impact of potential normalization of...

Impact of Potential Normalization of Interest Rates and Inflation on Global Sectors

ANTONIO DOCAL, CFAExecutive Vice PresidentPortfolio Manager, Research AnalystTempleton Global Equity Group

Templeton Investment Counsel, LLC

June 5, 2013

PETER A. NORI, CFAExecutive Vice President

Portfolio Manager, Research AnalystTempleton Global Equity Group

Templeton Investment Counsel, LLC

2013 Investment Forum Materials / Not for Public Distribution

Do We Have a Top-Down View?

3


So Why Think About Inflation and Interest Rates?

4


Transitioning From a Secular Bull to Bear Market in Bonds

Source: BCA Research, May 2013. Note: vertical lines represent a secular bottom or top in U.S. nominal treasury yields.

16%

12%

8%

4%

1880 1900 1920 1940 1960 1980 2000

16%

12%

8%

4%

U.S. 10-year Government Bond Yield

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0 100 200 300 400 500

Japan

Canada

G7

Spain

France

UK

US

Germany

Australia

Italy

Greece

1980 1990 2000 2011

Source: UBS, Cecchetti, Mohanty and Zampolli (2011), latest data available as of January 2013.

Sum of Household, Corporate and Government Debt as a Share of GDP (%)

*Except Germany and Canada.

Historically, the easy way out has been the printing press.

Total Debt as a Share of GDP has Continued to Rise*

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Impact of Normalization of Interest Rate and Inflation on Global Sectors

• From our perspective…

Winners

• Metal/Mining

• Energy/Oil Services

• Real Estate

• Insurance

Losers

• Consumer Discretionary

• Telecom Services

• Utilities

This commentary reflects the analysis and opinions of the speakers as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

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Metals & Mining: Inflation and Various Commodities

Rising Interest Costs Rising Cash CostsPotential Pricing Power

Platinum Group Metals

Recent equity raising reduce interest rate sensitivity

Positive for low cost producers as PGM prices are within the cost curve and should lead to higher prices

Likely highest of all

Coal Negative as debt levels remain high with maturities short

Positive as long as idled capacity is not immediately brought back on-line

Muted

Steel Negative as debt levels remain high with maturities short

Positive for low cost producers Muted unless capacity disappears or located in certain countries

Base Metals Negative as debt levels remain high with maturities short

Positive for aluminum since it sits on cost curve, less impact/potential negative for those metals sitting well above cost curve

Low

Diversified Negative as each of the diversified has significant debt maturities over next few years

Likely negative, particularly iron ore for the diversified miners given prices relative to cost curves

Low

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-9%

-6%

-3%

%

3%

6%

9%

12%

15%

18%

0

200

400

600

800

1000

1200

1400

1600

1800

2000

1970 1972 1975 1978 1980 1983 1986 1988 1991 1994 1996 1999 2002 2004 2007 2010 2012

CRB Metal Index (1967=1000) (LHS - 1st Axis)) Gold Spot Price (US$/Oz) (LHS) U.S. Short Term Real Rates (%) (RHS) U.S. Total CPI (YoY % change) (RHS)

Gold, CRB Metals, Inflation and Short-Term Real Rates

• The CRB Metals Index and Gold did relatively little until real rates approached the 0% bound.

• The implication is that the time to get more aggressive with commodity producers is postadjustment of real rates back to positive levels with the potential to have real rates fall again.

Source: Commodity Research Bureau, Dow Jones, and Federal Reserve System via FactSet.

Gold, CRB Metals, Inflation and Short-Term Real RatesJanuary 1970 to April 2013 (monthly)

0

200

400

600

800

1000

1200

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Energy Sector: Our Viewpoint

• Inflation globally should support higher crude prices, and energy companies should perform relatively well.

• Energy companies should fare relatively well if: – Oil markets remain balanced (i.e. no significant excess supply)– Prices remain supportive for continued re-investment – Underlying economy (and oil demand) continue to grow modestly

• During stagflation, real assets (e.g. commodities, real estate) have historically performed best, as they provide a natural hedge because they carry intrinsic value.

– While corporate profit margins are typically squeezed and unemployment rises, commodity producers maintain pricing power.

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Oil Services

• Historically, oil service companies perform relatively well during inflationary periods; oil services market should grow (nominally) with the marginal cost.

• Companies with propriety technology / high market shares, and those where equipment is in balance / short supply should be able to pass through price increases. Pricing power shifts between service companies and operators over time depending on market conditions.

• However, in an environment in which oil demand falls (and oil prices fall below marginal cost), demand for oil services would decline significantly and the market for services would likely become oversupplied.

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Real Estate: United StatesBond Yields Drive Valuations

REIT multiples have historically demonstrated a very strong correlation

to corporate bond yields. Normalization of corporate bond yields should result in a higher implied cap-rate, higher dividend yield and lower

AFFO multiple for REIT shares.

Implied Cap Rates vs. BBA Corp. Bond Yields and 10-Yr Treasury¹Through March 2013

1. Source: ISI Group (Bloomberg). 2. Source: Citi Research, April 5, 2013.

REIT Dividend Yield vs. BBB Corporate Yield (7-10 Year)²Through April 5, 2013

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REIT Absolute AFFO Multiple vs. BAA Bond Yield¹Through December 2012

12/02 12/03 12/04 12/05 12/06 12/07 12/08 12/09 12/10 12/11 12/12 3/13

12%

10%

8%

6%

4%

2%

0%

ISI REIT Implied Cap Rates 10-Year Treasury BBA


Insurance: Share Prices Have Generally Followed Yields

Source: © 2013 FactSet Research Systems Inc. All Rights Reserved. The information contained herein: (1) is proprietary to FactSet Research Systems Inc. and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither FactSet Research Systems Inc. nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

'00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '120

20

40

60

80

100

120

140

0%

1%

2%

3%

4%

5%

6%

MSCI Europe / Insurance -IG - Price Index (Left)Euro Benchmark Bond - 10 Year - Yield (Right)

December 31, 1999 to May 28, 2013

• Correlations highest in Europe and US due to product mix

• Earning the ‘spread’ between yields and guarantees

• Fee-based businesses (mostly UK and some US) also correlated with equities, similar to asset managers

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Insurance: Impact of Rising Yields on Reported BV and EPS

ReportedBook Value

(BV)

0

Mark-to-market losses on bond portfolio reduces

unrealized gains(potentially negative)

Assumption: Rates more than double to 5% at t = 0

1 2 3 4 5

Unrealized gains

‘Adjusted’ Book Value

Earnings Per Share

(EPS)EPS improves as spread between

investment returns and policyholder guarantees widens

This increase continues for as long as the duration of the of

investment portfolio

Ability to discount future liabilities at a higher rate

benefits BV as time passes

• Property & Casualty Insurance: the fall in unrealized gains will be less and increases in investment yields will occur sooner but impact on book value and earnings per share will be less in FY6. We believe life insurance will ultimately benefit the most.

Source: Templeton Global Equity Group. This commentary reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

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Consumer Discretionary

Higher Interest Rates and Higher Inflation = Tax on Consumer

• Higher Interest Rates– Higher mortgage payments– Higher car payments– Higher credit card rates

• Higher Inflation– Higher fuel prices – Higher food prices– Higher product prices

Impact on Consumers

More free cash flow = a higher standard of living for consumers

New all-time high in this series

Lower Rates and Retreating Commodities = More Money in Consumers’ Wallets!¹

Payroll tax increases

Higher interest rates

Higher inflation

Higher fuel prices

Improving housing

Improving stock market

ConsumerHeadwinds²

ConsumerTailwinds²

1. Source: Wolfe Trahan & Co. Portfolio Strategy and Bloomberg.2. Source: Templeton Global Equity Group.

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Telecommunication Services – Negative

• In general, telecommunication stocks have limited to no pricing power

• If cost of goods sold rises with inflation, margins will suffer

• May be able to push prices, but doubtful

• Tends to be highly leveraged given capital expenditures (CAPEX), although debt is mainly fixed

The commentary in this piece reflects the analysis and opinions of the speaker as of June 2013, and may differ from the opinions of other portfolio managers, investment teams or platforms at Franklin Templeton Investments. Because market and economic conditions are subject to rapid change, the analysis and opinions provided may change without notice. The commentary does not provide a complete analysis of every material fact regarding any country, market, industry or security. An assessment of a particular country, market, security, investment or strategy is not intended as an investment recommendation nor does it constitute investment advice. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

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Utilities Summary–Higher Inflation and Bond Yields

• Regulated: negative

• Regulated with Inflation Protection: neutral but depends on terms (i.e., partial pass-through of costs, timing, debt obligations linked to inflation)

• Unregulated: usually positive if rising inflation is feeding through to energy prices and higher power prices, but negative if underlying economies are weak and with excess generation and unsupportive government policy (i.e., presently in many countries)

• Emerging Markets: mixed but usually negative even when they have inflation pass-through, often behaves like developed market regulated utilities


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SummaryToday we covered:

Winners• Metal/Mining• Energy/Oil Services• Real Estate• Insurance

Losers • Consumer Discretionary• Telecom Services• Utilities

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Important Information

The information provided in this presentation, and during this conference is not a complete analysis of every material fact regarding any market, industry sector, security, or portfolio. Statements of fact cited by the presenters have been obtained from sources considered reliable but no representation is made as to their completeness or accuracy. Because market and economic conditions are subject to rapid change, opinions provided are valid only as of the date of the material and are subject to change without notice. The manager’s opinions are intended solely to provide insight into how the manager analyzes securities and are not intended as a recommendation or individual investment advice for any particular security, strategy, or investment product. Indexes are for illustrative purposes only. One cannot invest directly in an index. For more information on Franklin Templeton products or services, please contact your local Franklin Templeton representative at (800) 321-8563.

This presentation is provided by Franklin Templeton Institutional for informational purposes only. This information is considered proprietary and shall be treated as confidential. It shall not be distributed or otherwise communicated to third parties. While every effort has been made to ensure the accuracy of the information contained within these materials, we do not guarantee such accuracy.

19© 2013 Franklin Templeton Investments. All rights reserved.

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