Will equities see a sweeter ’16 ahead?

Global equity markets last year were weighed down by sputtering growth in developed economies

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As we shift our gaze to 2016, we remain generally constructive on the prospects for global equity performance potential due to a host of factors such as further declines in unemployment in key regions, an improving wage outlook for a broader segment of the global economy and the resiliency of corporate profitability, the latter of which continues to enable tremendous flexibility in capital allocation.

Financial markets stabilized somewhat in the fourth quarter of 2015 from the elevated levels of volatility experienced during the previous quarter. This was due in part to rising conviction that the US Federal Reserve (Fed) is unlikely to raise rates in a vacuum that disregards global economic conditions, and rather, as Fed Chair Janet Yellen put it, proceeds at a “gradual and measured pace.” This more data-dependent path for future rate hikes will ultimately hinge upon the forward path for key economic indicators that include unemployment, wages and inflation expectations, while also giving considerable thought to economic conditions around the world and the potential influences on the US economic outlook.

Meanwhile, the first week of calendar 2016 trading brought with it another wave of incremental financial markets volatility. A host of global macro-economic factors increased investors’ anxiety, including a combination of issues involving China: sharp volatility in Chinese equity markets, additional downward movement in the foreign exchange value of the Chinese yuan, and renewed concerns about the decelerating pace of Chinese economic growth. In addition, financial markets in the first week of trading in 2016 were somewhat unnerved by geopolitical tensions between Saudi Arabia and Iran, reports of nuclear military tests taking place in North Korea, and additional incremental weakness in global energy prices. While we take each of these factors into thorough consideration while formulating our investment views, we feel comfortable that—provided there is not substantial escalation in geopolitical tensions—markets will eventually look beyond these short-term headlines and return their primary focus to the merits and fundamentals of individual securities. Indeed, overreaction by financial markets to short-term negative news headlines oftentimes creates attractive investment opportunities for disciplined long-term investors.

Especially as various macro-economic and geopolitical challenges emerge—as they tend to do from time to time—it appears evident to us that a team effort in supporting global growth is both necessary and likely; recent indications from a broad range of central banks and governments, such as the European Central Bank (ECB) and Bank of Japan (BOJ), stand ready to continue their respective quantitative easing programs amid any economic or geopolitical uncertainty.

A challenging backdrop

During much of 2015, global equity markets labored under the weight of sputtering growth in developed economies, slumping emerging markets, and collapsing prices for a wide range of commodities and natural resources that had far-reaching consequences. Although extraordinary monetary policy measures from key central banks have been employed in efforts to stimulate economic growth over the last several years, these measures proved somewhat less effective in meeting 2015 growth targets in economies that comprise a substantial amount of global gross domestic product, including the United States, eurozone, United Kingdom and Japan.

This challenging backdrop occurred amid uncertainties surrounding economic growth in China and the country’s transition from an investment-led economy to one driven more by domestic consumption. The actions of the People’s Bank of China in 2015 to further cut interest rates and relax reserve requirements may smooth the transition occurring in that economy. Despite weakness in Chinese manufacturing, domestic consumption appears robust while keeping with the Communist Party’s latest five-year plan to restructure the Chinese economy to make it less reliant on investment and exports, and more driven by innovation and domestic consumption. Additionally, improvements in market conditions toward the end of 2015 seemed to reflect a lower likelihood that the Chinese have embarked on a full-scale competitive devaluation of their currency, a concern that at least partially contributed to the rise in equity market volatility during parts of 2015. Finally, markets remained fixated on the timing of the Fed’s December interest rate “lift-off” and the potential market implications. Succumbing to the pressure of these headwinds, global equity markets generally stalled out in 2015.

Discipline in corporate capital allocation

One defining characteristic of recent global equity markets that we expect to remain a key feature of 2016 is the discipline exhibited in corporate capital allocation.

With profitability measures remaining at historically elevated levels, corporate decision makers have enjoyed a tremendous amount of flexibility to consider a range of strategic and shareholder-oriented measures like merger-and-acquisition (M&A) activity, increased investment and capital expenditures, balance-sheet enhancement, dividend growth, and share buybacks. Additionally, many companies opted to shed non-core assets and re-prioritize investment opportunities to drive improvements in returns.

While our analysis indicates sales growth has been modest across many sectors lately, we believe it is likely that what happens below the top line should continue to filter down and continue to have a greater impact on today’s healthy profit levels, and we believe this will be sustained throughout 2016, as sales growth has been modest across many sectors. In our opinion, these favorable conditions are likely to persist due in part to low energy costs and prices for many commodities, moderate wage price pressures, and low interest costs and leverage. Given expectations for rising interest rates going forward, many investors have grown concerned about the impact of higher interest costs on corporate profits and, ultimately, share prices. While the impact would not be entirely insignificant, we believe other factors need to be considered, including the generally lower share of debt relative to total capital, as well as the limited role total debt and interest cost has on the majority of corporate balance sheets and income statements. Indeed, while the total quantity of debt issued by corporations globally over the past few years has been quite sizable, we believe the lion’s share of this debt issuance has been conducted for the right reasons, such as replacing more-expensive existing debt with less-expensive debt, and taking advantage of a historically low market interest rates to lock in attractive funding costs for several years.

A challenging time for income-oriented investors

The generally low level of market interest rates combined with the potential headwind of higher interest rates moving forward presents a challenge for income-oriented investors. Increasingly, an alternative for many investors remains dividend-paying equities, which may offer a combination of current yield and potential for future dividend growth. The overall level of dividends paid declined somewhat during the global financial crisis, after which many companies returned their focus to growing dividend payouts, a trend that remained as a dominant feature of equity markets through 2015. With the potential for interest-rate hikes going forward, many investors have expressed concerns about the sensitivity, or correlation, of dividend payers to long-duration fixed income assets. While we recognize high dividend-payout-ratio companies that have exhibited limited growth in earnings and dividends may be prone to such pressure, our fundamental analysis attempts to evaluate the whole picture—from competitive positioning and growth potential to balance sheet strength and the ability to generate rising free cash flow. It is our belief that equities with these characteristics may offer investors attractive performance potential in 2016 and beyond.

Will it pay to be picky in 2016?

We believe there are three things that will take us through 2016: our fundamental research, selectivity and optimism.

Despite the uncertainty surrounding the pace of global economic growth and the duration of the current economic expansion, numerous secular growth themes remain, offering investors multiple opportunities. The rising fortunes of the middle class on a global scale brings greater access to goods and services for a rapidly expanding segment of the population, particularly in the major emerging economies of China and India. With this, mobile technology has expanded on a global scale, creating opportunities for investment across a range of industries and companies.

The continued application of technology in health care is leading to advances in new drug development, customizing patient treatments and programs, as well as mobile and predictive monitoring. And while the energy sector presented tremendous challenges for investors in 2015 following a significant decline in global oil and natural gas prices, the self-correcting forces of reduced upstream investment, well depletion and declines in US drilling-rig activity should pave the way for a more balanced outlook in the year ahead, according to our analysis.

Global financial markets still face numerous risks, but the drivers of corporate profitability appear to us to be sustainable in the current business and economic environment. While fundamental challenges may certainly present themselves in the form of an unexpected economic slowdown, geopolitical conflicts, rising inflation and input costs, or an unanticipated increase in the pace and magnitude of rate hikes in the United States or elsewhere, we think the economic cycle remains intact, buoyed by continued job gains and an improving wage outlook. With this generally healthy backdrop, a robust opportunity set and a focus on the long term, we remain constructive on the prospects for active equity management across a wide range of sectors and regions as we enter 2016.

Ed Perks, Executive Vice President, Chief Investment Officer Franklin Templeton Equities

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