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Franklin US Government Fund - News
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Franklin US Government comment - Jul 06
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Monday, 28 August 2006
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Fund Manager Comment
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Mortgages outperformed similar-duration Treasuries during July, as the Citigroup MBS Index provided investors with 33 basis points of duration-adjusted returns. Freddie Mac MBS provided the strongest performance, outperforming Fannie Mae MBS by two basis points on a duration-adjusted basis. GNMA MBS securities were the biggest relative under-performer, providing investors with 24 basis points of duration-adjusted performance. Using GNMAs as a proxy, performance varied dramatically depending on coupon allocation, but generally lower coupon securities outperformed their higher-coupon counterparts. For example, GNMA 5.5% coupon MBS provided investors with 35 basis points of returns, and GNMA 6% coupon MBS provided investors with 25 basis points (both on a duration-adjusted basis). Additionally, GNMA 6.5% MBS provided investors with only eight basis points of returns, and GNMA 7% bonds provided -26 basis points of returns (all on a duration-adjusted basis).
Prepayment reports showed that the housing slowdown continues to impact premium coupon and cash-out refinancing activity, keeping discount prepayments relatively elevated. In July, prepayment rates slowed by 13% (across the mortgage universe) as a result of higher mortgage rates over the past few months and a slowing housing market. Fewer collection days and seasonal factors also contributed to slower prepayments.
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Franklin US Government comment - Aug 05
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Friday, 18 November 2005
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Fund Manager Comment
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Portfolio Strategy and Outlook
Mortgages had their third month of underperformance in over a year, as the Citigroup MBS Index provided investors with -15 basis points of underperformance on a duration-adjusted basis. FNMAs had the strongest performance, followed closely by GNMAs. In fact, while FNMA 30-year MBSs provided investors with -15.6 basis points of underperformance, GNMAs lagged FNMAs by only 0.7 basis points. This month, we saw some of the lower-coupon securities outperform other securities. For example, GNMA 5% coupon MBSs provided investors with 1 basis point of duration-adjusted returns, while some higher-coupon securities underperformed. This was the case, for example, with the GNMA 7% coupon MBS, which provided investors with -54 basis points of duration adjusted performance.
Economic Growth and Interest Rates
At the time of going to press, the United States was continuing to feel through the effects of the devastation brought to the Gulf Coast region by Hurricane Katrina. The size of the human and physical loss continues to be assessed. Rescue and recovery efforts are ongoing. The impact on the lives of the people affected will be felt for years.
While the costs of this catastrophe will indeed be quite large, it is still uncertain whether they will dramatically alter the outlook for the US economy in the months and quarters ahead. History shows that these types of events have little lasting economic effect. Generally, the US economy can be described as widely diversified in both industry and geography. But history may not prove a proper guide given the unique characteristics and size of the loss in this tragedy. First, there is a heavy concentration of energy sector activity in the immediate area impacted by the storm. The disruption in the supply of refined gasoline was felt immediately at gas pumps around the US, with prices rising sharply. And these price increases come on top of oil prices that have already pushed substantially higher over the past year. In addition, the impact of Hurricane Katrina on natural gas supplies may push heating prices higher as the weather turns colder. These price increases are felt by consumers across the economy. It is likely that households with less flexibility in their spending will be the first to alter consumer activity in response to the higher energy prices.
Of course, aid and reconstruction activity will begin to flow, and materials and labor expenses will be the drivers of economic activity in the short term. But thousands of workers and businesses have been displaced, hurting productivity. Many families still do not even know what has happened to their loved ones.
The broad U.S. economy had been chugging along, generating a moderate level of jobs ahead of Hurricane Katrina. Expectations for GDP growth in the third quarter had been in the 4% range, but are now being revised downward. The decline of the yield on the 10-year Treasury toward the 4% level is itself an indication that investors expect lower growth. Some estimates are saying the hurricane will knock as much as 1% off GDP growth. The shape of the yield curve is also suggesting that the Fed may slow the pace of monetary tightening in the aftermath of the disaster. Is this the right interpretation? Should the economic dominos remain standing, investors may, in fact, determine that market yields are too low.
Eventually, time will heal the sharp edge of emotional devastation and personal loss. The water will be gone. And homes and businesses will be repaired. But it is too early to project forward to that time. Those of us with the good fortune to have been to the Gulf Coast know that the character of the people, the moderate climate, and the natural beauty of the region make it a highly desirable place to live and visit.
It is clear from conversations among citizens that the political landscape has been altered as a result of this horrible event. Domestic policy objectives including infrastructure and emergency and safety response system investments will move up the list of priorities. These capital infrastructure expenses will be evaluated as local communities assess their unique risks and vulnerability and the role of government to supply safety and basic services. Just as the terrorist attacks of September 2001 pushed forward security investments, this event too will be expected to create another round of important spending projects. These investments will cost real money, likely pushing US fiscal budget deficits wider in the short term.
And it is important to remember that these cycles of investments can be quite long. Security investment plans continue, and we expect companies will continue to push forward their capital spending plans on important security networks to bolster technology infrastructure. This higher level of corporate investment supports our expectation that the U.S. economy will remain in positive territory.
Low risk premiums
Just prior to the savage storm, Federal Reserve chairman Alan Greenspan met with a group of US and global central bankers in Jackson Hole, Wyoming, for an annual summer meeting. Greenspan's tenure as the head of the U.S. Federal Reserve Bank was assessed. He has only a few short months left before vacating the post he has held for over 18 years. The US economy has gone through some dramatic changes in the years of his tenure. In his address to the group, one item that Greenspan spoke of was the low risk premiums that U.S. markets appear to be pricing in at this time. Credit spreads and the flat shape of the yield curve - with longer interest rates remaining low even as short-term rates have moved higher - imply a measure of complacency on the part of investors, according to chairman Greenspan.
In addition, there was much discussion about the role of central banks in targeting asset price levels when making monetary decisions. The objective of such targeting would be to avoid asset price bubbles before they grow out of control instead of dealing with their aftermaths. Current Fed policies remain focused on keeping inflation low and fostering labor markets. While the debate is interesting, it is hard to imagine any real changes in Fed policy ahead of the appointment of a new chairman at the end of January.
Yield curve flattening
The low level of long-term interest rates and the flattening of the yield curve between long- and short-term rates is a result of a confluence of factors, including growth expectations for the U.S. economy in the aftermath of Hurricane Katrina. Important considerations regarding the structural challenges to the U.S. pension system are also affecting yields, especially longer ones. Lower asset returns, combined with longer liabilities, mean that many defined benefit pension plans are on a less secure footing than before. With expected asset returns forecasted to remain low, the managers and trustees of these plans are looking to hedge their liabilities by simply matching the appropriate expected future cash outflows with lower risk investments. This liability-matching scheme results in an increased demand for longer "duration" assets to meet the cash-flow profile of the long-dated liability streams. Often, the assets used are the longer-maturity US Treasury securities. Higher demand for long-duration Treasury securities by pension schemes is driven more by the need to match liabilities than by any expectation of return and is another factor keeping longer rates lower and the yield curve flatter during the current cycle.
As the nation mobilizes support for those affected by Hurricane Katrina, we are reminded once again of our human limits in forecasting anything from weather to financial markets and economic activity. However, we are encouraged by the strength, resiliency and fortitude of the people hit by the storm that hit the southern US in August. Ultimately, those human characteristics define the economic systems they create and the political systems that support them. And that backbone provides us, as investors, encouragement going forward.
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Franklin US Government comment - Jul 05
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Wednesday, 14 September 2005
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Fund Manager Comment
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Portfolio Strategy and Outlook
Mortgages performed well in July, as the Citigroup MBS Index provided investors with 7 basis points of out-performance on a duration-adjusted basis. This represents the fourth consecutive month of positive monthly duration-adjusted returns, and the tenth month of positive returns over the past 12 months. GNMAs outperformed conventional MBS for the first month in four, as Ginnie Mae MBS provided investors with 18 basis points of out-performance. In July, we saw some of the midcoupon securities outperform other securities. For example, GNMA's 6.5% coupon MBS provided investors with 48 basis points of duration-adjusted returns, while some lower coupon securities under-performed, like GNMA 5% coupon MBS, which provided investors with -6 basis points of duration-adjusted performance.
Economic Growth and Interest Rates
After an absence of almost four years, the US Treasury announced at the beginning of August that it would start re-issuing 30-year bonds. The Treasury has stressed that the reintroduction of 30-year paper - which was preceded by a period of intense lobbying by Wall Street - was aimed at diversifying issuance and lowering borrowing costs.
In 2001, the Treasury justified the ending of 30-year bond issuance by its projections of long-term budget surpluses. It therefore shifted its focus to short-term financing, which was then cheaper. This led to reliance on short-term debt issuance to finance record budget deficits, but that debt has to be refinanced sooner than longer-term debt, exposing the government to potentially higher borrowing costs. Also, falling long-term market rates and rising short-term ones have significantly cut the difference in the borrowing costs between two- and 30-year bonds.
There is strong demand for the 30-year bond among hedge funds, investors looking for a long-term benchmark and pension-fund managers looking for relatively safe investments that match their obligations. The move by the US Treasury parallels trends in other countries. Both France and the UK have issued 50-year debt this year and others such as Germany and Japan are considering doing likewise.
The flattening yield curve "conundrum"
Since the Federal Reserve began raising short-term interest rates (from 1% in June 2003 to 3.5% by early August 2005), long-term rates have risen by less than 1%. As a result, the difference between short-term and long-term rates has declined sharply to a level that is well below the 0.75% historical average. In the past, a flattening yield curve has presaged economic downturns.
This time, however, things may be somewhat different. Fed Chairman Alan Greenspan stated recently, during testimony before the Senate Banking Committee, that the yield curve is less reliable in signaling recessions because of changes to the economy. The difference between short-term and long-term rates (or yield curve steepness), he explained, has been important in the past because it influenced bank-lending activity. Banks profit by borrowing at low short-term rates and lending to consumers and firms at higher long-term rates. Historically, as the Federal Reserve raised short-term interest rates it reduced the banks' incentive to lend. This reduction in the supply of credit enabled the Fed to achieve its objective of slowing economic activity to prevent inflation. But today households and companies are able to obtain financing from other lenders apart from banks, such as retailers and the bond market, thus reducing the impact of short-term interest-rate changes.
Other explanations of why the yield curve is flat include the need for companies to fund their pension plans, thus increasing demand for long-term bonds. Also, foreign central banks, particularly in Asia, have been investing proceeds from the region's trade surplus in US Treasury bonds. Finally, concerns regarding inflation appear to have diminished and, as a result, investors are demanding less of a risk premium for long-term securities.
These are all plausible explanations for why the flattening yield curve may not necessarily be signaling an economic downturn. The president of the Federal Reserve Bank of San Francisco, Janet Yellen, suggested during a recent speech one interesting monetary policy implication of this trend. She hinted that the stimulus generated by low long-term rates might require the Fed to raise short-term rates more than they otherwise would have to slow economic growth and prevent inflation. Given that consumption growth has remained strong - largely due to the housing market and related mortgage lending activity - and taking into consideration that a significant share of new mortgages are adjustable-rate interest-only loans, the stimulus provided by low long-term mortgage rates may need to be offset by higher short-term rates. Hence, as banks play a lesser role in the transmission of monetary policy into the economy, and as the impact of the housing market increases, we could see a flatter yield curve than we would otherwise; without this necessarily being bad news for the economy.
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Franklin US Government comment - Jun 05
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Tuesday, 16 August 2005
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Fund Manager Comment
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Economic Growth and Interest Rates
Recent US economic data indicates that global growth remains robust and that the "soft patch" feared early in the second quarter did not fully materialize. First-quarter GDP growth in the US was revised upwards twice, from an original 3.1% to 3.8%, which is the same rate of growth as in the fourth quarter of last year. While there were signs of more sluggish activity in the industrial sector in the second quarter, manufacturing appeared to stabilize while households continued to support overall economic activity. Retail sales (excluding auto sales) rose over 8% from June of 2004, while auto sales rose over 15%, albeit on heavy price discounting. Additionally, continued strength in the labor market underpins healthy consumption and confidence. According to the latest payroll data, the economy created nearly 1.1 million jobs in the first half of 2005. Investment growth also remains solid, as does future investment capacity, with corporate cash balances still at historically high levels. While the market had begun to lower expectations for future rate hikes, in June, the Federal Reserve Board (the Fed) communicated that rate increases were likely to continue, in line with our view of ongoing rises in short-term interest rates.
Reassessment of the growth picture in the US was replicated globally, with signs that pessimism over Asian growth was exaggerated. While core European growth continues to disappoint, Asia shows signs of ongoing resilience. In Singapore (often a good indicator for non-Japan Asian regional growth dynamics given the composition and intensity of its export sector), growth rebounded in the second quarter of 2005 after moderating in the first quarter. Real GDP growth rose 3.9% from the same quarter a year ago, accelerating from 2.4% in the first quarter. Additionally, we continue to see further evidence of growth rebalancing in Asia, with the drivers of growth shifting from the export sector towards domestic sources. Indications of this include a rebound in consumer confidence in South Korea following two years of depressed sentiment, a notable pickup in household consumption in Japan coupled with potential revival in the housing market there, and increasing vehicle sales across the region, particularly in Thailand (up 22% in May).
With domestic recovery gaining traction in Asia, the region's external savings - in the form of a massive current account surplus and accumulated reserves - could potentially be reduced. This correction of the external imbalance would have significant consequences for the US, given that much of Asia's external savings are funneled into the U.S. securities markets and provide an important source of financing for the large and worsening current account deficit. In the first quarter of 2005, the U.S. current account deficit widened to 6.4% of GDP, up significantly from an already large deficit of 5.1% a year before.
Portfolio Strategy and Outlook
Mortgages performed well in July, as the Citigroup mortgage-backed securities (MBS) Index provided investors with 5 basis points of out-performance on a duration-adjusted basis. This represents the third highest monthly returns year to date. Conventional MBS continued to outperform Ginnie Mae MBS for the third month in a row. As mortgage rates have remained near their historical lows, the 5.0% and 5.5% coupon mortgages have become the predominant coupons within the mortgage index. Generally speaking, lower -coupon securities (5.0% and 5.5%) outperformed their higher-coupon counterparts. For example, GNMA 5% MBS's provided investors with 5 basis points (bps) of duration-adjusted returns, but GNMA 6.5% coupon bonds provided investors with -14 bps of underperformance. The trend was similar in conventionals. We have continued to focus our research in the specified pool marketplace rather than the to-be-announced (TBA) markets over the past few months. We continue to look to the GNMA sector in general as a source of potential value over the long term.
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Franklin US Government comment - Mar 05
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Friday, 29 April 2005
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Fund Manager Comment
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The Fund
This quarter was characterized by increasing interest rates, as the curve had a flattening bias. The benchmark 10-year Treasury ended the period 26 basis points higher than where it began. The 2, 3 and 5-year portions of the yield curve increased by 71, 70 and 56 basis points, respectively. During this time period, the FTIF US Government Fund outperformed its benchmark by 61 basis points1. Historically speaking, the high income and low volatility characteristics of GNMAs help them to outperform comparable Treasuries during periods of rising interest rates. We believe these same factors have largely contributed to providing investors with very competitive Sharpe Ratios, or, risk adjusted returns, across the past market cycle.
In the GNMA sector, we continued to use our proprietary models to uncover areas of the markets in which we deem prepayment risk to be mis-priced. During the period, GNMAs outperformed conventional. Additionally, GNMAs provided investors with 35 bps of duration-adjusted performance. Generally speaking, GNMA 7.5% coupon securities provided investors the best performance, on a duration-adjusted basis, in the 5%-7.5% coupon stack. We continued to look to instruments across the spectrum of coupon and program types, focusing our research on uncovering value in specified pools.
Economic and Market Overview
The U.S. Economy continued to grow during the 1st quarter of 2005, as strength in consumer spending and corporate profits driving growth. A consumer's ability to spend is largely driven by their ability to become and remain gainfully employed, and over the first quarter of 2005, non-farm payrolls added an average of 159,000 workers a month. This, combined with a strong housing picture, has helped to buoy consumer spending over the course of the past quarter. The business investment component of GDP increased at an annualized 14.5% during the 4th quarter of 2004, and expectations are for continued strength in the 1st quarter of this year as well. The Federal Reserve Board (Fed) raised the federal funds target rate to 2.75% during the reporting period. Although they did admit that they have seen some inflationary pressures begin to surface, the Fed echoed previous statements, stating, "Longer-term inflation expectations remain well contained."
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Franklin US Government comment - Feb 05
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Wednesday, 23 March 2005
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Fund Manager Comment
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The Fund
Mortgages provided flat returns relative to Treasuries. This month, lower coupon securities under-performed their higher coupon counterparts. For example, GNMA 5% MBS provided investors with 4 bps of duration-adjusted returns, while GNMA 6.5% coupon bonds provided investors with 28 bps of out-performance. Generally speaking, however, GNMAs out-performed conventional, as the 30-Year GNMA Index provided a boost to overall mortgage market performance with 8 basis points of duration-adjusted returns. Conventional lagged Treasuries by 2 bps.
U.S. growth dynamics
Alongside economic data in February showing solid U.S. economic performance, the Fed yet again increased the Fed Funds rate by 25 basis points in February. Intermediate and longer-term interest rates also rose, indicating the market's expectation that the Federal Reserve will continue to raise short-term rates in the months ahead. We agree. Our expectations over the past months have been for a firmer U.S. economy led by improving jobs and higher business investment spending. It would appear that those expectations have come to pass.
According to U.S. Labor Department data, non-farm payrolls grew by 262,000 in February, the largest amount in four months. And, importantly for the financial markets, it appears the new jobs are not yet producing cost pressures. The Labor Department report showed that average hourly earnings were flat in February, and that the unemployment rate actually rose, as more participants jumped into the improving job market.
The strong labor report actually pushed interest rates lower when it was announced. The markets were "relieved" to see the lower cost pressures in the wake of a number of other inflation reports that seem to show that price increases have moved up as the current cycle has extended. Investor nervousness was further heightened by increases in oil prices back above the $50 per barrel level seen last October.
It is anybody's guess whether the higher costs will be passed through by businesses to consumers in the form of higher prices for goods and services. Right now, businesses' financial health is better than it was a few years ago. Corporate earnings projections continue to be revised higher. Corporate balance sheets are flush with cash. Companies are financing growth via internal funds rather than borrowing. Corporate defaults have yet to show signs of moving measurably higher. While shareholder (as opposed to bondholder) friendly activity has been increasing (witness rising stock dividends from companies like Microsoft), only now are we seeing the beginnings of any re-leveraging of corporate America through M&A activity and a net increase of borrowing. It is possible that, given their financial health, U.S. companies might just absorb the added costs they face. Or they may attempt to continue to extract efficiencies from their operations in order to compete.
Productivity and inflation
Key to being able to keep prices low is an ability to get more goods and services out of the same level of labor inputs - n other words, increasing productivity. During February, the Commerce Department revised sharply higher its estimates for U.S. productivity increases for the fourth quarter of 2004, even as fourth-quarter GDP figures also increased. Economists tell us that productivity gains should diminish as business cycles extend and mature. The theory is that the marginal costs rise as operational slack declines with expanding demand and top line growth. This is one reason we see the Federal Reserve strongly focusing on the fight against inflation. We simply don't know whether the U.S. can continue to enjoy ever-higher levels of productivity. And the risk of being wrong and allowing inflation to embed itself long term into the economic system is too high.
Recent months have seen more dialogue among leading monetary officials about narrowing the Fed's mandate to specific inflation targeting objectives. We also remind investors that we are in the final months of Alan Greenspan's tenure as chairman of the Federal Reserve. As we transition to new leadership, we expect various Fed officials will continue to talk and act tough on inflation to solidify the new leadership's credibility with the global financial markets. This is why we expect that the Fed will continue to raise short-term interest rates in the months ahead.
Social Security reform
Some larger issues have moved to the center of public debate in the U.S. One of these has been potential reform of the Social Security system. President Bush has outlined his ideas, while, at this point, there has been no alternative plan championed by the opposition Democratic Party. Yet the Democrats are steadfastly opposed both to the idea of financing any transition to private accounts via increased Treasury borrowing and to cuts in benefits. We expect that some political compromise will develop.
From an investor standpoint, any meaningful attempt to rectify future imbalances is a positive development. And if those solutions also result in policies that help increase the broad level of savings in America, then the U.S. economy should also enjoy lower interest rates and higher growth, all other things being equal. Perhaps more important is that leadership from Washington on tackling social security imbalances has to have some positive influences on the other, far larger problem of massive future Medicare and Medicaid liabilities with uncertain financing sources. So, as investors, we are encouraged by the increased dialogue and attention to tackling these problems of tomorrow.
Of course, the strong economic growth of the type we are currently seeing does not always translate into consistent financial market returns for investors. The sensitivity of differing assets to changing interest rates and profit margins will be important when considering asset allocation changes in the period ahead. And while the past few weeks have seen a return to that wonderful "Goldilocks" scenario of not too hot, not too cold economic growth, it's fairly easy to imagine any number of potential shocks to the system. On the short list of items, one could include terrorist attacks within the U.S., a global flu pandemic, or imminent political transitions in Saudi Arabia. Assigning probabilities to these possibilities is difficult, but must be included when planting the investment seeds to be harvested in the future.
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Franklin US Government comment - Oct 04
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Thursday, 18 November 2004
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Fund Manager Comment
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The Fund
Mortgages provided their highest duration-adjusted returns in about a year, providing investors with 36 basis points of returns on a duration-adjusted basis. Generally speaking, GNMAs performed well, with lower coupon bonds (5% - 5.5%) outperforming their higher coupon counterparts over the period. To juxtapose lower and higher coupon bonds, 5.5% GNMAs provided 58 basis points of duration-adjusted returns versus the 8% GNMAs, which provided -4 basis points of duration-adjusted returns.
Overview
The US economy continued to grow in the third quarter as GDP came in at a 3.7% annual rate in the face of record oil prices. The headline employment numbers for September came in slightly below consensus, but other indicators point to a stronger underlying employment environment. The consumer continued to exhibit strength as third quarter spending grew at almost triple the rate of the second quarter. The housing market also continued to thrive, exceeding expectations in September and maintaining its record sales pace. Business spending increased again in the third quarter, as fixed investment rose at an 11.7% annual rate, the sixth straight quarter of increases. Finally, inflation remained at historically low levels, with prices of consumer goods and services (excluding food and energy) rising just 0.7% during the third quarter, the lowest in over 40 years.
The Consumer
Consumers continued to spend during the third quarter, recovering from the second quarter soft patch and spending at nearly triple the pace of the April through June period. In September, consumer spending rose 0.6%, while incomes climbed 0.2%, causing consumers to dip into savings and pushing the savings rate to the second lowest on record at 0.2%. While consumer spending is outpacing income growth, the fact that wage growth continued to outpace inflation helped to put money into consumer's pockets. The housing market exceeded expectations again in September, as home sales for existing and new homes spiked 3% and 3.5% respectively, amid continuing year over year price increases.
The strength in consumer spending is continuing despite mediocre non-farm payroll numbers. The economy averaged 103,000 new jobs per month in the third quarter, down from 204,000 during the first half of the year. However, employment growth may be stronger than non-farm payrolls suggest. We continue to monitor strength in the NFIB Small Business survey, temporary employment, selfemployment and online employment demand, all of which suggest the possibility that employment is stronger than headline numbers. This makes us somewhat positive on consumer spending going forward, despite the lower savings rate we have seen in the 3rd quarter data.
Business Activity
Overall business activity continued to expand in the third quarter and into early October, as indicated by the Beige Book published on October 27 by the US Federal Reserve. Reports from the 12 Federal Reserve Districts indicated continuing acceleration of economic activity despite a restraining effect from higher energy costs. Increased reports of permanent hiring, especially in the manufacturing industries, were present, along with increased spending on labor in retail and service industries. As noted, business fixed investment, including construction, equipment and software, rose for the sixth straight quarter, at an 11.7% annual clip. Specifically, equipment and software spending increased 14.9%, the fastest in a year. In addition, inventory dwindled over the third quarter, a possible indicator of increasing demand from consumers.
The Institute for Supply Management also continued to indicate strength from the business sectors. Their manufacturing index was at 56.8 in October, remaining above 50 for the 17th straight month. A reading over 50 indicates continuing expansion in manufacturing. Further, their non-manufacturing index, encompassing industries accounting for 85% of GDP, expanded in October at the fastest pace in three months with a reading of 59.8. Finally, the employment component of the index rose to 55.8 in October, trailing only the survey's all-time high of 57.4 in June of this year. The signs in business activity point to a continuing recovery and solid business spending looking ahead to the final quarter of 2004 and into 2005.
Inflation
Inflation fell to historically low levels during the third quarter as the perception of a jobless recovery took hold on Wall Street. The ten-year note ended October yielding 4.03% as oil fell through the USD50 mark for the first time in a month. The headline CPI number was up just 2.5% year-over-year in September, down from 3.3% in June. Core CPI (which excludes volatile food and energy costs) was up just 2% over the same time period.
Oil and gas continue to be primary concerns for the Federal Reserve and economists, as crude oil prices have climbed approximately 75% over the past year. According to RBS Greenwich Capital, the increase in energy prices could add 0.3% to our next CPI number. However, Alan Greenspan noted in October that although high oil prices were having a "noticeable" effect on the economy, the shock was not enough to cause problematic inflation or significantly slow growth. According to Blue Chip Financial Forecasts inflation should be around 2.4% for the next 12-18 months, which should not be a cause for economic concern in the foreseeable future.
Conclusion
The outlook for the economy is stable, as the consumer continues to exhibit strength. We believe there is evidence that the job market is stronger than the consensus forecast. This vigor should lead to continued demand from the consumer, leading to ongoing support for the expansion in business activity that has been observable over the past 12-18 months. Combining strong demand with the moderate inflation outlook, we continue to have a positive stance on the US economy moving forward.
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Franklin US Government comment - Aug 04
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Tuesday, 21 September 2004
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Fund Manager Comment
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The Fund
Mortgages outperformed similar duration Treasuries for the third month in a row. This period was characterized by relatively stable interest rates, with the benchmark 10-year Treasury trading in a narrow range of 4.12% to 4.45%. During periods of stable or rising interest rates, GNMAs tend to outperform comparable duration Treasuries. Generally speaking, GNMAs would benefit from a more measured pace of movements by the Fed.
Over this time period, our research guided us to the opportunity to move current positions toward higher coupon issues. We reduced allocation in the 5% coupon, 30-year maturity GNMAs and increased exposure to the 5.5% and 6% coupon range. These higher coupon positions offered less price risk and provided increased income of their lower coupon brethren.
Our research also found value in specific GNMA securities that were pooled as a result of a "builder buy-down" program. These pools are constructed with mortgages that have attractive prepayment characteristics. The mortgages in these pools are unique, in that the builders of the new homes that are being financed have offered payment support to entice new homeowners. We expect this offers investors a degree of prepayment protection as the homeowner receives a below market mortgage rate for the first several years of the loan, decreasing the incentive to refinance the loans in the short term. Our research has come to pass as the investments in these assets have indeed resulted in slower prepayments for the securities purchased vs. other GNMA investments.
Finally, we executed a swap between the GNMA I and II programs where we felt it was appropriate. GNMA IIs tend to have better geographic diversification, and lower weighted average coupons. Additionally, these bonds are becoming used by more investors, and the liquidity continues to improve. We have found that our GNMA II investments over the period have demonstrated the prepayment characteristics we had been expecting.
The high income and low volatility characteristics of GNMAs continue to make them an attractive sector, especially over the long-term. We believe that income will dominate total returns in this sector over the next market cycle, and the income premium that mortgages have over Treasuries should help to keep their Sharpe ratios high when compared with other assets.
Overview
The U.S. economy grew by a revised 2.8% in the second quarter and underlying economic data points to strong growth going forward. Although non-farm payrolls were below expectations for June and July, there were signs of strength according to other employment indicators. The housing market remained strong with falling interest rates and demand maintaining a near-record pace. Additionally, business investment remained particularly strong in the second quarter, growing at the fastest pace since the third quarter of last year. Inflation stayed within the Federal Open Market Committee's forecast of 1.5% - 2% for the year 1 , and continues to be closely monitored by the Federal Reserve Board. The Federal Reserve Board reiterated its stance for "measured" rate increases for the rest of the year and the markets appear to have priced in two 25 bps rate increases by the end of this year.
The Consumer
Retail sales grew 0.7% in July and personal spending was up 0.8%. Auto sales increased 2.4% in July and sales at general merchandise stores rose 1%. Sales at furniture stores also rose 1% in July, reflecting the continuing strength in the housing market. The growing job market is currently seen as the driver of the consumer going forward. While the change in non-farm payrolls for June and July came in under consensus, at 78,000 in June and 32,000 in July, other job figures point to growth in hiring in the coming months. For example, the net percentage of small businesses looking to hire rose to 16% from 11%. The Bureau of Labor Statistics household survey showed a gain of 629,000 jobs in July for a total of 2.3 million in the past 12 months. Manpower, the country's largest employer with over 2 million temporary employees on its payroll, said 30% of companies surveyed are looking to add staff, against only 6% looking to reduce it. Federal Reserve Board Chairman Alan Greenspan dismissed concerns over new hiring, saying, "a fairly significant pace" of job growth should be seen as the economic recovery continues to pick up steam.
Both new and existing home sales continued on a record-setting pace through July, remaining near the all-time sales highs set in June. As rising interest rates from the Federal Reserve push up the short end of the yield curve, mortgage rates, which are largely dependent on the intermediate part of the yield curve, have been declining. This dynamic is caused largely by the fact that intermediate- to long-term rates are driven by inflation expectations and cannot be completely dictated by the Federal Reserve. As a result the 30-year mortgage dipped back below 6% at the beginning of the month, ending the month at 5.82%. ARM rates, which are becoming more important as an increasing number of mortgage purchasers opt for adjustable rate or hybrid mortgages, fell as well, with a 1-year ARM declining to 4.05% by month end. Because of the increasing utilization of hybrid and fixed rate loans, more consumer debt is financed at a short-term fixed rate.
Business Activity
The Beige Book, Fed-produced summary of regional economic conditions, reported increases in production in each of its 12 regions for the month of June and into early July. Inventory levels rose 0.9% in June, even with the increased stockpiles, inventories remain close to the record-low of 1.22 months from March of this year, hovering at 1.31 months as of June. An increase in inventories can be indicative of a perception of an increase in future final demand.
Business activity was strong for the month of July, with most major economic indicators rising. The Institute for Supply Management's (ISM) non-manufacturing index rose to 64.8 from 59.9, the index has now exceeded 50, indicating expansion, for 14 straight months. The Institute for Supply Management's factory index for July rose to 62 from 61.1, it has stayed above 60 for nine straight months, the longest stretch since the early 1970s. While ISM's gauge of employment dropped to 57.3 in July from 59.7 in June, indicating a slower pace of business hiring, it remained above 50, pointing to continued employment growth going forward. The combination of manufacturing and service expansion and slightly slower job increases, contributed to making business investment the main driver of the economy's expansion in the second quarter.
Inflation
With inflation holding in the 1.5%-2% range that the Federal Reserve Board says it is forecasting, inflation is at relatively low levels historically. The producer price index rose just 0.1% in July, on the heels of a 0.3% decline in June. The core index rose 0.1% as well, following a 0.2% rise in June. The Consumer Price Index (CPI) also eased in July, falling 0.2% before seasonal adjustment, indicating a 3% rise over the past year.
While energy and food prices continue to put upward pressure on both PPI and CPI, both eased substantially in July. The CPI for food rose 0.3% in July, totaling a 3.8% rise over the past 12 months and the CPI for energy, fell 1.9% in July, rising 14.3% year-over-year. Oil prices reached an all-time nominal high of nearly $50 in late August, though oil would have to reach $80/barrel in order to match the inflation-adjusted highs of the late 1970s/early 1980s. Considering that energy and food prices tend to be more volatile than other inflation inputs, many market observers believe inflation remains relatively low.
Conclusion
The question facing the economy right now is where the fuel to continue the recovery will come from. As the housing market continues on its record pace it clearly could be the answer in the short-term. Long-term, job growth must pick back up in order to keep the economy moving ahead. While the non-farm payrolls have not met expectations over the past couple of months, other indicators point to a stronger job market. The Bureau of Labor Statistics Household Survey, temporary employment and NFIB Small Business Survey all indicate strong labor demand. Moreover, it is our conclusion that business investment remains strong and clearly is anticipating rising consumer demand going forward. With inflation under control, strong business investment and growth in the job market, the U.S. economy should continue to grow.
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Franklin US Government comment - Jun 04
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Friday, 13 August 2004
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Fund Manager Comment
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In the GNMA sector, we used our proprietary models to undercover areas of the markets in which we deem prepayment risk to be mispriced. We continued to look to instruments across the spectrum of coupon and program types. Due to the fluctuating nature in which prepayments are received in the MBS sector, mortgage investors demand a yield premium as compensation. It is our contention that income will continue to dominate total returns in this sector over the next market cycle. We have found prepayment protection offered at attractive levels recently, and have been looking to certain MBS structures (such as builder buydown pools) for value.
Economic and Market Overview
The past quarter saw the U.S. economy continue to expand, as the rapidly improving job market is now acting as the primary driver of economic growth. At the end of the period, the Federal Reserve (the Fed) raised short-term rates 25 basis points in order to keep inflation in check and keep the economy growing at a stable, measured pace. Employment growth has lead to increased consumer incomes, which translated into stronger consumer spending and retail sales during the month. Gauges of consumer confidence are also showing signs of improving consumer sentiment. Businesses are continuing to expand their workforce and inventories to keep pace with consumers increased demand for goods and services. Inflation continues to be a concern with most indices reflecting rising prices. Increases in raw materials have been the primary stimulus for inflation. With rising rates, there is much speculation about how higher borrowing costs will affect numerous sectors of the economy.
Consumers are realizing the benefits of an improving job market in the form of increasing incomes and spending. Non-farm payrolls increased another 248,000 in the most recent reading, and the April and March numbers were revised upwards to 353,000 and 346,000 respectively. The economy has now created almost 1.2 million jobs since January. The increase in jobs has directly translated into higher incomes and spending. Personal incomes rose 0.6% at the end of the period, and wages and salaries, the largest portion of personal income, increased 0.7%. The confidence indices showed that consumers' perception of the job market also ticked up. According to the consumer confidence board, at period's end, the percentage of consumer that found jobs "hard to get" fell from 31% to 26.5%. Over the next 6 months 19.7% of consumers saw jobs as plentiful up from 18.7%.
With more cash in their pockets, consumers spending grew and retail and sales also increased. Personal consumption expenditures rose 1% at the end of the period, their biggest rise in since October of 2001. Retail sales rebounded solidly last month improving 1.2% and retail sales excluding cars and automobiles rose 0.3%. Sales at car dealerships, gas stations and general merchandise stores lead the way for the higher sales numbers. Gauges of consumer confidence support the argument that we can expect the consumer to continue to spend in the coming months. The Fed's move to raise interest rates may not have a significant immediate impact on the consumer despite record consumer debt levels. The majority of consumer borrowing is locked in at a low fixed rate and the effects of rising rates should not have a significant impact on consumer spending in the near future as rates continue rise. Various studies show consumer fixed rate debt at levels ranging from 67% to 85% of total debt.
The housing market continues to show robust growth in the face of higher borrowing costs. During the quarter, 30-year fixed mortgage rates increased to end the period around 6.30% while 1-year adjustable rate mortgages increased to 4.14%. Nevertheless, existing home sales, which comprise 85% of the housing market rose to a new record, and new home building permits rose to their highest level in 30 years. However, refinancing activity has declined with the rise in rates. With less refinancing activity, consumer will receive less "cash-out" equity, which could adversely affect consumption expenditures. Looking in a broader historical context, interest rates are still low and the housing market remains strong with continued home price appreciation and strong sales.
The economic indicators for business activity sent mixed signals near the end of the quarter, but with the overall improvement in consumers' financial strength and rising demand, we can expect business to remain strong. The current readings from the Institute of Supply Management (ISM) Non-Manufacturing Index and Manufacturing indices continue to be over 50. An ISM survey reading over 50 indicates a period of expansion and we can still expect positive growth trends. As consumers continue to see rising incomes, business can expect to see higher revenues and larger profits. The Fed's move could have a significant affect on borrowing costs for businesses going forward which could cut into profits. At the same time, a lot of businesses have already negotiated financing at the low rates of the previous economic cycles.
Inflation continues to grow, lead by commodity prices; more specifically energy and food prices. In its June release the Federal Reserve stated, "The Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability." There is speculation that the Fed is moving too slow in its battle with inflation, though inflation still remains relatively low in historical terms. The most recent reading as of quarter's end showed that the producer price index (PPI) rose 0.8%, and core PPI, excluding the volatile food energy categories, rose 0.3%. Prices for crude goods rose 2.8% and core crude goods actually fell 3.8%, proving that food and energy are raising price levels. Food prices rose 1.4% last month while prices for energy rose 1.6% and gasoline prices 5.7%. However in recent weeks we have seen crude oil prices retreat somewhat and we can expect that price levels for energy and gasoline could stabilize. With employment increasing, there is a tendency for the costs of labor to rise as well, which could have further effects on the prices.
The prices consumers are paying for goods also increased during the second quarter. The consumer price index (CPI) rose 0.2% with core CPI rising 0.3%. Despite the rise in price levels, inflation still remains low on a historical basis. Also, similar to PPI, the current inflationary trends in the CPI have been caused by higher commodity prices which tend to be volatile. The combination of higher labor and commodity costs could increase the prices in the months ahead.
Largely in anticipation of the Fed's move at the end of June, longer-maturity Treasury yields shifted upward throughout the period. The benchmark 10-year Treasury yield rose from 3.84% at the beginning of the reporting period to 4.58% on June 30, 2004. The market expected another 1% increase in the federal funds target rate by the end of 2004, according to the Fed Funds Futures Contract table. Despite the removal of the stimulus provided by lower interest rates, many sources of economic stimuli remained, including an improved jobs picture and higher corporate profits.
As people attempt to decipher the effects rising interest rates have on consumption and spending, the economy is likely to expand. Employment continues to grow at a strong pace and is expected to do so in the coming months. Increased spending and a robust housing market should help to fuel rising demand within the U.S. economy. Businesses stand to gain significantly from higher consumer demand and will struggle to keep inventories paced with sales. Businesses trying to catch up with rising consumer demand could help to support job creation in the future. Rising borrowing rates could have a negative affect on corporate profits, but indices of growth are still showing strong signs of expansion. Inflation remains a concern especially with the employment gains putting upward pressure on labor costs, though inflation historically remains low. The Federal Reserve will be watching labor markets closely to help keep inflation under control.
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