Impact of Potential Normalization of Interest Rates and Inflation on Global Sectors
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2 Impact of Potential Normalization of Interest Rates and Inflation on Global Sectors
3 ANTONIO DOCAL, CFA Executive Vice President Portfolio Manager, Research Analyst Templeton Global Equity Group Templeton Investment Counsel, LLC PETER A. NORI, CFA Executive Vice President Portfolio Manager, Research Analyst Templeton Global Equity Group Templeton Investment Counsel, LLC June 5, 2013
4 Do We Have a Top-Down View? 3
5 So Why Think About Inflation and Interest Rates? 4
6 Transitioning From a Secular Bull to Bear Market in Bonds U.S. 10-year Government Bond Yield 16% 16% 12% 12% 8% 8% 4% 4% Source: BCA Research, May Note: vertical lines represent a secular bottom or top in U.S. nominal treasury yields. 5
7 Total Debt as a Share of GDP has Continued to Rise* Sum of Household, Corporate and Government Debt as a Share of GDP (%) Greece Italy Australia Germany US UK Historically, the easy way out has been the printing press. France Spain G7 Canada Japan *Except Germany and Canada. Source: UBS, Cecchetti, Mohanty and Zampolli (2011), latest data available as of January
8 Impact of Normalization of Interest Rate and Inflation on Global Sectors From our perspective Winners Metal/Mining Energy/Oil Services Real Estate Losers Consumer Discretionary Telecom Services Utilities Insurance This commentary reflects the analysis and opinions of the speakers as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 7
9 Metals & Mining: Inflation and Various Commodities Rising Interest Costs Rising Cash Costs Potential Pricing Power Platinum Group Metals Recent equity raising reduce interest rate sensitivity Positive for low cost producers as PGM prices are within the cost curve and should lead to higher prices Likely highest of all Coal Negative as debt levels remain high with maturities short Positive as long as idled capacity is not immediately brought back on-line Muted Steel Negative as debt levels remain high with maturities short Positive for low cost producers Muted unless capacity disappears or located in certain countries Base Metals Negative as debt levels remain high with maturities short Positive for aluminum since it sits on cost curve, less impact/potential negative for those metals sitting well above cost curve Low Diversified Negative as each of the diversified has significant debt maturities over next few years Likely negative, particularly iron ore for the diversified miners given prices relative to cost curves Low This commentary reflects the analysis and opinions of the speakers as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 8
10 Gold, CRB Metals, Inflation and Short-Term Real Rates The CRB Metals Index and Gold did relatively little until real rates approached the 0% bound. The implication is that the time to get more aggressive with commodity producers is post adjustment of real rates back to positive levels with the potential to have real rates fall again. Gold, CRB Metals, Inflation and Short-Term Real Rates January 1970 to April 2013 (monthly) % 15% 12% 9% 6% 3% % -3% -6% -9% CRB Metal Index (1967=1000) (LHS - 1st Axis)) Gold Spot Price (US$/Oz) (LHS) U.S. Short Term Real Rates (%) (RHS) U.S. Total CPI (YoY % change) (RHS) Source: Commodity Research Bureau, Dow Jones, and Federal Reserve System via FactSet. 9
11 Energy Sector: Our Viewpoint Inflation globally should support higher crude prices, and energy companies should perform relatively well. Energy companies should fare relatively well if: Oil markets remain balanced (i.e. no significant excess supply) Prices remain supportive for continued re-investment Underlying economy (and oil demand) continue to grow modestly During stagflation, real assets (e.g. commodities, real estate) have historically performed best, as they provide a natural hedge because they carry intrinsic value. While corporate profit margins are typically squeezed and unemployment rises, commodity producers maintain pricing power. This commentary reflects the analysis and opinions of the speakers as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 10
12 Oil Services Historically, oil service companies perform relatively well during inflationary periods; oil services market should grow (nominally) with the marginal cost. Companies with propriety technology / high market shares, and those where equipment is in balance / short supply should be able to pass through price increases. Pricing power shifts between service companies and operators over time depending on market conditions. However, in an environment in which oil demand falls (and oil prices fall below marginal cost), demand for oil services would decline significantly and the market for services would likely become oversupplied. This commentary reflects the analysis and opinions of the speakers as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 11
13 Real Estate: United States Bond Yields Drive Valuations Implied Cap Rates vs. BBA Corp. Bond Yields and 10-Yr Treasury¹ Through March % REIT Absolute AFFO Multiple vs. BAA Bond Yield¹ Through December % 8% 6% 4% 2% 0% 12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 3/13 ISI REIT Implied Cap Rates 10-Year Treasury BBA REIT Dividend Yield vs. BBB Corporate Yield (7-10 Year)² Through April 5, 2013 REIT multiples have historically demonstrated a very strong correlation to corporate bond yields. Normalization of corporate bond yields should result in a higher implied caprate, higher dividend yield and lower AFFO multiple for REIT shares. 1. Source: ISI Group (Bloomberg). 2. Source: Citi Research, April 5,
14 Insurance: Share Prices Have Generally Followed Yields December 31, 1999 to May 28, '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 MSCI Europe / Insurance -IG - Price Index (Left) Euro Benchmark Bond - 10 Year - Yield (Right) 6% 5% 4% 3% 2% 1% 0% Correlations highest in Europe and US due to product mix Earning the spread between yields and guarantees Fee-based businesses (mostly UK and some US) also correlated with equities, similar to asset managers Source: 2013 FactSet Research Systems Inc. All Rights Reserved. The information contained herein: (1) is proprietary to FactSet Research Systems Inc. and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither FactSet Research Systems Inc. nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. 13
15 Insurance: Impact of Rising Yields on Reported BV and EPS Property & Casualty Insurance: the fall in unrealized gains will be less and increases in investment yields will occur sooner but impact on book value and earnings per share will be less in FY6. We believe life insurance will ultimately benefit the most. Reported Book Value (BV) Assumption: Rates more than double to 5% at t = 0 Mark-to-market losses on bond portfolio reduces unrealized gains (potentially negative) This increase continues for as long as the duration of the of investment portfolio EPS improves as spread between investment returns and policyholder guarantees widens Earnings Per Share (EPS) Unrealized gains Ability to discount future liabilities at a higher rate benefits BV as time passes Adjusted Book Value Source: Templeton Global Equity Group. This commentary reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 14
16 Consumer Discretionary Impact on Consumers Higher Interest Rates and Higher Inflation = Tax on Consumer Higher Interest Rates Higher mortgage payments Higher car payments Higher credit card rates Higher Inflation Higher fuel prices Higher food prices Higher product prices Consumer Headwinds² Lower Rates and Retreating Commodities = More Money in Consumers Wallets!¹ New all-time high in this series Higher fuel prices Higher inflation Higher interest rates Payroll tax increases Consumer Tailwinds² Improving stock market Improving housing More free cash flow = a higher standard of living for consumers 1. Source: Wolfe Trahan & Co. Portfolio Strategy and Bloomberg. 2. Source: Templeton Global Equity Group. 15
17 Telecommunication Services Negative In general, telecommunication stocks have limited to no pricing power If cost of goods sold rises with inflation, margins will suffer May be able to push prices, but doubtful Tends to be highly leveraged given capital expenditures (CAPEX), although debt is mainly fixed The commentary in this piece reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 16
18 Utilities Summary Higher Inflation and Bond Yields Regulated: negative Regulated with Inflation Protection: neutral but depends on terms (i.e., partial pass-through of costs, timing, debt obligations linked to inflation) Unregulated: usually positive if rising inflation is feeding through to energy prices and higher power prices, but negative if underlying economies are weak and with excess generation and unsupportive government policy (i.e., presently in many countries) Emerging Markets: mixed but usually negative even when they have inflation pass-through, often behaves like developed market regulated utilities The commentary in this piece reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 17
19 Summary Today we covered: Winners Metal/Mining Energy/Oil Services Real Estate Insurance Losers Consumer Discretionary Telecom Services Utilities The commentary in this piece reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy. 18
20 Important Information The information provided in this presentation, and during this conference is not a complete analysis of every material fact regarding any market, industry sector, security, or portfolio. Statements of fact cited by the presenters have been obtained from sources considered reliable but no representation is made as to their completeness or accuracy. Because market and economic conditions are subject to rapid change, opinions provided are valid only as of the date of the material and are subject to change without notice. The manager s opinions are intended solely to provide insight into how the manager analyzes securities and are not intended as a recommendation or individual investment advice for any particular security, strategy, or investment product. Indexes are for illustrative purposes only. One cannot invest directly in an index. For more information on Franklin Templeton products or services, please contact your local Franklin Templeton representative at (800) This presentation is provided by Franklin Templeton Institutional for informational purposes only. This information is considered proprietary and shall be treated as confidential. It shall not be distributed or otherwise communicated to third parties. While every effort has been made to ensure the accuracy of the information contained within these materials, we do not guarantee such accuracy Franklin Templeton Investments. All rights reserved. 19
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