Sequestration Stings

|
 |  Includes: LMT, RTN
by: Franklin Templeton Investments

Whether it's called "austerity" or "sequestration," tightening belts is no fun for anyone. There's pretty much universal agreement that sequestration - the stern term given to the US government spending cuts already stinging the country's citizens in the form of airport delays, work furloughs, and reductions in social welfare programs - isn't ideal, but the big question is whether these cutbacks will poison the still-tenuous US economic recovery.

Depending on your point of view, sequestration is either a very big deal, not a big deal, or not yet a big deal. Ed Perks, Portfolio Manager for Franklin Income Fund and Franklin Balanced Fund, believes the spending cuts now underway and looming ahead certainly could act as a drag on the US economy, but not inevitably drag it into a recession.

"The sequester is a fairly meaningful event now. But we also need to think about the fiscal cliff impact, things like the payroll tax expiration and higher ordinary income tax rates. The US economy is still growing modestly, but some of the very recent data imply it's growing maybe a little bit below expectations.

"I also think it's very important to step back and think about all the different influences on the economy. First and foremost are Fed [Federal Reserve] policies and quantitative easing. We still see tremendous monetary support for the economy, and that's obviously a very powerful offset to these fiscal drags that we're seeing on growth. The US has an opportunity to develop a very long-term plan to address the fiscal imbalances. We're still in the camp that thinks these are challenges that can be met over time in a fairly disciplined manner, and that the economy can still perform quite well in that environment."

While there's no denying the negative impact of these cuts, as is usually the case, it's not always so cut and dried. Perks said he and his team managed to find opportunities that arose in advance of these spending cuts, because they believed the market had overreacted as the sequester approached.

"Two stocks in particular that stand out to me are in the defense sector, Lockheed Martin1, and Raytheon2, which I think are very good companies that fit the profile of having strong dividends and share prices that we believed were undervalued as a result of short-term market concerns. We felt both companies were ultimately less exposed to and/or would be able to offset some of the pressures from reduced defense spending as a result of the across-the-board cuts in the sequester. So we are still able to react to what's happening in the markets as a result of these influences that are out there."

And while the popular political refrain is one of woe, Perks still sees positive signs in the US economy.

"We had seen, on the private side, strong domestic demand, growth and consumption. We have what appears to be some sustainability in the recovery in the housing sector, a very important sector for the economy overall. We continue to benefit from low energy prices and everything that's happening in that sector of the economy domestically. And, the overlay of company balance sheets has been strong. So we're still very constructive on the market, albeit at maybe a more modest pace of growth, given the fiscal drag."

If US consumers have expressed disdain over newly enacted tax increases and spending cuts, investors don't seem to have lost faith in the stock market, which has been reaching record heights in the first half of 2013. Are investors a bit too optimistic right now? Should they be nervous about buying equities? Here's what Perks has to say.

"Looking at broader market averages or market valuations, at levels that we were at in 2000 or 2007, today's market still looks a lot more compelling to us. For one, we have lower valuation levels. If you look at something like price-to-earnings in the overall market, we see a discount today compared to where we were in those two prior time periods when the market averages were at a similar level.

"When we overlay that with the outlook that we think exists for companies in terms of sustaining a very high level of profitability and very strong balance sheets, it has enabled strong cash flow. We believe dividend growth opportunity is higher today than it has been historically."

The message seems to be that whether it's sequestration, austerity, the fiscal cliff, or other apocalyptic-sounding events shaping the day's headlines, there are opportunities out there for those hardy enough to see them.

What Are the Risks?

All investments involve risks, including possible loss of principal.

Franklin Balanced Fund

The fund's share price and yield will be affected by interest rate movements. Bond prices generally move in the opposite direction of interest rates. As the prices of bonds in the fund adjust to a rise in interest rates, the fund's share price may decline. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. These and other risks considerations are described more fully in the fund's prospectus.

Franklin Income Fund

The fund's share price and yield will be affected by interest rate movements. Bond prices generally move in the opposite direction of interest rates. Thus, as the prices of bonds in the fund adjust to a rise in interest rates, the fund's share price may decline. Changes in the financial strength of a bond issuer or in a bond's credit rating may affect its value. Investments in lower-rated, higher-yielding instruments include higher risk of default and loss of principal. These securities carry a greater degree of credit risk relative to investment-grade securities. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. These and other risk considerations are discussed in the fund's prospectus.


1. Lockheed Martin Corp. common stock represents 0.45% of total net assets of the Franklin Income Fund as of 3/31/13. Franklin Balanced Fund has no assets invested in Lockheed Martin Corp as of 3/31/13. Holdings subject to change without notice.

2. Raytheon common stock represents 0.16% of total net assets of the Franklin Income Fund and 1.02% of the Franklin Balanced Fund, as of 3/31/13. Holdings subject to change without notice.

Disclosure: I am long LMT, RTN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.