Coming to America

 

In the months after Donald Trump’s election victory, US equities rallied strongly on the heels of the president-elect’s pledges to deregulate the financial sector, reform US corporate tax rates and increase infrastructure spending. Three months into his presidency, it appears the honeymoon period is over, and the markets are engaged in something of a holding pattern. Whether Trump’s major poli­cies will actually pass through Congress is a matter of contention, and with the Fed raising interest rates, fund managers have a lot of variables to consider.

 

For Edward Perks, executive vice-presi­dent and chief investment officer at Franklin Templeton Equity, volatility brought on by the political climate creates plenty of opportun­ities for those who know where to look.

 

Perks joined the firm in 1992 and has risen through the ranks; today, he oversees the Franklin Equity Group, Templeton Global Equity Group, Franklin Mutual Series and Franklin US Value.

 

Prior to becoming CIO, he made his name as a portfolio manager for the Franklin Income Fund and Franklin Balanced Fund. The fund he manages today, the Franklin US Monthly Income Fund – boasting $207 million in assets and a five-star rating from Morningstar – remains a central plank of the firm’s suite for Canadian investors.

 

“The asset mix has shifted quite substan­tially in the past year,” Perks says. “Last year the cash in the portfolio was a more typical, low single-digit level. We had 60% weighting in equities and slightly less than 40% in fixed income. That equity bias has driven a lot of the performance over the past year.”

 

The fund’s cash position in March was as high as 20%, but with interest rates rising, Perks and his colleagues are now considering increasing the weighting in fixed income, and they expect the cash weighting to decline accordingly. The fund’s equity portfolio, its main driver in 2016, is also being repositioned.

 

“We are a little more concerned about risks creeping into the market,” Perks explains. “The best example of that would be our utility sector exposure, which over the past year has gone from about 9% to 5%. The concerns there include both sensitivity to rising interest rates and valuations, as the relative scarcity of yield in a low-rate environment has driven especially strong demand for yield-oriented equities such as utilities.”

 

The value of active management is readily apparent during transitional periods like these. As the Fed makes meaningful changes to US monetary policy, Perks and the other managers of the Franklin Monthly US Income Fund have been actively adjusting its holdings.

 

“As the Fed raised rates and we saw volatility in the corporate markets, we have been able to redeploy a fair amount of that cash into corporate bonds,” Perks says. “We like high-yield corporate bonds, particularly the shorter and intermediate maturities where we think fundamentals remain quite strong.”

 

A key tenet of the US Monthly Income Fund is its flexible selection mandate. The fund’s managers – Perks, Matt Quinlan, Todd Brighton and Richard Hsu – choose the underlying securities by looking at a number of key fundamentals, as well as various outside forces. It’s a liquid process, and the fund is constantly evolving, which is central to its success, Perks says.

 

“I have been a manager on Franklin income strategies since 2002 and a lead manager since 2004 on our US strategies,” he says. “When I look back over that period, the opportunity to earn attractive dividends really exists today across a far greater range of sectors than before. That, combined with the low interest rate, is what led us to have a substantial equity tilt.”

 

In terms of outside forces, monetary policy by central banks is one of the most important considerations for fund managers. A manager must be able to anticipate possible central bank policy changes and understand how these changes could impact the individual securities in a portfolio.

 

“We just saw a rate hike by the Fed; the market expects two more this year and two or three next year,” Perks says. “We generally agree with that path. The 10-year US Treasury yield had a pretty substantial adjustment from the middle of last year, when it bottomed out at 1.04%. We expect further increases to be a little more moderate than the strong upturn we have seen over the past six months.”

 

In the corporate space, March saw the highest-ever weekly total for high-yield bond issuance in the US. Companies are clearly keen to take advantage of still-low interest rates and issue new, longer-term corporate debt.

 

“We have seen some pretty strong performance in corporate debt with declining credit spreads across the board in the high-yield market,” Perks says. “Going forward, we want to be more selective with our credit selection, as well as where we are in the maturity spectrum. I think more opportunity exists in the shorter- to intermediate-term securities where yields are still attractive and where we can best manage the risks associated with rising interest rates.”

 

When it comes to stocks, the Fed’s policy movements will be beneficial to some companies, while the opposite will undoubtedly be true for others. Perks explains how he has adjusted the fund to reflect the new interest-rate environment.

 

“On the equity side, we have reduced our weighting in utilities quite substantially from a year ago,” he says. “Part of that is the valuations we see in that sector, but also the sensitivity to higher long-term interest rates. That’s also a potential risk for REITs, telecom services and even staples companies that benefited from the overall market environment of fairly low growth. We are less exposed to those areas today.”

 

But what is one sector’s albatross is another’s opportunity, and such is the case in the US today.

 

“With rising interest rates, we think financials continue to make sense,” Perks says. “That’s our second highest sector weighting on the equity side. That’s followed by a mix of opportunities we see in markets like industrials, technology, materials or an area like healthcare.

 

“There’s a lot of uncertainty there tied to the political environment,” he adds, “and we see that creating some long-term opportunities for investors.”

 

The past few years have been difficult for active managers – beating benchmarks has been tough proposition for many. The Franklin US Monthly Income Fund has had a 12.66% annualized return since its inception in 2013, with some peaks and valleys along the way. As a 25-year veteran of the business, Perks realizes that the next bear market may not be too far off, which increases the need for active management.