Beyond Bulls & Bears

Equity

Volatility Is Not an Indicator of US Recession

Signs of a global economic slowdown have impacted the US equity market this year and led to discussions about a possible recession in both the US economy and US corporate profits. Grant Bowers, vice president, Franklin Equity Group, says current conditions and the outlook for a key economic indicator don’t warrant such strong language. In this Q&A, Bowers maintains that, with the help of stronger consumer spending, the backdrop for the US economy and US companies should remain generally positive for the remainder of 2016.

There seems to be a disconnect between the relatively strong fundamentals in the US economy and the weak performance of the stock market so far this year. What do you think is driving this, and is it warranted, in your view?

Concerns about growth in emerging markets and collapsing energy prices have led many to fear that despite generally positive economic data in the United States, we may not be able to avoid lapsing into a recession. This has driven market pessimism to extremely high levels in the first few weeks of 2016.

Despite these fears, we continue to believe the US economy is performing well, and 2016 will likely surprise many with modest corporate earnings growth, strong consumer spending and gross domestic product (GDP) growth in the 2%–3% range. These types of broad-based selloffs typically create opportunities for long-term investors to buy high-quality companies at attractive prices, and we have been actively seeking bargains for our portfolios in recent weeks.

The upcoming presidential election in the United States has been dominating recent headlines. What impact do you think the election will have on the financial markets?

Politics and elections are not a large part of our fundamental analysis; we like to focus on tangible factors like earnings, free cash flow and identifying great potential growth opportunities. However, anytime you change the status quo you create uncertainty, and the markets don’t like uncertainty.

I think the political uncertainty of the 2016 US presidential election has contributed to some of the volatility we have seen year-to-date. I would expect we will continue to see volatility in the markets until the presidential primaries are settled and we have a better understanding of who the major parties’ nominees are and what their policy proposals will be.

Considering the recent volatility, are you constructive on the US equity market? If so, why?

Yes, we are currently constructive on the US equity market. Despite a rough start to the year, we don’t see a recession on the horizon, and believe the US economy is stronger than many believe. Every expansion since World War II has gone through periods of slow growth. I believe that when we look back in the rear-view mirror later this year, we will see this period as a growth pause in a longer expansionary cycle.

The strength of the US consumer is one of the reasons we remain constructive on US equities. US consumer spending makes up approximately two-thirds of US GDP, so the health of the consumer is key to any investment outlook for the United States. Employment and job growth continue to be strong, and tight labor markets are starting to impact wages and salaries. We believe this should have a positive effect on consumer confidence this year.

Additionally, inflation remains low, as do interest rates. Relatively low interest rates will likely continue to support the ongoing housing market recovery in many areas as financing remains cheap. We also believe there is still pent-up housing demand in the market, which should also be beneficial.

Low energy prices should be a boon for US consumers, but we haven’t seen the effects flow through to all areas of the economy. Do you expect energy savings to eventually boost consumption?  

Many believe that lower energy prices put extra spending money in consumers’ pockets immediately, but history has shown us that lower energy prices are a lagging indicator, as consumers initially save much of the windfall and don’t change spending habits quickly. Much of last year’s savings went to pay down debt or to increase savings, both of which we have seen in the economic data. We believe that as consumers become more comfortable with lower energy prices, they will start increasing their spending on discretionary goods and increased consumption.

You said you don’t think an economic recession is on the horizon in the United States, but some pundits have said US companies already are in an “earnings recession.” How do you respond to that?

We are almost done with earnings season in the United States, and we have a good picture of how the fourth quarter of 2015 ended and what companies are expecting for 2016. It is true that earnings and revenues were down in the fourth quarter, on average, for the S&P 500,1 and some might describe that as an earnings recession. But I think investors should look deeper into the numbers to see what the key drivers of the decline were.

We see two key themes that emerged from earnings season. First, a stronger US dollar was a headwind for many multinational companies, and the currency impact combined with slower global growth resulted in companies with high international exposure experiencing slower growth relative to more domestic or US-focused companies; second, lower oil and gas prices had a negative impact, where year-over-year earnings were down more than 70% for the energy sector,2 dragging down the average growth rate.

But the top-down view does not always provide the clearest picture. When you look at earnings from the bottom up on a sector-by-sector level, you’ll see that growth sectors like consumer discretionary and health care both had positive earnings on average for the quarter, and if we remove the energy sector from the discussion, earnings overall were positive on average for the S&P 500 in the fourth quarter of 2015.3

After posting very strong returns in the last few years, the technology and health care sectors have pulled back in 2016. Has this downturn changed your outlook, or do you think it has created a buying opportunity? 

Despite this year’s pullback, we still have a positive long-term outlook for technology and health care companies. Both the technology and heath care sectors have great growth outlooks, in our view, with a tremendous amount of change likely to take place in the next few years.

The technology sector has always experienced some bouts of volatility, but historically these events have been excellent buying opportunities for investors. The outlook for spending remains strong, as many companies have realized that investments in technology improvements are required to remain competitive in the global marketplace. New software, factory automation and data analytics can all improve productivity and lower the cost of production for companies, keeping them ahead of the competition.

Some of the areas of technology that we are focused on are cyber security, Software as a Service (SaaS), cloud computing, digital payments, mobility and smart devices.

In the health care sector, we continue to like the long-term outlook, where an aging population globally will drive increased consumption of health care services and demand for improved treatments and cures. This demographic tailwind combined with innovation in drug development and medical technology is creating numerous investment opportunities as well.

As long-term investors, we always try to look through the short-term market noise and identify sectors and companies that are benefiting from large multiyear growth trends. Often these trends are driven by disruptive technologies, innovation, changing consumer habits or demographic shifts. The types of broad-based selloffs like the one we have seen recently typically create opportunities for long-term investors to buy high-quality companies at attractive prices.

To get insights from Franklin Templeton Investments delivered to your inbox, subscribe to the Beyond Bulls & Bears blog.

For timely investing tidbits, follow us on Twitter @FTI_US and on LinkedIn.

This information is intended for US residents only.

The comments, opinions and analyses herein are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

What Are the Risks?

Franklin Growth Opportunities Fund

All investments involve risks, including possible loss of principal. Growth stock prices reflect projections of future earnings or revenues, and can, therefore, fall dramatically if the company fails to meet those projections. Smaller, mid-sized and relatively new or unseasoned companies can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. Historically, these securities have experienced more price volatility than larger company stocks, especially over the short-term. To the extent the fund focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a fund that invests in a wider variety of countries, regions, industries, sectors or investments. These and other risks are described more fully in the fund’s prospectus.

Investors should carefully consider a fund’s investment goals, risks, sales charges and expenses before investing. Download a prospectus, which contains this and other information. Please carefully read a prospectus before you invest or send money.

_____________________________________________________________

1. Source: FactSet Earnings Insight, February 16, 2016. See www.franklintempletondatasources.com for additional data provider information.

2. Ibid.

3. Ibid.