Equity markets in the US performed very well during 2012, in our view, despite continued uncertainty. Most major indexes posted double-digit returns through November, and volatility during most of the year was noticeably lower than in 2011. A number of factors, including the European debt crisis, slower emerging-market growth, and the election along with fiscal issues in the US weighed on the markets at times, but none of these factors were enough to derail what has been the slow-but-steady growth of the US economy. Corporate earnings growth decelerated, but the overall level of earnings pushed into record territory, and companies generally continued to use their strong free cash flow for shareholder-friendly activities such as share repurchases and dividend increases. High dividend paying stocks did particularly well as many investors looked to companies that generated yield in an extremely low interest rate environment.
Heading into year-end, investors were focused on the looming fiscal cliff and its potential impact on economic growth. As of this writing, Congress and the President had not yet come to an agreement that would avoid going over the fiscal cliff. However, most discussions involved a combination of higher taxes and spending cuts that would more likely be a slight drag to economic growth as opposed to a stimulus. While growth in the US is likely to be constrained by high debt levels at the government (and consumer) level, we do not believe the US is headed toward a contraction provided policymakers resolve the fiscal cliff issues in a timely fashion. Furthermore, a constructive resolution would boost confidence for corporations and individuals who may have curtailed spending and investing in the face of policy uncertainty. Other factors that caused concern at different times during 2012 included the continued European debt crisis (which pushed the continent back into recession) and the slowdown in China. While fiscal policy (i.e., austerity) in many parts of the world remains somewhat restrictive, monetary policy is generally very accommodative, and interest rates throughout the world have remained generally low. We regard this as a likely positive environment for equities.
Although the US faced uncertainty surrounding the election and fiscal issues, the economy was a relative bright spot, particularly compared to other eveloped countries. Earnings for many companies in the S&P 500 moved further into record territory before retreating slightly in the third quarter (due to lower earnings from overseas). The employment picture continued to slowly improve, as the unemployment rate declined a full percentage point from November of 2011 through November of 2012.
Both the energy complex and manufacturing have been important contributors to job growth. The US is undergoing an energy ?revolution? (due to hydraulic fracturing) that has pushed production to levels not seen in over 15 years, and the International Energy Agency believes the US will be the world?s largest producer of oil in 2020. We believe this energy revolution should keep natural gas prices low as well and help lead to a continued manufacturing enaissance. Manufacturing in the US has benefited from low input costs, a steady decline in US manufacturing wages (and surging wage growth in the emerging markets), a relatively low trade-weighted dollar and high shipping costs. We view these factors as unlikely to reverse in the near term, which should mean continued growth in the manufacturing sector. Other areas of strength in the US economy include housing and autos. Housing, in particular, has gone from a drag on the economy to a contributor to growth as the sector has benefited from record-low interest rates, a gradual repairing of individuals? balance sheets and significant pent-up demand. Higher home prices have also helped reduce the number of individuals with negative equity in their homes while also providing a strong wealth effect, which we think bodes well for continued improvement in the housing sector. All combined, these factors should lead to an environment of slow-but-steady economic growth, in our view.
Housing, manufacturing, autos, the energy sector and monetary stimulus provide the backdrop for a likely continuation of US economic growth, which should allow for steady earnings growth. Near year-end, US equity valuations generally appeared reasonable to us and slightly below long-term averages. We also think equities look particularly interesting in an environment of very low interest rates, and many companies have the cash flow and balance sheet strength to likely continue to provide shareholder value, according to our analysis. For investors with an eye on long-term potential, we believe this is a good time to invest in the US equity market.
Ed Jamieson is the president of Franklin Advisers, Inc. and chief investment officer of Franklin Equity Group. The group manages global growth, core and hybrid strategies. He is the portfolio manager of Franklin Small-Mid Cap Growth Fund.