Beyond Bulls & Bears

Chris Molumphy: Frank Talk on Fundamentals

In spite of the general doomsday consensus that the U.S.economy is heading toward a double dip recession, today’s market conditions exhibit some notable differences from what they were in October 2007. Although volatile markets and the continuing European debt crisis capture headlines, macroeconomic data suggests that the likelihood of the dreaded double dip in the near term is fairly remote. Chris Molumphy, CIO of Franklin TempletonFixed Income Group® cites some of the differences between slow growth and no growth:

“There’s no question that it’s been an exceptionally volatile period marked by flight to quality. Risk aversion has also been a key theme and many assets—including credit—have traded off, in many cases indiscriminately, regardless of fundamentals. That said, the fundamentals simply have not changed that dramatically over the past several months and, overall, are reasonably positive.”

Corporate credit is one area Molumphy notes where fundamentals do not justify some of the cheaper valuations witnessed during the past several months. Investment-grade corporate credit currently has been trading at roughly 2.5 percentage point spreads above U.S. Treasuries and noninvestment-grade corporate credit is trading at a roughly 8 percentage point spread differential above Treasuries[1], both relatively cheap in a historical context:

“We think valuations relative to fundamentals present opportunities in the corporate market. Looking outside the U.S., we see a number of opportunities in global bond markets.”   

The recent flight to quality has kept longer-term U.S.government interest rates low amid the uncertainty related to the European debt crisis. U.S.credit spreads will likely remain relatively wide versus the fundamentals for several months to come:

Our view is that over the longer term, given the fundamentals, yields most likely have to go a fair amount higher. We think we could stay in this lower interest rate environment for some time. Our base case is for somewhat sluggish growth in the U.S.  Coupled with a good deal of labor market slack and 9 percent unemployment with prospects for only gradual improvement, this will likely result in fairly benign inflation and continued low rates in the near-to-intermediate term.

On margin, the European debt crisis has been and may continue to be a dominating factor in the marketplace for short- and longer-term U.S.yields and the equity markets. Although European leaders finally reached an agreement to reduce Greece’s debts, shore up the region’s banks and reinforce its bailout fund to prevent the crisis from spreading and to protect its currency from unraveling, their plans’ effectiveness will depend on executing the details, which may take several weeks or months. Continued uncertainty could keep credit spreads in theU.S.relatively wide versus fundamentals. Although this may present some opportunities in European markets because of the dislocation occurring there, it also presents challenges in identifying income opportunities in a low-yield environment:

“It’s probably not an environment to be greedy when it comes to yield or income. Near-term yields and returns in general are somewhat lower than the long-term averages. That said, whenever the market experiences a good deal of volatility and dislocation, it also presents opportunities. In addition to what we’ve seen in the corporate market, fundamentals look relatively good for municipal bonds. In many cases, we’re seeing yields in excess of taxable yields, even before taking the tax advantage into account.”  

Noteworthy factors that differentiate current conditions from the economy of 2007-2008 include a leaner corporate environment marked by deleveraging and built-up cash holdings. Default rates are relatively low, and while earnings prospects aren’t stellar, they remain reasonably constructive:

“While recession is certainly a possibility, we think it’s fairly unlikely in the near term. When we look at today’s environment, we don’t see the excesses which typically precede a recession. Housing prices are 30-35 percent lower than they were before the bubble burst in 2007. Consumers are in much better shape, averaging 5 percent savings. Corporations and financial institutions are much healthier and don’t have the bad assets on their balance sheets, which we saw in 2007-2008. Current macroeconomic data just isn’t consistent with what you would see preceding a recession.”

Until next time, Beyond Bulls & Bears leaves you with this quote from the late Sir John Templeton:

“Investors are the people who buy for fundamental values. Speculators are those who buy in the hope of selling later to someone else at high prices.”




[1] As of 9/30/11.  Source: Barclays Capital.