Listen to our latest “Talking Markets” podcast. A transcript follows.
Host: Hello and welcome to Talking Markets, exclusive and unique insights from Franklin Templeton.
Ahead on this episode: the potential for different regions to experience very different economic and market activity from the coronavirus pandemic.
Ed Perks, Chief Investment Officer, Franklin Templeton Multi-Asset Solutions, looks at concerning factors in the US, reasons for optimism in Europe, and early success in Asia. Plus, opportunities in the credit market, as well as views on the energy sector and all of the attention on gold.
A lot to talk about, and here’s Renee Anderson with the conversation.
Renee Anderson: Thank you for joining us today, Ed.
Ed Perks: Hi, Renee.
Renee Anderson: Let’s start off with where we are right now globally with economic activity and financial markets, compared to a few months ago. And, what to expect over the next few months.
Ed Perks: You know, over the past several months as a result of the COVID-19 pandemic, we’ve experienced some truly unique circumstances, both in terms of what is occurring in global and regional economies as well as in global and regional financial markets. While these certainly exert influences on one another and in some respects have a tendency to true-up over the longer term, this period certainly presents investors with some real areas of divergence that we believe impact dynamic asset allocation decisions and thus, cannot be ignored.
First, kind of looking at growth from the depths of the lockdown, to the nascent recovery that’s replaced it, you know, certainly economic surprises have swung to both extremes. From the record lows in March and April, to the record highs as the process of normalization began in late May and June, there’s certainly been no shortage of places to look to witness this movement, including economic statistics like PMIs [purchasing managers indexes], dynamics playing out in labor markets, auto and housing, sales activity, in particular, as well as kind of future-looking business CapEx [capital expenditure] plans, personal savings rates, certainly profound effects being felt across economies. And, during this global pandemic, this is something that’s relatively common across geographies, across markets, with differences that we’re now seeing largely driven by severity and duration of the virus outbreak.
The expectations that exist for V [shaped] recoveries, we think they hinge on a number of factors, including the duration of the lockdowns and measures designed to control the virus. The ability, particularly with the copious amounts of monetary and fiscal policy that we’ve seen to bridge that gap period, as well as the ability to reopen and reestablish economic activity.
And finally, something that we’re experiencing more currently is the ability to mitigate flare ups in virus cases, and thus sustain the economic recovery momentum that’s being established with the normalization. We expect the forecast error in some of these GDP [gross domestic product] expectations to be fairly significant over the next several quarters and for regional differences, potentially to play a greater role in market performance going forward. You know, I think we’re increasingly skeptical of true V [shaped] recoveries and believe numerous shapes will present themselves over time. And, that there is this potential for economies and markets to begin to diverge as we move into the second half of 2020 and then more specifically into 2021.
Renee Anderson: Talking a lot about divergence, you see it geographically. How do you view the US, Europe and Asia, and the directions they are heading?
Ed Perks: So, one key area, that I think we’re thankful that we’re not seeing tremendous divergence so far during this crisis is in policy response, both monetary and fiscal policy across developed economies. I think following the experience of the global financial crisis of 2007-2009, many of us, myself included I’m guessing, would not have expected to see this level of policy intervention again in our careers. Not only have we witnessed this action in a globally synchronized fashion, but the speed of implementation and the absolute magnitude of response has been hard to fathom at times. You know, globally, we’re now well more than US$20 trillion in stimulus growing by the day via QE- [quantitative easing] driven central bank purchases, balance-sheet growth, and then more creative aspects of policy response, capital markets liquidity facilities, and certainly on the fiscal side, the extensive unemployment support, just to name a few of the many initiatives that we’ve seen policymakers roll out. You know, I think, yet while the initial response was fairly uniform, we believe that cracks are potentially starting to form, and this could open up prospects for greater divergence by region.
Despite what we think have been pretty unprecedented actions in the United States to date, we’re now witnessing greater political discord that certainly is threatening the follow on fiscal programs that very well may be critical to ensuring the temporarily unemployed, bridging the gap, do not become permanently unemployed.
With less than 100 days to go until the US presidential election, combined with at least at times what we’re witnessing is suboptimal efforts to control the growth in virus cases, we believe there remains maybe an elevated risk of the US recovery stalling, particularly in these next several quarters.
And while US equities have certainly performed phenomenally well, driven by large-cap, secular-growth plays, very much tied to the digital transformation that we’ve seen in our economy, arguably accelerated by the COVID-19 pandemic, I think the increasingly uncertain macro outlook, both in absolute—as well as in relative, right—may jeopardize some of this continuation and I think argues for a real look at reallocation of global multi-asset portfolios.
I think it’s also important to contrast that a bit to other regions, including the European Union, in particular, where arguably fundamentals and equity markets have lagged behind the experience in the US. I think it’s possible that a different picture is potentially emerging with greater cooperation and progress toward fiscal union and coordinated stimulus action. Whether this truly becomes Europe’s game-changing moment, I think that remains to be seen. But, it’s difficult to deny the promise of fiscal union which is so regularly been approached with foreboding has moved closer to reality with recent actions, with a parent kind of ease and willingness of participants. That’s particularly noteworthy in our opinion.
I think this opens up a clear opportunity to dig deeper on that opportunity. Specifically, what role can European risk assets play in your portfolio? We’re actively evaluating this potential improvement and really looking for ways to increase our conviction for opportunities in both equities and higher-yielding segments of government bonds—Italy, in particular, where they may be more suited to benefit or better position to benefit from the EU recovery fund.
Another area that seems to be diverging from other parts of the global clearly is Asia and specifically where efforts have been more successful in suppressing the coronavirus itself. These efforts, clearly, outpacing other areas in particular, the Americas. I think given that the macro uncertainty of the next four to six quarters is likely to be influenced in large part by the path of the virus, case growth in particular. This dynamic, I think, if sustained, could begin to yield meaningfully different economic and market outcomes, certainly than what has been experienced to date and in the COVID-19 period.
Renee Anderson: And then there’s divergence actually within the financial markets.
Ed Perks: I think the initial expectation of correlations elevating early in the crisis—certainly, late February to the latter March time period—the subsequent policy induced risk asset recovery and rally has started to see that greater divergence. Key areas include, maybe on a sector, or style, or factor basis, secular growth, momentum and quality plays meaningfully outperforming value, cyclical, defensive and dividend plays. In the US, this has been apparent in large caps meaningfully outperforming small caps. And then, maybe more specifically, an increasingly narrow feel to the market advance, as evidenced by the S&P market-cap weighted benchmark outperforming the equal weighted benchmark by nearly 750 basis points year to date.
While many investors may be tempted by rotational shifts or the opportunity that presents a tendency for markets to occasionally revert to the mean, I think we tilt toward a more disciplined approach, considering a range of factors, some of which laid out here, but principally, valuations, growth dynamics, the trajectory and sustainability of growth, and ultimately, the effectiveness of policy to manage the virus which makes this period incredibly unique.
Renee Anderson: So as we look ahead to the rest of 2020, we have ongoing concerns with the pandemic, we have the US elections. How do you view both of those risks when making investment decisions, and are there other risks that have your attention?
Ed Perks: I would say in a normal environment, we’d be much more focused on the impending US election, particularly given the divisive nature of the United States today politically and the impact that that could have on policy. You know, clearly this is not a normal election year in cycle for a number of reasons, but COVID-19 pandemic and what it’s done to the economy is, first and foremost on that list.
When I think about some of the other challenges, elevated valuations is one, and this is a period in time where I think we need to effectively throw out a bit of the playbook that we’ve had for what would be more garden-variety recessions, and how to think about valuations through the period. This is just such a unique and enforced lockdown, shutdown of economic activity and all related or substantial amounts of related corporate activity and earnings. As a result, we’re seeing that real time with over 40% of the S&P 500 companies here in the US reporting earnings. Now, that’s the second quarter that was the real meat of the decline in activity. It’s really more about what they see happening in the recovery experience and what they see happening going forward.
So, while indices have recovered substantially, there is a lot of divergence. Divergence on a style basis, but simply on sector basis, the more value-type cyclical oriented sectors, really depressed much closer to the lows during the depth of the crisis, then clearly, not hitting the new highs that many of the growth technology companies really tied into that theme of digital transformation are having a very different experience. So, we believe that when you’re at a 30,000-foot level, it’s easy to look at market valuation levels and question whether or not they’re elevated, but we find you’re drilling down into smaller parts of markets leads to a different perspective on valuation, and still gives us some time or opportunity to find attractively valued assets. Now, clearly how they’ll perform going forward brings us back to that primary answer, whether or not the risk remains high, that further outbreaks in virus cases, what impact that will have, how detrimental will that be to reopening re-establishing sustaining momentum as I described in economic activity.
Renee Anderson: Some of the uncertainty that we’re seeing today has affected dividends in some companies and some parts of the market. What’s your view on dividend health more broadly, and how is that impacting the opportunity set for income-oriented investors?
Ed Perks: There has been an initial impact that we think makes sense given the extent to which activity was shut down and that companies were challenged with liquidity and managing their business. So we have seen that, broadly speaking, it’s about a 10% decline in expectations for total market, total S&P 500-company dividends. So we would say, it’s kind of, at this point, a bit more on the margin and very manageable, still plenty of high-quality companies with very strong balance sheets and long-term expectations of continued dividend growth. So, there are still key pockets where we’re able to function. Now, I think the real challenge becomes managing this overall process. Kind of tying back into that prior concept question and some of the themes I touched on the greater ability we have to manage through this to remain active in terms of the economy open and sustaining some recovery momentum, even if drug treatment and developments or vaccine developments are pushed further out in time, clearly nobody has a crystal ball on that. We’re certainly encouraged by the extent of effort and the breadth of the industry that is attempting to solve the problem. We’re certainly encouraged by that, but we still have no assurance exactly when, so learning to live in this new kind of world where we are keeping control of public health and the expansion of the virus preventing future outbreaks. That really, will be critical in many respects to the ability of companies to continue to do that. Certain sectors clearly like financials, like energy, are a bit more tied to that dynamic and could have greater risk of dividend reductions moving forward, if we’re not successful in finding that balance.
Renee Anderson: Let’s change gears a bit and talk about credit markets. Where are you seeing opportunities today? Where are we thinking about yields and defaults?
Ed Perks: We need to think about and touch on the corporate credit market. Some of the extraordinary policy measures, many of those having to do with the corporate debt markets, and while the Fed initially stepped in, I think to officially sustain market functioning was the mandate, the remit in late March to get markets working again, and to step down into investment-grade corporate debt markets with large asset-purchase programs to step into non-investment grade corporate debt, which is, I think something that probably of all of the actions may have taken most market participants by surprise. Clearly, an effort is playing out in corporate credit markets that would be detrimental or offsetting to other elements of the monetary and fiscal stimulus that was being enacted in order to get us through the so-called gap of lockdown economic activity.
I think as we move forward and think about what markets have done clearly pricing themselves off of Treasury markets that have fallen and stayed near relative lows. We’ve seen yields come down across the board. That said, spreads do look a bit more attractive to us in higher- quality corporate debt securities, certainly in investment grade and maybe in the higher-quality segments of high yield, but we’re also cautioned a bit by some of the actions that we’ve seen. While some of the capital markets activity has slowed more recently, the relatively torrid pace in April, May, June has led us to some pretty record levels of debt issuance across markets. So, we see companies facing a crisis, a liquidity or maturity in terms of term structure, crisis terming out debt, but many cases adding leverage and that does give us some concern down the line. More distressed entities clearly don’t have that same kind of support, whether it be a policy, a backstop, so to speak, or even access to the capital markets, the way that the higher-quality companies have. So, we think there’s a bit more risk and the lower credit quality segments, a bit more risk in exactly how more distressed credits play out. But, we do see with a continuation of the crisis, the likelihood that defaults and credit losses do elevate as we move forward.
Renee Anderson: Curious on your thoughts with respect to commodity markets more broadly. Energy as well as gold and precious metals are clearly seeing some divergence in those areas in the last few months. Maybe some high-level thoughts, please?
Ed Perks: Yeah, certainly high level, I think with energy and gold have been two of the commodity segments that have maybe been more pronounced in terms of focus during this crisis. Energy at the front end, if you will, a significant collapse feeling the effects of both the decline in demand as a result of the policy measures that we needed to implement in order to control the virus outbreak, pandemic outbreak and at the same time a supply response, given some of the dynamics within global energy markets in terms of share of the growth of US shale. So, you really had a perfect storm, something that we’ve not witnessed in energy markets in quite some time that drove a substantial collapse in prices, but we have seen the market start to respond. First, you move to a point where companies, many regions are simply not operating at breakeven cash costs so we start to see greater shut in production. We start to see greater delays and elimination of capital expenditures, and with natural depletion rates, we start to see balance come back.
At the same time, the reopening, the re-establishing of economic activity has helped demand. We’re certainly not back to levels where we were prior in terms of energy consumption but that supply-demand balance starts to look better. And subsequently we’ve seen a modest improvement. Now, we think the path forward is a bit more challenging and certainly going to be dependent upon the level of activity, recovery that we see, and then certainly, ultimately, bringing back large segments of demand certainly aviation is a key player in terms of getting demand back to levels that was at prior to the COVID crisis. So, at this point we think for energy, the worst has passed, but a more durable sustained recovery, and certainly any kind of upward move in commodity prices in the energy sector will certainly require a bit more progress in terms of activity and virus mitigation.
In terms of gold, certainly it is an area that we’ve seen increased attention and activity and move higher on gold prices. I think while many associate gold as a hedge to inflation, this longstanding view of the role it can play in portfolios from that respect. We actually think with [interest] rates as low as they are in sovereign debt markets, and maybe as much concerned about deflation as inflation, we think gold has also proven to be an effective haven asset in times like this. We do think it’s arguably a bit more extended in the current market, but do still see the benefits of including assets, alternative exposures in portfolios for the longer term.
Renee Anderson: Terrific. Thanks, so much Ed for joining us and sharing your perspectives with us today.
Host: And thank you for listening to this episode of Talking Markets with Franklin Templeton. If you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other major podcast provider. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.
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