European Drama Hasn’t Derailed US Growth

With the Greek debt crisis coming to a head and China’s equity market experiencing a correction, the summer doldrums have not been in effect this year—except in the United States, where relatively calm economic conditions have prevailed. The recent turmoil in the eurozone and China, however, has roused US investors to attention, and many wonder if the relatively healthy US economy will be jolted by some resultant market volatility. Ed Perks, executive vice president and chief investment officer, Franklin Equity Group, provides his views on US markets, and discusses why he thinks, despite challenges facing some parts of the world, the US economy is likely to continue on its growth trajectory.

Ed Perks, CFA

Executive Vice President, Chief Investment Officer

Franklin Equity Group®

Portfolio Manager, Franklin Income Fund, Franklin Balanced Fund

With US financial news comparatively humdrum this summer, many US market watchers have turned their attention to economic events in other parts of the world, particularly in Europe and China. In doing so, some investors are wondering if any potential volatility arising in the aftermath of the Greek debt crisis could undermine the US economy.

Despite the recent uncertainties surrounding Greece, we remain fairly confident about Europe’s economic prospects in general, and have found opportunities in various segments of the market. We have holdings in European equities in sectors such as health care and energy, and we think the current volatility in the European markets presents an opportunity to take advantage of relative value between European companies and their US-based peers. In fact, we have initiated purchases of many of our foreign holdings during similar market dislocations. That said, we do not take a top-down approach to our region or country allocations. Rather than focusing on a company based on where it’s domiciled, we’re more interested in its underlying valuation, the potential yield opportunities it presents, and if we’re able to take advantage of market dislocations or valuation disparities.

US Economy Sails Along

Turning to the US economy, we believe headwinds to growth have been easing, and what the current leg of the US expansion has perhaps lacked in intensity may very well be made up for by a transition to a more durable or lengthy expansion. We think conditions look favorable for this expansion to continue with a bit more of a tailwind from several important factors.

First, we’ve seen a tremendous decline in unemployment in the United States in recent years. I think what’s particularly positive about that dynamic is that the drop in joblessness has been an accelerating trend. Monthly job growth in the United States has been trending higher, in fact it has been better during the last six to 12 months than it was in the prior six to 12. We’ve also started to see improvement in US wages, which will likely benefit economic activity and economic growth moving forward.

Second, the United States continues to experience persistently low inflation, which we believe is very positive for the economy. We think the Federal Reserve will work to reduce potential inflationary pressures in the future as it transitions to normalizing interest-rate policy and engaging in interest-rate increases.

Third, companies have been increasing their cash flow by using a variety of techniques. Current historically low interest rates have allowed companies to substantially lower their borrowing costs. And we believe companies that have issued long-term debt at very low rates may, in time, come to regard those bonds as the “jewels” of their capital structure. We believe bonds issued under such conditions will likely be out in the market until maturity, which could allow companies to free up cash flow over an extended period. Many companies also have been successful at “creating runway,” meaning they have arranged their debt instruments such that it will be a period of years before substantial liabilities come due.

Searching for Yield

A low-return environment is likely to dominate bond markets for the remainder of 2015, in our view, and the core of our fixed income strategy remains constructively positioning ourselves to navigate what we think will be a rising-rate environment. Managing bond risks will likely require a delicate balancing act.

We believe value still exists in the high-yield sector given the low yields offered in other segments of the fixed income market. Although debt defaults have risen year-to-date in 2015—particularly among select oil companies—we do not expect a major deterioration in the overall default rate. If we do see rising long-term interest rates concurrent with improving economic conditions and business fundamentals, it could actually serve to support many issuers within the high-yield asset class.

Thus far in 2015, US high yield has occasionally seen pronounced investor outflows, but well-regarded and well-capitalized investors have expressed renewed interest in the asset class. Brief periods of challenging performance have historically occurred at monetary policy inflection points, which present a risk to our view. A potentially larger opportunity for us exists in equity-like convertible bonds. Interest in issuing convertible securities seems to have accelerated recently, a trend we are watching closely and believe could present further investment opportunities later in the year.

Dividends on the Rise

In our hybrid portfolios, we remain quite