach to Managing ESG Risks and Opportunities Julie Moret Head of ESG Franklin Templeton Investment Management Limited We are living in a rapidly changing world. Sustainability challenges such as resource efficiency, climate change impacts and transitional risks continue to grow in relevance, as does the growing number of policy and regulatory pressures targeting sustainability issues. We are seeing a more acute awareness amongst investors of an alignment between sustainability and financial impact, as evidenced by the growing number of signatories to industry-led initiatives such as the Principles for Responsible Investment (PRI). An international group of institutional investors developed the PRI to reflect the growing importance of environmental, social and corporate governance (ESG) issues within investment practices. Since its launch in 2006, nearly 2,000 signatories representing US$81.7 trillion in assets under management 1 have signed up to the principles. Signatories commit to integrate ESG considerations into investment decision-making, ownership practices and reporting. Despite that growth, there remains variability of interpretation and implementation of ESG practices. This is compounded by the tendency across the investment world to use a confusing and often interchangeable array of terms and acronyms, which in some cases actually refer to different concepts and objectives. THE HISTORY OF ESG ESG analysis can trace its roots back to the 1960s, when certain faith-based organisations adopted ethical screens to identify and exclude companies from their portfolios that did not meet their moral values. Typical so-called sin stocks included tobacco and alcohol. As the emergence of heightened social and political awareness grew in the 1970s, the practice of screening extended to encompass conduct, behaviour and violations of internationally accepted norms and standards. Today, ESG involves a nuanced approach that can incorporate a broad range of techniques from positive screening and/or the use of ESG to mitigate risk or contribute potential alpha. 2 Analysing the Impact of ESG Themes At Franklin Templeton, we make a clear distinction that ESG is different from ethical investing or values-based investing and doesn t require a trade-off in terms of performance. As active managers, we want to understand how these broad ESG themes impact the longer-term strategic risks and opportunities for the companies that we re invested in. So we believe ESG analysis should be an inherent component of research and investment decision-making. We see value in the intersection of evaluating traditional financial measures alongside sustainability measures. In our view, the combination of the two really helps deepen our fundamental research and provides an additional tool to differentiate between companies and sectors that are vulnerable to disruption and those that are adaptive. Over time, these considerations can reshape competitive advantages and ultimately the sustainability of business growth and long-term value creation for shareholders. ESG as a Fiduciary Duty As the business rationale for ESG crystallises, we expect investment managers increasingly will be forced to engage in this space as a matter of fiduciary duty as policymakers and regulators turn their attention to sustainability. In the wake of the 2015 United Nations Climate Change Conference in Paris (known as COP21), the French authorities passed the French Energy Transition for Green Growth Law (or Energy Transition Law). The ambitious legislation sets out a roadmap to mitigate climate change and diversify the energy mix. In June 2017, the Financial Stability Board s (FSB s) Task Force on Climate-Related Financial Disclosures (TCFD) unveiled a list of voluntary, consistent disclosure recommendations. More recently, the European Commission has established a comprehensive framework to hardwire sustainability in the financial sector based on recommendations of its High-Level Expert Group on Sustainable Finance (HLEG). The direction of travel is clear: there is a growing expectation that investment managers and investors should deepen their understanding of the scope and impact these issues pose to long-term operational business resiliencies and new avenues for future growth potential. We believe there are likely to be wide-reaching implications from benchmark selection, reporting and investor duties. 3

4 An Integrated Approach to Managing ESG Risks and Opportunities continued Examples of Material ESG Factors Depending upon asset class, geography, and/or industry, the following are examples of ESG factors that may be material to a particular investment. Environmental Factors Social Factors Governance Factors May include: Regulatory breaches/fines Commodity/raw material access Natural resource management Hazardous waste and toxic chemical disposal/cleanup Carbon emissions, measurement and reporting Climate change risks and opportunities May include: Labour practices (e.g., living wage diversity, discrimination, child or slave labour) Health and safety of employees and products Diversity May include: Shareholder rights Board structure and independence Executive compensation Accounting standards, independent audits Integrating ESG Alongside augmenting existing research with deepened ESG analysis to assess intrinsic value and alpha potential, investment managers need to be able to measure and understand risk in order to manage it. At Franklin Templeton, we want to ensure risks we take in our portfolios are well understood and have the potential to be compensated. We believe that analysing the more traditional quantitative-risk measures such as tracking error or beta alongside more qualitative ESG risk metrics that capture quality of management and reputational risk provide for a more multi-dimensional perspective and deepen our understanding of potential downside risk. ESG data can provide that new perspective to uncover potential hidden risks that lie beneath the surface of balance sheets and financial ratios alone. Correspondingly, we believe time invested today on evolving investment research to incorporate an ESG framework as part of the process will distinguish those firms that will likely be successful tomorrow. Who s Who in the ETF Ecosystem Jason Xavier Head of EMEA ETF Capital Markets Franklin Templeton Investment Management Limited A motto that has served me well in my career is keep it simple. Too often in the investment world, we can find ourselves resorting to jargon. That can alienate even experienced investors, especially when describing unfamiliar concepts. So, in this article, I intend to go back to basics and introduce the main participants in the exchange-traded fund (ETF) ecosystem with whom my colleagues and I deal with on a daily basis: authorised participants and market makers. I ll explain their roles, responsibilities and why they matter. But first, let s remind ourselves of what an ETF is. ETF Basics ETFs are open-ended investment funds which trade around the globe on regulated stock exchanges. In many instances, ETFs track indices which are developed according to either a marketcapitalisation weighted approach or a fundamentally weighted approach. Proponents of ETFs tout liquidity and the flexibility of intraday trading as benefits. The table on the next page highlights the main differences between ETFs and mutual funds. 4

5 Who s Who in the ETF Ecosystem continued Now, let s consider the functions that underpin ETF trading. Market Maker ETFs trade like single stocks on regulated stock exchanges, such as the London Stock Exchange, the New York Stock Exchange and other bourses around the world. So-called market makers facilitate the trading of ETFs by setting buy and sell prices for the ETF shares. These market makers tend to be household banking or stock broking organisations, and they fulfil a similar role to market makers in traditional stock trading. 5

6 Who s Who in the ETF Ecosystem continued Authorised Participants Like an open-ended mutual fund, ETF shares can be created or redeemed at the end of the day s trading, based on net asset value (NAV 3 ). This is where the authorised participant (AP) comes in. An AP acts as an intermediary between the buyer and seller of the ETF shares. Shares will only be created and transferred once the ETF issuer has received cash from the AP. The process is reversed for redemptions: only upon receiving shares from the AP would cash be transferred. trades on a delivery versus payment (DVP) basis. To continue the comparison with traditional mutual fund trading, APs carry out a similar function to mutual fund platforms or advisers acting on behalf of end clients. However, not all market makers are APs, so there may be occasions in which market makers call on the services of an AP to create or redeem shares. In other words, APs may facilitate primary market activity on behalf of market makers. The diagram below illustrates this process. In the vernacular, we say APs facilitate end-of-day primary It s important to understand who all the constituent parts of a transaction are and how they work together, but there can be a tendency to misunderstand the distinct roles and conflate their responsibilities. Our response is that it s market makers, not APs, that underpin the trading of ETF shares. But we recognise that confusion about those responsibilities can lead to questions about the resilience of these functions. For instance, we have occasionally received questions about the possible impact on ETF liquidity of APs failing or stepping away from the market. 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. Bond prices generally move in the opposite direction of interest rates. Thus, as 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. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal a risk that may be heightened in a slowing economy. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Brokerage commissions and ETF expenses will reduce returns. ETF shares may be bought or sold throughout the day at their market price on the exchange on which they are listed. ETFs trade like stocks, fluctuate in market value and may trade above or below the ETF s net asset value. However, there can be no guarantee that an active trading market for ETF shares will be developed or maintained or that their listing will continue or remain unchanged. While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress. 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. FTI 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. Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FTI affiliates and/or their distributors as local laws and regulation permits. Please consult your own professional adviser for further information on availability of products and services in your jurisdiction. Australia: Issued by Franklin Templeton Investments Australia Limited (ABN ) (Australian Financial Services License Holder No ), Level 19, 101 Collins Street, Melbourne, Victoria, Austria/Germany: Issued by Franklin Templeton Investment Services GmbH, Mainzer Landstraße 16, D Frankfurt am Main, Germany. Authorised in Germany by IHK Frankfurt M., Reg. no. D-F-125-TMX1-08. 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Phone: +46 (0) , Fax: +46 (0) FTIML is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is authorised to conduct certain investment services in Denmark, in Sweden, in Norway and in Finland. Offshore Americas: In the U.S., this publication is made available only to financial intermediaries by Templeton/Franklin Investment Services, 100 Fountain Parkway, St. Petersburg, Florida Tel: (800) (USA Toll-Free), (877) (Canada Toll-Free), and Fax: (727) Investments are not FDIC insured; may lose value; and are not bank guaranteed. Distribution outside the U.S. may be made by Templeton Global Advisors Limited or other sub-distributors, intermediaries, dealers or professional investors that have been engaged by Templeton Global Advisors Limited to distribute shares of Franklin Templeton funds in certain jurisdictions. This is not an offer to sell or a solicitation of an offer to purchase securities in any jurisdiction where it would be illegal to do so. 1. Source: UN Principles for Responsible Investing. Data as at April Alpha is a risk adjusted measure of the value that a portfolio manager adds to or subtracts from a fund s return. 3. Net Asset Value (NAV) represents an ETF s per share value. The NAV per share is determined by dividing the total NAV of a fund by the number of shares outstanding. Important data provider notices and terms available at Please visit to be directed to your local Franklin Templeton website. Copyright 2018 Franklin Templeton Investments. All rights reserved. 12/18