Templeton outlook: Tempered optimism

(July 23, 2004) While it is tempting to think the heady days of the late 1990s have returned, investors need to realize that 2003 was an extraordinary year for North American equity markets, according to a panel of fund managers assembled for Franklin Templeton’s annual Outlook and Opportunities Forum in Toronto this week.

“My message is optimism, but tempered optimism: With such a strong year behind us, there are a number of elements in the economy and the global system right now that challenge us,” said George Morgan, manager of the Templeton Growth Fund.

He says the plan going forward is to “stick with his knitting” and continue to pick up the cheapest stocks on a valuation basis.

“We tried to say to people last year that as best our gauges could indicate, there was a profit potential, the recovery potential was strong,” Morgan says. “Profits have recovered to a 35-year high. Things have done amazingly well. That gives us solace in the days to come ahead. There’s good reason to expect this picture to remain intact.”

Typically, the Templeton Growth Fund takes a three to five year approach to stocks, but Morgan says the markets have rebounded so rapidly, that their value-based stock picks have reached their intrinsic value in as little time as nine months.

With “sell” targets being reached so quickly, Morgan and his team have to work harder to find stocks they believe are undervalued — a difficult task in the U.S.

“We don’t own very much there [in the U.S.] for the simple reason that Europe and Asia are far, far cheaper, he said. His team faces the same problem in Japan, where the Nikkei is leading the world’s major indices in year-to-date growth. “We have been looking very, very hard, but it’s been very, very tough finding stocks.”

Those seeking the best growth opportunities should set their sights on the overseas markets, with Templeton now taking an overweight position in Europe and Asia.

The focus of much media attention, China is now becoming more difficult to read as well, as it remains unclear whether the government’s efforts to reign in inflation will succeed. Even if Chinese inflation remains low, the country’s demand for resources has raised commodity prices around the world for everything from oil to iron ore.

“As I read it, China was getting away from itself earlier this year, but they seem to have quelled the pace of growth, which is precisely what we want for a period of time,” Morgan says. “If they can do that successfully, it’s an ongoing good news story. Otherwise it would have a serious knock-on negative effect on the global economy.”

Overall, he says, valuations are still attractive, measured by price to book.

“Yes, we’ve been though some difficulties, but there’s no reason to expect anything that should be cataclysmic or a renewal of the dark depths of 2000.”

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Outlook for fixed income

To combat the dangers of inflation, interest rates have started heading higher in the U.S., with credit tightening expected to hit Canada beginning in the fall. Despite concerns over rising interest rates, Eric Takaha, manager of Franklin High Income Fund and Franklin Strategic Income Fund, sees opportunities in the global fixed income market.

“On a nominal basis, inflation remains below 2% in the U.S. at the end of June, which is still very low by historical standards,” he says. “What’s allowed inflation to remain relatively low, not just in the U.S. but across many other economies, is the base of strong economic growth. One of the big drivers particularly in the U.S. has been productivity.”

Typically, as the economy ramps up and hiring increases, productivity declines, but Takaha says the discipline U.S. corporations have taken toward cost-cutting helps to allay such fears.

“If you look at short term rates in the U.S., we expect to see gradual but continual rises through the balance of 2004 and 2005,” he says. “If you look at short-term rates relative to inflation, they’re at unsustainably low levels.”

But while the short term rates are bound to rise, he expects stability in longer term rates.

“That’s important to bond investors, because price performance in the bond market is much more impacted by long term rates than by short term rates.”

Another good-news story in the debt market, is that the default rate has declined in the high yield bond market.

“Over the past 18 months we’ve seen a significant decline in the default rates for high-yield companies,” says Takaha. “In fact, current default rates are well below long term averages and the outlook for 2004 and 2005 is that the default rate will remain well below long-term averages. Fundamentals for high yield corporation are still very positive.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(07/23/04)