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Stephen Dover, CFA
Chief Market Strategist
Franklin Templeton Investment Institute
Introduction
When news of COVID-19 first spread, few of us could have imagined how disruptive the pandemic would be, how it would impact nearly every aspect of our daily lives—and that we would still be dealing with it two years later.
The ramifications of the pandemic will continue to influence capital markets in 2022. I gathered eight of our investment managers to discuss investment themes and risks they are focused on. Here are highlights from our conversations:
- Electric vehicles (EVs) exemplify the roles innovation and technology are playing in equity markets. These “smartphones on wheels” are disrupting the auto industry as EV pioneers capture the interest of growth managers. Our value managers are also finding opportunities in this dynamic market by focusing on how established players are transitioning to keep up with the changes in the industry.
- The United States and China exemplify the starkly different supply and demand fundamentals across global real estate—while the United States navigates housing shortages and rising prices, China is dealing with the meltdown of one of its largest developers along with housing oversupply.
- In the search for yield, investors are exploring an expanding universe of fixed income opportunities:
- Corporate credit has seen balance sheet improvement and a positive ratings trajectory during the pandemic. We still see opportunity for improvement in 2022, with real relative value opportunities in investment-grade credit.
- The US municipal bond space has seen stronger-than-expected tax revenues, which have trickled down into local governments and various municipal sectors. This bodes well for the asset class, particularly in an environment of strong demand and constrained supply.
- Emerging market fundamentals are generally in good shape. Fiscal balances have improved as revenues rebounded, and we have seen rebuilding of liquidity buffers. Local emerging market currencies look vulnerable, which we believe favors hard currency.
We hope you find these views thought-provoking as you chart your investment course in 2022. On behalf of Franklin Templeton and the Investment Institute: Happy New Year!
Key investment themes for 2022
Looking into 2022, I find myself reflecting on the past two years, marked by disruption and opportunities. COVID-19 upended not only financial markets, but also our daily lives and how we interact with the world. The pandemic has been a catalyst for trans- formative change in a short period of time. Individuals, communities and institutions proved to be far more adaptable than we could have ever imagined. This pandemic has shown that disruption brings new opportunities as well as new risks.
Our 2022 investment outlook explores the nature of disruption across equity, fixed income and real estate investments. We gathered investment managers from across Franklin Templeton to look at three major themes:
Each of these themes played a large role in markets in 2021, and we believe they will continue to drive markets in 2022. Below are some of my key take- aways from the conversations.
Technology is playing an outsized role in driving changes in our economy and in equity markets. The rapid emergence of electric vehicles (EVs) is the poster child, with new entrants into the market and their soaring valuations disrupting the industry and impacting equity markets. On the heels of COP26, which highlighted the pressing need for global cooperation between industry and governments to cut greenhouse gas emissions, the global automobile industry is expected to invest another US$330 billion into EVs before 2025.1
To understand how this seismic shift is impacting legacy automakers and EV pioneers, I spoke with three of our investment teams who look at the same companies, but through different value and growth valuation lenses. Our conversation spanned the role EVs are playing in supply-chain disruption, from raw materials to make EV batteries to the semiconductors used in their processors, as well as the global infra- structure investments in charging stations and modernized grids necessary to power electric fleets of cars, trucks and buses.
Jonathan Curtis from Franklin Equity Group views leading EVs as brilliant smartphones on wheels. By selling high-margin software subscriptions for things like autonomous driving and broadband access, there may be the potential to generate attractive gross margins and market share. This point of view places such companies in a league (or orbit) of their own. On the other hand, for a deep value manager like Tim Rankin from Franklin Mutual Series, he sees opportunity in focusing on incumbent automobile manufacturers—some of which have moved aggressively into battery technology, with scalable modular systems that can work in a wide variety of vehicle models. There’s no denying there’s huge opportunity across the EV and autonomous space. But, from a value manager’s perspective, the challenge is to stay true to one’s investment philosophy while still finding ways to access battery and autonomy innovation. And, as ClearBridge Investments’ Rob Buesing explained, while the future of the internal combustion engine (ICE) has never been darker, the profitability for gasoline-powered vehicles has never been higher.
I think one of the trickiest tasks for analysts is gauging the pace of future innovations and how inherently disruptive they may be. Will traditional automobile manufactures be able to compete in the new EV environment, or are they hopelessly tethered to their past, and will the new, innovative companies without the baggage surpass them? If someone claims to know exactly how EV upstarts and incumbents will hash things out in 10 or 15 years, I wouldn’t bet on it.
The great migration
The United States and China exemplify the starkly different supply and demand fundamentals across global real estate. According to Tim Wang of Clarion Partners, the United States has a deficit of 5.5 million single-family homes and rentals. With demand vastly outstripping supply, housing prices have soared. Meanwhile, China has an oversupply of housing built by highly leveraged property developers.
For Clarion Partners, pinpointing opportunities in private real estate starts with understanding US migration trends. Given work-from-home flexibility, more households are leaving expensive coastal metros for affordable suburbs and US sunbelt cities like Austin, Texas. Just over the horizon, as more millennials get married and start families, Clarion sees a 10-year cycle of demand for multifamily rentals in cities like Charlotte, North Carolina.
While the United States has a glaring housing deficit, it has an excess of brick-and-mortar retail real estate. With e-commerce accelerating, shopping malls face particularly negative headwinds. Clarion sees positive momentum for industrial e-commerce warehouses and life science facilities at the forefront of gene therapy and vaccine innovations. In terms of inflation, higher costs for construction materials and labor could remain elevated given fresh demand from US President Joe Biden’s infrastructure bill. But there’s a silver lining: if costs constrain new projects, landlords of existing buildings will have more latitude to increase rents, benefiting real estate owners.
China’s Evergrande saga
Turning to China’s housing market, Brandywine Global’s Tracy Chen explained how China’s policymakers intend to avoid Japan’s fate in the 1990s of an imploding real estate market. Back then, in Japan, high debt and falling land prices led to decades of stagnation. To escape this scenario, China has methodically redirected capital away from its highly leveraged property developers, such as Evergrande, into more productive sectors like high-tech manufacturing. It’s a delicate balancing act, especially when you consider the size of China’s property sector.
According to Tracy, real estate makes up 15%–18% of gross domestic product (GDP) in the United States and Europe, while property markets comprise 29% of China’s GDP. What’s more, the average Chinese household has 70%–80% of its assets tied up in real estate. In the United States, that figure is roughly 25%.2 In expensive Chinese tier 1 cities, it’s common for parents and grandparents to help kids afford down payments on apartments (homeownership is typically a prerequisite for marriage). A precipitous drop in housing prices would hurt three generations in one household. Tracy thinks China’s policymakers have the right toolbox to transition its red-hot property market into a more stable, government-driven housing sector going forward.
A new frontier for yield investors
With sovereign debt in developed economies offering low or negative real yields, bond investors continue to reassess allocations to emerging market debt (EMD) and frontier markets for better yields and overall value. One high-profile risk coming into 2022 is a global slowdown, punctuated by China shifting its economy away from its debt-driven property sector. Stephanie Ouwendijk with Franklin Templeton’s emerging market debt team predicts this slowdown will likely have a bigger impact on China’s neighbors in Asia, where trade ties with China remain strongest. Even before China’s slowdown, the team’s overall exposure to Asia was the lowest out of all regions and remains so. In their view, strong regional demand has pushed down Asian yields far enough that risks are no longer adequately compensated. Outside of Asia, growth from the United States and Europe points to better risk-adjusted opportunities (higher yields, better spreads) in select frontier economies with strong fundamentals, including strong current account balances. Today’s commodity price inflation should benefit export- oriented emerging countries and corporates, some of which stand to benefit from accelerating global infrastructure investments.
New audiences for munis
With yields in much of Europe and Japan close to zero or negative, some institutional investors outside the United States are turning to the taxable US municipal (muni) bond market. In my discussion with Ben Barber, head of Franklin Templeton Municipal Bond team, infrastructure assets appear to be a natural fit for European investors.
They understand the space and prefer munis that are backed by high-quality state and local governments. Navigating a space like transportation infrastructure, however, requires deep domain expertise. The economics of toll roads, for example, are quite distinct from airports, which are different from trains, and so forth. Looking into 2022 and beyond, Franklin Templeton’s muni team thinks the new US$1.2 trillion infra- structure package may boost taxable muni bond supply. What’s still unclear is how this US federal money will be financed. One scenario is that federal money may come in the form of grants that local governments and entities can use to service their infrastructure- oriented bond obligations. That would offer the best of both worlds—increased supply of taxable munis and an increase in higher-rated paper backed by the federal government.
Corporate credit
My conversation with Kurt Halvorson of Western Asset was a fascinating bookend to earlier discussions on China’s property sector and the technological wizardry driving automaker valuations. Across certain sectors, US companies navigated the pandemic by reinforcing capital discipline, improving their balance sheets and protecting bondholders. Take the energy sector. Even after crude oil prices jumped north of US$80 per barrel, US oil rig counts didn’t bounce back as expected. Instead, many energy companies plowed half of their free cash flow into paying down debt and making payouts to shareholders. As for the disruptive power of technology, the tech sector offers red flags for Western Asset. Looking ahead 10 years—which isn’t a long time for bond analysts—its credit team doesn’t see enough spread in tech companies’ bonds to compensate for the risks of technological obsolescence. The dynamism of the tech sector—while thrilling to many equity analysts—can be a deterrence for bond analysts who need to forecast dependable cash flows five or 10 years down the road.
More twists and turns
Finally, as we’ve seen during the last two years, things can change quickly. I am writing this just days after a dramatic “risk-off” move out of stocks, quickly followed by markets snapping back to “risk-on.” Besides the worrying Omicron variant, two shocks sparked this volatility. The first is the US Federal Reserve’s (Fed’s) shift to be more hawkish and the retirement of the word “transitory” when discussing inflation. The second is China’s pro-growth policy pivot. Following a new liquidity injection, the Politburo announced its top priority is stabilizing China’s economy in 2022. Shares of China’s beleaguered property developers jumped on the news.
There’s a good chance that more market gyrations are on the horizon or are already happening when you read this. The tug of war we’ve seen between value and growth disciplines will likely continue, driven by shifting risk-off and risk-on appetites. To navigate these choppy waters, I think it helps to have a north star. For me, that star is fundamental research brought to life through wide-ranging discussions with analysts and senior managers.
Endnotes
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the port- folio may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors or general market conditions. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector. Growth stock prices may fall dramatically if the company fails to meet projections of earnings or revenue; their prices may be more volatile than other securities, particularly over the short term.
Small- and mid-capitalization companies can be particularly sensitive to changing economic conditions, and their prospects for growth are less certain than those of larger, more established companies. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Sovereign debt securities are subject to various risks in addition to those relating to debt securities and foreign securities generally, including, but not limited to, the risk that a governmental entity may be unwilling or unable to pay interest and repay principal on its sovereign debt.
To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks. Because municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond’s issuer, insurer or guarantor, may affect the bond’s value. Investments in lower-rated bonds include higher risk of default and loss of principal.
Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a port- folio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results. Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. Real estate securities involve special risks, such as declines in the value of real estate and increased susceptibility to adverse economic or regulatory developments affecting the sector. Investing in the natural resources sector involves special risks, including increased susceptibility to adverse economic and regulatory developments affecting the sector.
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