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U.S. Fiscal Issues to be Biggest Challenge and Greatest Opportunity for Investors in 2013

January 4, 2013

With the fiscal cliff only partially addressed by the January 1 legislation, investor sentiment and the potential for increased volatility may play a greater role in the short-term direction of financial markets.
-Ed Perks, director of portfolio management for Franklin Equity Group and portfolio manager of Franklin Income Fund, Franklin Templeton

 

In broad terms, US stock and bond markets continued to improve in 2012, with volatility declining despite global macro issues that remained largely the same as in previous years. This trend seemed to be supported by financial markets’ general acceptance that global central banks have become more coordinated and determined to lead through periods of economic and fiscal challenges. In the US, we noted strong, positive action from the Federal Reserve to support the economy in 2012 through the implementation of a third round of quantitative easing and the expansion of programs like “Operation Twist,” which had a favorable impact on both equity and credit markets, in our view. Additionally, US corporate profit margins have generally remained healthy despite a slowdown in revenue and earnings growth. As a result, many corporations have continued to generate abundant free cash flow, enabling them to maintain sound balance sheets while expanding the potential for greater shareholder-oriented actions such as dividends and share buybacks. Lower long-term interest rates have also proved beneficial, allowing many corporations to extend maturities and refinance their debt at lower costs. As one would suspect, aggressive central bank interventions combined with greater investor risk tolerance and the continued search for yield proved highly beneficial to corporate bond markets, resulting in record new issuance for both investment-grade and non-investment grade corporate bonds in the US.

Looking forward, we expect US fiscal issues to be both the biggest challenge and greatest opportunity for investors as we enter 2013. With the fiscal cliff only partially addressed by the January 1 legislation, investor sentiment and the potential for increased volatility may play a greater role in the short-term direction of financial markets. However, the possibility of finding a middle ground between government revenue increases and long-term spending reforms amid the coming set of fiscal deadlines may pave the way for greater confidence in the economy with positive implications for both credit and equity markets. One area of focus has been related to the taxation of corporate dividends going forward. The new legislation, less burdensome than previously anticipated, should lessen investors’ concern about dividend-paying companies falling out of favor as a result of significantly higher tax rates. We continue to see opportunity in dividend-paying companies as we believe their dividend payouts are generally driven more by fundamental views; the strength and ability of the business; and the desire to pay dividends consistently over long periods of time.

Consistent with our approach to look across a wide range of equity and fixed income asset classes, we continue to see a variety of potential opportunities for our hybrid strategies. Despite generally reducing our fixed income exposure in 2012 because of low absolute yields and tighter credit spreads, we have continued to selectively find fixed income market opportunities, with an emphasis on situations where there is potential for credit improvement. For example, we recently have been favoring corporate term loans, which we believe can offer attractive current yields, low exposure to rising interest rates in the intermediate and longer term, and positioning that is typically either senior to other debt in a company’s capital structure or benefits from being shorter in maturity. In terms of equity market opportunities, we expect to continue to gravitate toward bottom-up, research-driven ideas across a range of sectors, including utilities, health care, energy, materials and financials. One of our biggest themes going forward may be increases in potential investment opportunities in sectors such as technology, which historically speaking hasn’t been as associated with dividends as some other sectors. The sector has been impacted by macro fears and slower growth, which has reduced valuations across the sector while at the same time we have seen more technology companies either initiating dividends or announcing dividend growth, improving the yield potential. Going forward, we will continue to focus on our bottom-up fundamental research to seek investment opportunities that we believe are consistent with the investment objectives of our various portfolios.