Beyond Bulls & Bears Bulletin

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1 May 2018 Beyond Bulls & Bears Bulletin INSIGHT FROM FRANKLIN TEMPLETON INVESTMENTS MANAGERS IN THIS ISSUE: The articles in this issue are as at 23 May An Unconventional New Government in Italy: Two months after the Italian election, the country looks set to form a new government led by the right-wing La Lega and left-wing Five Star movement. While markets take some time to digest the full implications of this unusual tie-up, David Zahn, Franklin Templeton s head of European Fixed Income, offers his analysis of the political situation. Is It Time For Value Investing to Return to the Limelight?: In recent years, value investing has played second fiddle to growth investing. But now could the stage be set for its return to the limelight? Franklin Mutual Series CEO Peter Langerman weighs in with his thoughts and explains why he is optimistic. Second Quarter Hedge-Fund Strategy Outlook: K2 Advisors: In their second-quarter (Q2) 2018 outlook, K2 Advisors Research and Portfolio Construction teams share their views on why investors should not fear the return of market volatility and why it may unlock opportunities for active managers. We believe offering these insights will help investors better understand the rationale for owning retail mutual funds that invest in hedge strategies. An Unconventional New Government in Italy David Zahn, CFA, FRM Head of European Fixed Income, Senior Vice President, Franklin Templeton Fixed Income Group In our analysis immediately after the Italian election in March this year, we felt a tie-up between Five Star and La Lega (The League), two populist parties at opposite ends of the political spectrum, would be the worst outcome for markets. Now, two months after voting, those two parties look set to form the next Italian government, subject to gaining the approval of the country s president for their compromise candidate for prime minister. Political Risk Hurts Italian Markets Italian markets have undergone a widespread selloff, as investors have reacted to the increasing likelihood of a new populist administration. It is the proposed policies of this coalition of opposites that have raised the hackles of the financial markets. The two sides have been good at talking about how they will spend money and not so good at telling us how they will raise money. For example, some of the broad themes that have emerged from their discussions include operating a low, flat tax rate, reducing the retirement age (at a time when most other countries are doing the opposite) and introducing a form of universal basic income for the poor. These are noble causes, but they all cost money. Italy already has a fairly large budget deficit. It runs a primary surplus excluding interest payments, but its debt-to-gross domestic product (GDP) is more than 130%. So in our eyes, more spending doesn t seem to be the answer. Furthermore, Italy is viewed as having one of the weakest major economies in Europe. Lower Demand for Italian Government Bonds We think the Italian government should be looking at reforms that could generate long-term growth, rather than trying to drive that growth through government spending.

2 An Unconventional New Government in Italy continued The European Central Bank s (ECB s) reduction of its bondbuying programme might present a further challenge for the incoming government s ambitions. Last year the ECB spent 60 billion a month buying European government and corporate bonds. Italy accounted for a fair portion of those government bond purchases, and the programme was quite supportive for Italian government bonds. The ECB has now reduced the monthly purchases to 30 billion per month, and the programme is scheduled to end in September. We think the bank will extend the asset-buying programme into 2019, but our expectation is that it will focus more on corporate bonds. As the ECB steps away, demand for Italian government bonds is likely to be less than it was a year ago, even if the current volatility related to domestic politics proves to be temporary. Therefore, the Italian government will have to find other buyers, adding further to pressure on its funding costs. How Supportive Will France and Germany Be? Although we think that fears about the League/Five Star coalition s euro scepticism are over-played, we recognise there could be tensions between Rome and Brussels in particular over the new government s spending plans. Italy s current constitution would not allow a referendum on the country s membership either of the euro or the European Union. And at the moment League/Five Star would be unlikely to have the requisite three-quarters majority in parliament to change the constitution. However, the spending plans of the new administration could cause some friction in the euro area. There s a question of how supportive the governments of France and Germany are going to be of the new Italian government s plans. Perhaps surprisingly, we believe there are reasons to suggest they could be quite supportive. Given the more aggressive trade stances being taken by the United States and China, Europe may want to maintain a more unified front. Although Italian bond yields are already quite high compared with the rest of Europe, we think the new government will struggle to deliver on its programme and keep financial markets onside. This is likely to keep Italian yields under pressure in the short term, and so we maintain our negative view of the country's debt. We are, however, monitoring developments closely, and if yields move to levels that appear to offer better compensation for the political risks, we may reconsider our negative stance. Is It Time For Value Investing to Return to the Limelight? Peter Langerman Chairman, President, Chief Executive Officer Franklin Mutual Series We believe macroeconomic developments in the United States and elsewhere could prove a fillip to value investing after several years of underperformance. The combination of suppressed interest rates and low volatility has contributed to an extended period in which the performance of value investing has lagged growth investing. But as we shift from what may be perceived as abnormal conditions to more normal conditions when there is some degree of volatility and a higher interest-rate environment we think the equilibrium between growth and value will also normalise. We are not predicting that there s going to be a period of dramatic value outperformance versus growth. Rather, fundamentals suggest to us there should be more of an equilibrium reached. And so, we think it s an environment that s more attractive for us as value investors than it has been for the past several years. The Return of Volatility Offers Opportunity The global political environment certainly makes daily life interesting and may from time to time play a role in increased market volatility. We see volatility as an opportunity, particularly where the market is trading on shorter-term technical assumptions. Our job as long-term, bottom-up investors is to filter out the noise and to focus on fundamental valuations. Of course, some of these developments do have impacts. Issues such as tariffs or taxation can have a real economic influence. We look for those developments that are likely to have a longerterm earnings impact or that could affect stock valuations, rather Beyond Bulls & Bears Bulletin 2

3 Is It Time For Value Investing to Return to the Limelight? continued than those pronouncements that might be reversed tomorrow, and then reversed again the next day. We see this approach as an opportunity set. People tend to react very quickly to events, but our longer-term perspective can allow us to take advantage of situations where we think markets have over-reacted or misinterpreted. Rising Rates, But Not Too Fast We think most people have recognised that the period of artificially low interest rates seen around the world is not a permanent state of affairs. Markets globally are emerging from an abnormally low interestrate environment that has been influenced in large part by central bank decision-making globally. In general, we consider rising rates to be reasonably positive, if done on a controlled basis. If there were to be too much of a spike in rates, that could prompt some recessionary concern. However, rising rates can be considered a reflection of better economic activity. Rising employment and economic growth are positives. Over the past months, our view has been that banks could be modest beneficiaries of a slightly rising rate environment. But slightly is the key word there. There s a risk if the US Federal Reserve (Fed) were to fall behind the curve in its current tightening cycle, it might find itself having to respond aggressively to too-high inflation. An overly aggressive central-bank approach could suppress economic growth. But so far the path that the Fed and other global central banks have taken seems prudent to us. Taking a Global View As global investors, our investment decisions are not based on our view of a specific country, or even on our view of a specific sector within a country. Our decisions are based on overall valuations. We want our stockpicking to be our differentiator. Second Quarter Hedge-Fund Strategy Outlook: K2 Advisors David Saunders Founding Managing Director K2 Advisors Brooks Ritchey Senior Managing Director Head of Portfolio Construction K2 Advisors Robert Christian Senior Managing Director Head of Research K2 Advisors Don t Fear the Fear Index We suggested at the end of last year that when the massive tide of global liquidity injected into markets post-2008 begins to recede, a wave of volatility could follow. It appears as though the wave has arrived. Market volatility as measured by the VIX (the so-called "fear index") surged 80% in the first quarter of the year. The S&P 500 Index and Dow Jones Industrial Average both declined for the quarter respectively, while the Nasdaq Composite Index managed a modest gain based largely on its sharp rise in January. Nine out of 11 S&P 500 sectors traded lower. The steepest declines were in telecommunication services, consumer staples and energy. Information technology and consumer discretionary were positive outliers despite selling off broadly in March. The negative quarter for the S&P 500 Index broke a string of nine positive quarters, the longest streak in 20 years. In addition, all of this happened following the nine-year anniversary of the US bull market, which began on 9 March 2009 and 10 years after the bailout of Bear Stearns. CBOE Market Volatility Index ( VIX ) One Year Ended 31 March Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 Source: CBOE via FactSet. 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, mid-quote prices of S&P 500 Index call and put options. Data from 31 March 2017 to 31 March Past performance is not an indicator or a guarantee of future performance. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Beyond Bulls & Bears Bulletin 3

4 Second Quarter Hedge-Fund Strategy Outlook: K2 Advisors continued So now what? From our perspective, a reversion from the unprecedented low levels of volatility was to be expected perhaps even welcomed. In some ways it reflects the resumption of more normalised market behaviour. This is a good thing, in our view. As we have said in past commentaries, the historic levels of quantitative easing following the global financial crisis that is the expansion of the Fed s balance sheet from around US$900 billion to nearly US$4.5 trillion today was one of the most dominant market-shaping forces over the last decade. In our view, it caused a distortion in prices, a suppression of volatility and a reduced emphasis on corporate fundamentals. In addition to yields being driven towards record lows and stock markets to record highs, many investors were pushed towards riskier assets while the cost of capital was kept artificially low. While passive investing thrived in such an environment, it could be argued that active management and hedge funds suffered. As this era of quantitative monetary stimulus slowly winds down, we believe an improved environment for active management will emerge. Reduced central bank support should make stocks more responsive to idiosyncratic factors. The consensus thought seems to be that less-supportive monetary policy will lead to greater price sensitivity from individual company fundamentals, which in turn could lower pair-wise correlations. If this were to occur, we feel this should lead to greater sector dispersion as well, creating a more conducive environment for managers to identify potential winners and losers. As a result, we believe the environment for alpha capture 1 for the remainder of 2018 may remain fertile. Discretionary Macro Our outlook for the discretionary macro strategy continues to improve. Increased central bank activism and policy divergence, combined with political uncertainty across major economies, have contributed to an increase in volatility across major asset classes. The increase, while modest, is nevertheless indicative of higher uncertainty and potentially better trading opportunities for managers with flexibility to trade across asset classes (most notably in fixed income and currencies, which have traditionally been a core area of focus for discretionary managers). Long/Short Equity Europe The opportunity set in Europe remains favourable for long/short equity managers. European equities continue to trade below their historical average valuation versus the United States, which we believe to be fully valued. Eurozone forward earnings estimates are trading well below their prior peak, providing ample room for further recovery. US forward earnings, by contrast, are well above their 2008 peak. European economic growth should continue to improve with low rates, resumption in bank lending, and strong external expansion. We believe the fears of a catastrophe following the Brexit decision are beginning to subside, as the issue appears to be reaching an amicable end for both Europe and the United Kingdom. In addition, Europe looks to be positioning itself close to US President Donald Trump s administration at the trade table, likely putting it in a better position related to China or Japan in terms of any tariff actions by the administration. Furthermore, the alpha environment appears strong with increased dispersion and decreased correlations 2 impacted by varied regional macro developments, ECB meetings and elections. MSCI Europe 12-Month Forward Earnings per Share November 2001 March Nov-01 Jan-03 Mar-04 May-05 Jul-06 Sep-07 Nov-08 Jan-10 Mar-11 May-12 Jul-13 Sep-14 Nov-15 Jan-17 Mar-18 Source: Thomson Reuters I/B/E/S. Data from 17 November 2001 to 15 March Time-weighted average of the consensus earnings estimates for MSCI Europe Index for current and next year. Monthly through December 2005, weekly thereafter. The MSCI Europe Index captures large- and mid-cap representation across 15 developed markets countries in Europe. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Past performance is not an indicator or a guarantee of future performance. Indices are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. There is no assurance that any estimate, forecast or projection will be realised. Beyond Bulls & Bears Bulletin 4

5 % of Market Weight Second Quarter Hedge-Fund Strategy Outlook: K2 Advisors continued Relative Value Fixed Income With interest rates finally starting to rise, duration 3 risk is coming into focus for fixed income investors. Relative value fixed income managers such as long/short credit managers appear well positioned, given their shorter duration portfolios, and, in our view, should be able to generate alpha from rising sector dispersion. The diverging paths of central banks in the major global economies are expected to present improved directional opportunities. Participation from directional buyers and sellers of bonds should result in greater market inefficiencies between cash bonds and futures, benefitting less directional relative value trading. The strategy is still subject to greater leverage and funding risks, justifying a cautious approach. US High Yield Market Weight by Yield-to-Worst As at 21 March % 38% 35% 30% 25% 20% 15% 10% 5% 0% 22% 15% 10% 5% 3% 2% 3% 1% 0% 0% 1% < 5% 5%-6% 6%-7% 7%-8% 8%-9% 9%-10% 10%-11% 11%-12% 12%-13% 13%-14% 14%-15% >15% Yield-to-Worst Source: BofA Merrill Lynch. High yield market represented by the ICE BofAML US High Yield Index, which tracks the performance of US dollar-denominated below investment grade rated corporate debt publically issued in the US domestic market. Past performance is not an indicator or a guarantee of future performance. Indices are unmanaged and one cannot invest directly in them. They do not reflect any fees, expenses, or sales charges. 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. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Value securities may not increase in price as anticipated or may decline further in value. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Investments in companies engaged in mergers, reorganisations or liquidations involve special risks as pending deals may not be completed on time or on favourable terms, as well as lower-rated bonds, which entail higher credit risk. Investment in these types of hedge-fund strategies is subject to those market risks common to entities investing in all types of securities, including market volatility. There can be no assurance that the investment strategies employed by hedge fund and liquid alternative managers will be successful. It is always possible that any trade could generate a loss if the manager s expectations do not come to pass. Hedge strategy outlooks are determined relative to other hedge strategies and do not represent an opinion regarding absolute expected future performance or risk of any strategy or sub-strategy. Conviction sentiment is determined by the K2 Advisors Research group based on a variety of factors deemed relevant to the analyst(s) covering the strategy or sub-strategy and may change from time to time in the analyst s sole discretion. Beyond Bulls & Bears Bulletin 5

6 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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