CONTRIBUTORS
Christian Correa, CFA
President & Chief Investment Officer
Franklin Mutual Series
It’s been an eventful year so far. Investors are navigating geopolitical and economic challenges in the United States and abroad. Some investors and economists believe the specter of a US recession still lurks on the horizon. Regardless of the market environment, we believe there are three main themes emerging for the final months of 2023. We believe strong underlying forces carrying the US economy forward, continued investment in real assets and growth in Japan can provide a beacon for investors the back half of the year.
The US macroeconomy
Inflationary pressures may not be the deathblow for the US economy that many expected. A tight labor market, strong consumer spending and economic strength across several industries have driven inflation but are also generally positive for economic activity. However, we expect the consumer to pull back on spending if we start to see job losses or deteriorating confidence, which in turn might dampen pricing pressures.
Exhibit 1: An Employed Consumer Continues to Spend
Sources: FactSet, US Department of Labor, US Census Bureau.
The prospect of higher interest rates leading to a recession has made investors nervous, causing volatility and market dislocations. But as US inflation continues to subside and labor markets remain strong, we continue to see opportunities at reasonable prices.
Meanwhile, valuations for growth stocks have inflated again to historically high levels, which are correlated with historically low forward returns. Moreover, long-term interest rates have a greater bearing on economic strength than short-term rates, in our view. And through the rate hiking cycle, long rates have responded more slowly and have remained near historic lows.
Exhibit 2: A Less Expensive Entry Point for More Potential Upside
MSCI USA Value Index vs. MSCI USA Growth Index
Price-to-Earnings (P/E) ratios
January 2008–June 2023
Source: FactSet. The MSCI USA Value Index captures large- and mid-cap US securities exhibiting overall value style characteristics. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield. The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the US market. With 627 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in the United States. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
Investing in real assets
We expect an increase in infrastructure spending to support investment in real assets. This increased spending should be positive for the US and global economies as well as for value investors. Recent US legislation incentivizes US infrastructure building and reshoring initiatives, while Europe and Japan have their own initiatives.
Spending on projects has only just started, and we expect increased construction and manufacturing activity to bolster the economy and revenues for companies that produce physical items, like mining and aluminum companies, or those which could benefit from the knock-on effects of increased demand for these things. We expect value-oriented companies that deal in building materials, construction equipment, manufacturing, and other related industries to see increased demand as this trend continues over the next several years.
Exhibit 3: Construction Spending Booms...
Nominal Total US Manufacturing Construction Spending
January 31, 2005–May 31, 2023
Sources: FactSet, US Census Bureau.
Exhibit 4: ...Providing an Opportunity for Value Stocks
Percentages of Indexes Allocated to Industrials and Materials Sectors
As of June 30, 2023
Source: Russell Investments. The Russell 1000® Value Index measures the performance of the large-cap value segment of the US equity universe. It includes those Russell 1000 companies with relatively lower price-to-book ratios, lower I/B/E/S forecast medium term (two year) growth and lower sales per share historical growth (five years). The Russell 1000® Growth Index measures the performance of the large-cap growth segment of the US equity universe. It includes those Russell 1000 companies with relatively higher price-to-book ratios, higher I/B/E/S forecast medium term (two year) growth and higher sales per share historical growth (five years). Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
Japan
Opportunities to invest in undervalued companies outside of the United States abound, particularly in Japan, where we believe the economy is poised for growth and modest inflation. Additionally, the government, the stock exchange and shareholders are all pushing companies to improve business dynamism.
Japanese companies provided a competitive price to book (P/B) value in the 1980s but have lagged the rest of the world in recent decades. Unlike in the past, management teams are now younger and more willing to change. As a result, we see a focus on corporate reform and returns on equity, producing new investment opportunities.
Exhibit 5: Japanese Companies are Focused on Improving Price-to-Book Value
LTM=last 12 months
Sources: FactSet, MSCI. The MSCI Japan Index is designed to measure the performance of the large- and mid-cap segments of the Japanese market. With 237 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in Japan. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
In our opinion, an overarching catalyst for reform in Japan is a societal understanding that demographics have changed. Japan is an aging society, and thus the ability to add more labor is difficult. To fund the government, social insurance payments and health care, the Japanese economy needs to increase the returns on its capital base. Changes in the economy and to the way businesses operate will be necessary to facilitate returns.
Exhibit 6: An Aging Population Means a Need for Increased Business Dynamism
Sources: FactSet, IMF WEO - World Economic Forecast., Oxford Economics. Important data provider notices and terms available at www.franklintempletondatasources.com.
Our approach to investing in Japan mirrors our approach for all markets—to look for inexpensive, undervalued companies that can find new growth opportunities globally and where management is willing to engage with us.
In the back half of this year, we think it is possible geopolitical events and central bank decisions may continue to drive market volatility. We will continue to look for these dislocations to provide chances to purchase quality companies below what we believe to be their fundamental value. Despite these factors, we currently see opportunities in non-US and US companies driven by strong underlying trends in the US economy, incased investment in real assets and changes in Japanese capital markets. We think that these themes stand out against the backdrop as areas of opportunity for investors in the coming months and look forward to providing additional insights and updates as the year unfolds.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal.
To the extent a strategy invests in companies in a specific country or region, it may experience greater volatility than a strategy that is more broadly diversified geographically.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Value securities may not increase in price as anticipated or may decline further in value. The investment style may become out of favor, which may have a negative impact on performance.
Active management does not ensure gains or protect against market declines.