Fiduciary Trust International


Perspective on Sectors

February 2012


Our view is that the U.S. will not fall back into a recession and that Europe can find a constructive solution to its credit crisis. However, we expect volatility in financial markets to continue due to political issues among the Eurozone members and lingering doubt about whether China and India, each so important to sustained growth, can deftly avoid a hard landing following their efforts to blunt inflation.

We became less defensive in client portfolios in the latter part of 2011 as company fundamentals-jobs, orders and costs—began gathering momentum, and measures of consumer sentiment also began showing some further improvement. We have been selectively reinvesting cash back into the markets, favoring sectors that have been particularly hard hit and that we believe are now attractively valued.

As positive economic underpinnings continue to present themselves, we expect investor confidence to increase and market volatility to also subside. We caution, however, that the issues faced by the Eurozone nations and the loud political debate underway in the U.S. will be unsettling to investors and may bring on volatile trading. In this environment, we continue to take a fundamental and bottom-up approach to the companies in each sector as we evaluate their operations relative to their valuations, seeking to take advantage of opportunities as we identify them


Consumer Discretionary: Marketweight
We have increased our recommendation to marketweight as recent economic data in the U.S. and China has become more positive. In the U.S., consumer confidence has shown significant improvement—the U.S. savings rate has declined from 8.3% in May 2008 to 4.0% in December 2011, suggesting that Americans have greater confidence in the future and are spending. The increased spending is likely a reflection of the improved outlook for the jobs market as well as some positive signs in the housing market, including general price stabilization and inventory improvements in non-depressed areas.

We continue to favor companies within the sector that have strong global brands and those that we believe are well-positioned to exploit the demand of the rising middle-class in developing economies.
Sector Positives

  • Recent data on employment in the U.S. has been encouraging: initial jobless claims fell below the critical 400,000 level in February 2011 and continued lower through the ensuing months; additionally, the unemployment rate dropped to 8.3% in January.
  • Gasoline prices remain 6% below their April 2011 peak, providing a tailwind for consumers.
  • The emerging economies, such as China and Brazil, are showing increasing evidence of easing inflation.
  • The European Central Bank has adopted the Federal Reserve’s playbook and begun a new round of purchasing European nation’s sovereign bonds; this action has shown investors that the central bank will backstop liquidity and support recovery while the difficult political negotiations continue.
  • We expect the middle-class populations in the emerging market economies to continue to drive demand for luxury, discretionary items.

Sector Negatives

  • While clearly improving, the specter of defaults by Greece and other European nations has impaired consumers’ optimism.
  • Americans may defer spending if they believe taxes will rise based on the outcome of the U.S. Presidential election.
  • Aging baby boomers are likely to save more and spend less over the long term; if the economy continues with muted growth, nearly three out of five baby boomers are estimated to be at risk of running short of money in retirement.

Team Leaders: Carin Leong Pai, Maria Losquadro, Bibi Conrad

Consumer Staples: Overweight
We continue to recommend an overweight position, consistent with our preference for quality companies that are supported by growing dividends. Valuation premiums have risen given the relative outperformance of the group in 2011. However, we are attracted to the above-average yields that can help provide income in an environment in which cash and bond yields are nearly zero.

We recognize that the market is beginning to transition away from defensive stocks and more toward cyclical sectors as recent economic data has improved. We are monitoring the real-time data, and when we have conviction that the strength in data is sustainable we intend to move toward a marketweight recommendation.

Sector Positives

  • We observe that balance sheets for many firms within the sector are healthy with high levels of cash.
  • In a low-growth economy, this balance sheet strength has the potential to allow companies to enhance shareholder value by increasing dividends and/or by buying back shares.
  • Commodity costs have moderated from early 2011 peaks, easing pressure on profit margins. We also see companies beginning to raise prices which further adds to margin.
  • Energy costs have declined, allowing room in consumers’ budgets for more spending.
  • Although growth in emerging markets generally slowed in 2011, companies that are strategically targeting these regions are expected to benefit over the long run as standards of living rise and the middle-class expands; for 2012, the International Monetary Fund’s economic growth forecast for the emerging markets is 5.4% versus 1.2% for developed economies.
  • We expect the use of packaged goods and convenience products to see strong growth.

Sector Negatives

  • Relative valuations are above historical averages. Based on an average of 2012 and 2013 price to earnings multiples, the group is trading at about an 18% premium versus the historical 10% premium to the market, with an average expected earnings growth rate of 5.5%.
  • As cyclical sectors show durable growth, we expect investors to begin to rotate away from staples and other defensive sectors.
  • The cuts in research, development and marketing that were made in 2011 to help alleviate commodity inflation could negatively impact innovation. 

Team Leaders: Steve Dutka, Xavier Martinez, and Kimbrough Towles

Energy: Marketweight
The sector reflects a confluence of geopolitical fears and uncertainties. Among these are threats of military confrontation in the Straits of Hormuz and the impact of the Eurozone debt crisis on global demand. In addition, natural gas prices dropped to historical lows as a result of the sharp increase in proven reserves of shale gas in the U.S. and elsewhere. Unseasonably warm weather has also aggravated the medium-term demand outlook for gas. Companies are finally having to respond to the weak price environment and are announcing joint ventures, or reducing their rig counts and capital expenditures.

We maintain our preference for companies with greater orientation to oil versus gas. The integrated oil companies have outperformed other energy subsectors given their defensive characteristics, such as diversified asset bases, economies of scale, consistent dividends and often above-market average dividend yields. We prefer the global oil majors as we believe they are best positioned to benefit from the secular trend toward deepwater exploration and greater service intensity.

Sector Positives

  • We believe that growth in demand from non-OECD countries is likely to remain above developed country demand, even during a global economic slowdown.
  • We expect the increased use of new exploration technologies to provide opportunity to oil service and drilling companies.
  • From a long-term perspective we believe unconventional exploration opportunities, such as shale and deepwater, will drive demand for drilling and recovery technologies and oilfield services.

Sector Negatives

  • Geopolitical instability continues to plague investors’ outlook.
  • The prospect of increased regulatory oversight remains a chronic negative.
  • The rising prominence of national oil companies poses a competitive threat to integrated companies.

Team Leaders: Karen Fang, Jody Terry, Jon Hatch

Financials: Marketweight
The financial sector suffered as a result of multiple concerns: 1) rising interest rates in China; 2) uncertainty regarding tightening regulatory rules in the U.S. and Europe; and 3) ongoing doubts about the quality of sovereign credits in Europe and, as S&P averred, in the U.S.

We believe that poor current expectations present potential opportunities for the long-term investor. Our recommendation is for portfolio managers to take advantage of this bout of fear to move sector exposure incrementally closer to the benchmark to maximize upside potential.

We believe that issues regarding mortgage repurchases, foreclosure liability and increased regulation may delay earnings growth, but are not likely to suppress it. Credit restrictions have begun to ease, and corporate and consumer loans have begun to rise, quite possibly signifying that the banks are comfortable with their capital ratios. We are inherently cautious but acknowledge the improvements in credit, which lift earnings, along with solid reserve positions as catalysts for growth for the sector.

Sector Positives

  • Loan growth has continued to advance as demand for credit from businesses and consumers has risen.
  • The credit environment continues to improve as credit losses moderate.
  • Most large banks have reduced costs to reflect the current environment of greater and more costly regulation and low interest rates.
  • We expect increasing merger and acquisition activity and an increase in IPOs to drive gains in revenue.

Sector Negatives

  • The housing market remains the leading issue for banks as the inventory of unsold homes remains high, although it is no longer increasing.
  • European sovereign debt exposure remains a concern for European-based banks; however, the European Central Bank’s commitment to maintain liquidity among banks by buying sovereign bonds has reduced the risk of defaults and recession.
  • In our view, uncertainty about the shape and reach of proposed regulations poses headwinds whose consequences are difficult to define at this time.
  • Net interest margin (the difference between what banks earn on loans and pay to depositors) is under pressure in light of the Federal Reserve’s quantitative easing programs.

Team Leaders: Jon Hatch, Xavier Martinez & Mackin Pulsifer

Healthcare: Marketweight
We continue to recommend a marketweight position. We are reluctant to recommend an overweight exposure because we believe that healthcare company earnings will be impaired by multiple factors including slow growth in the volume of medical procedures, ongoing downward pressure on pricing, more restrictive insurance reimbursements and likely cuts in federal and state healthcare funding. Many of these concerns, however, appear to be priced in, and valuations are hovering below their five year averages versus the S&P 500.
For 2011, the large-cap pharmaceutical companies were among the best performers in healthcare given their high dividend yields and relatively predictable sales and earnings. For this year, our focus is directed toward mid-cap healthcare companies that are operating in the bio-tech and life science tool sub-sectors. Many of these firms underperformed last year, but are outperforming so far this year.

Sector Positives

  • Growth from the emerging markets should offer continued opportunities for the sector.
  • Firms are generally operating with strong balance sheets and the ability to generate a large free cash flow.
  • We believe there is modest room for an expansion in price to earnings multiples.
  • The utilization of the healthcare system is expected to ramp up over time as the U.S. population ages.

Sector Negatives

  • The high unemployment rate and rising out-of-pocket insurance co-payments have resulted in lower utilization of medical services in the short term.
  • The economic climate has made it difficult for manufacturers to raise prices.
  • Reimbursement pressures from government and managed care companies are material headwinds to growth.
  • A more difficult regulatory environment for new product approvals may limit growth in our view.

Team Leaders: Linda Krouner, Paul Nolle, Carl Scaturo

Industrials: Marketweight
We believe industrials should continue to perform in line with the market in the near term. Our long-term view for the sector remains positive, given strong fundamentals such as high levels of cash, strong balance sheets, a positive outlook for capital expenditures and expanding global infrastructure.

The construction replacement cycle continues to be strong and energy infrastructure continues to grow along with increases in demand from developed and emerging markets. In the short-term, however, we are more cautious as continued global economic uncertainty weighs on this cyclical sector. We maintain a positive view toward companies that are diversified and have specific growth drivers that can be sustained through a slower-growth environment.

Sector Positives

  • Company valuations are attractive in our view, and we believe dividends are likely to increase.
  • Companies are still flush with cash and expense controls continue to help margins.
  • We believe that merger and acquisition activity is likely to continue.
  • We expect the sector to benefit from lower input costs as commodity prices have decreased.
  • Despite economic uncertainties, global infrastructure growth remains positive.

Sector Negatives

  • The volatile outlook for Europe, particularly if the continent will go into recession, poses challenges for global industrial companies.
  • Fiscal austerity worldwide could delay or prolong a substantial global infrastructure build-out.
  • Defense spending is under pressure as deficit reductions become more prominent in the U.S. and Europe.

Team Leaders: Ken Siegel, Linda Krouner, Alexandra von Stackelberg

Information Technology: Overweight
The application of technology to business processes remains a key to reducing corporate costs and raising productivity. We expect that fundamentals in the sector will remain solid. Demand remains a key driver. Many corporations that postponed purchases during the recession are now resuming investment in technology. Others are stepping up investment to exploit weakened competitors and gain market share. Corporations are seeking to improve the return on investment from their technology infrastructures through a combination of collaboration tools.

In the consumer products area, devices such as smartphones, tablet computers and related products remain pockets of strength. We expect 2012 revenue growth for the sector to be approximately 5%, with stronger growth in the second half of the year. We also believe that operating margins should remain high.

Inventories, which had been increasing in the second half of 2011, are now being worked off; this bodes well for sector earnings for 2012 as demand continues to sop up supplies. Orders for semiconductor production equipment have been stronger than expected, and this measure has been a reliable leading indicator of sector demand.

Sector Positives

  • Increasing numbers of “smart” connected devices should lead to continued spending in areas related to technology infrastructure.
  • We anticipate the wider adoption of enterprise collaboration software to leverage relatively untapped corporate social networks.
  • In our view, new storage and network solutions will be required to address bandwidth needs driven by increasing multimedia traffic.

Sector Negatives

  • High growth leaders in areas such as cloud computing are among the most expensive companies in the sector and we believe they are therefore subject to corrections if investors’ expectations are not met; even so, select exposure is desirable over the long term in our view, and we continue to recommend select investments in this area.
  • Global competition is increasing, especially from regions with low labor costs, which may exert downward pressure on prices and profit margins.
  • We believe cuts in government spending will inevitably dampen demand in the near term and may somewhat offset the positives of the enterprise sector and select consumer-related subsectors. 

Team Leaders: Penny Knuff, Joseph Portillo, Gabriela Adessi

Materials: Underweight
The materials group was a major underperformer in 2011, and we believe it will continue to be extremely volatile going forward based on the direction of economic data. We are therefore maintaining our underweight recommendation, reflecting the continuation of the sluggish U.S. economy, the possibility of a recession in Europe and slowing growth in Asia. We expect downward adjustments for 2012 earnings per share, which have started with the moderate lowering of expectations by the major companies within the sector.

Company selection within the sector will be key in this environment, and we believe those companies that are less cyclical in nature and are stronger financially will fare better this year.

Sector Positives

  • Falling energy and commodity prices should benefit companies’ cost structures.
  • Barriers to entry remain high for new competitors to enter the marketplace.
  • A supply shortage among some industrial metals is likely to benefit miners.
  • We expect improvement in housing and manufacturing to benefit the group.
  • Global food demand remains strong as wealth increases within emerging economies.

Sector Negatives

  • The sector is driven by GDP growth; for 2012 the International Monetary Fund’s economic growth forecast for developed economies is just 1.2%.
  • Broad demand for metals and mining services are slowing.
  • Currency volatility-especially for the U.S. dollar-makes forecasting earnings and valuation unusually difficult.

Team Leaders: John Trainer, Robert Bridges

Telecommunication Services: Marketweight

The sector’s non-cyclical and defensive attributes have made it appealing to investors during periods of slow growth. The companies’ stable dividends are attractive to income-oriented investors, especially during this time of low interest rates.

We are finding quality companies to choose from in the U.S., in developed international markets and the emerging markets. However, growth has been limited in many companies due to sluggish core businesses and intense competition. The sector can be expected to underperform when economic growth reignites. In the more variable, consumer-dependent wireless arena, we prefer firms with strong subscriber growth, robust average revenue per user and low debt to total capital.

Sector Positives

  • The sector’s steady earnings, strong cash flows and stable dividends can make it an attractive substitute for bonds for investors seeking income.
  • We anticipate ongoing consolidation in the industry as companies seek to drive costs down and gain market share.
  • The U.S. market has driven strong wireless data growth.
  • Capital spending needs are slowing for the sector.

Sector Negatives

  • The wireless market is approaching saturation in the U.S. with a 90% penetration rate.
  • Traditional wireline losses are accelerating.
  • Margin pressure is increasing due to smartphone subsidies.
  • Increasing promotional spending may be a sign of price wars.

Team Leaders: Bill Leffingwell & Pascal Wirz

Utilities: Underweight
The utilities sector outperformed the S&P 500 by 17.9% in 2011. Investors typically increase demand for utilities during economic uncertainties, and move away when growth expectations improve. We are maintaining our underweight recommendation as we believe investors will become less risk-averse as economic conditions improve.

Price-to-earnings ratios are above historical averages, driven there by yield-seeking investors, suggesting only limited upside. Utilities are already underperforming year-to-date 2012. We expect less upward pressure on costs due to the Obama administration’s less aggressive regulation of coal plant emissions which reduces the need for large capital expenditures by the companies.  In addition, the expected slow growth of the U.S. economy will reduce power demand and therefore revenues.

Regulated electric utilities continue to offer lower volatility combined with high current dividend income. However, earnings per share growth is expected to be mid-single digits across the group in a slow U.S. recovery scenario. In contrast to other sectors, the earnings estimates for utilities have been revised downward by a number of research firms.

Sector Positives

  • Utilities have continued to display less volatility and an above-average dividend yield.
  • The sector has historically been less sensitive to economic downturns.
  • High barriers to entry and the possibility of further consolidation could benefit the sector.

Sector Negatives

  • Earnings growth is expected to be in the low to mid-single digits.
  • Volatile oil, natural gas and coal prices can be detrimental to the sector.
  • As economic growth revives, we anticipate that investors will move assets toward growth companies.
  • Ever-tightening emissions standards are expected to impose higher costs and may further impair earnings, in our view, if the companies cannot recoup the expenses through higher rates.

Team Leaders: Jennifer McCaleb, Robert Bridges

Fixed Income
Uncertainties in Europe drove investors to seek safety in U.S. Treasuries, driving yields to historical lows and generating capital gains which resulted in impressive total returns in 2011. We believe investors should limit their expectations for total returns in 2012 as the potential for price appreciation has run its course in our view, and we expect returns will come largely from coupon income.

Our projection for moderate growth in the U.S. and a possible recession in Europe leads us to expect yields to remain low and volatile at least through the first half of the year. Operation Twist, which was designed to bring down yields on long-term bonds, will conclude in the second half of 2012, and the Fed has vowed to keep short-term rates near zero until late 2014. However, we believe interest rates, particularly longer term rates, could gradually move higher over the course of the year as the current low levels do not seem justified when inflation and non-recessionary growth expectations are taken into account.

Investment Grade Corporate Bonds: Favorable
Yields on corporate bonds also fell but to a lesser degree than Treasuries. Valuations remain attractive to us on a historical basis as they are well above their long-term averages. Our view remains positive given the improved credit profile of the corporate sector and the generally stronger balance sheets that exist across many firms. Barring any economic shocks that would cause investors to avoid risk--such as worse news out of Europe or a slowdown in the U.S.--we believe that the sector will perform well compared to Treasuries. 
Sector Positives

  • The improvement in credit quality continues in spite of the systemic risks out of Europe and concerns of global recession.
  • We believe the new issue market may offer attractive opportunities to selectively add to the sector.
  • The Federal Reserve’s policy to keep rates low supports the economy which can help increase investors’ confidence and their willingness to take more risk in return for higher-yielding investments.

Sector Negatives

  • Investors may again become more risk-averse if macroeconomic concerns resurface surrounding European debt.

High Yield Corporate Bonds: Favorable
We continue to believe the sector offers compelling valuations. We are seeing improved credit fundamentals and believe that U.S. non-financial high yield companies are in a good position to weather economic and financial market turbulence. Assuming investors remain willing to take on risk, we expect continued demand and light supply to contribute to the potential for positive returns for this sector.

Sector Positives

  • Accommodating credit markets have allowed companies to refinance debt and extend maturities to 2012 and beyond, further strengthening corporate balance sheets.
  • The additional yield offered on high yield bonds over U.S Treasuries provides attractive income.

Sector Negatives

  • If there is a shock to the economy investors may again become more risk averse and valuations will decline as investors leave the sector in favor of higher quality securities.
  • A weaker-than-expected economy could pose challenges for high yield companies and increase the default rate.

Municipal Bonds: Neutral
In 2011, the municipal bond market experienced a robust rally as yields declined to near record lows. As with Treasuries, we do not anticipate  a repeat of this strong performance continuing through 2012 as we expect coupon income to be the primary driver of returns.

Many states have been the beneficiary of the economic recovery and have seen improvement in tax revenues. Despite these increases, overall tax collections are still not back to pre-recession levels and the number of credit ratings downgrades was at a four-to-one ratio relative to upgrades in 2011, marking the third year in a row that downgrades exceeded upgrades.

Sector Positives

  • We expect investors to continue to find the tax-free nature of the income appealing, and we believe that a steady demand for municipal bonds should help keep valuations in a stable range.

Sector Negatives

  • Yields remain low, and we believe capital appreciation potential will be limited from here.
  • Structural credit challenges persist as tax revenue growth is unlikely to be enough to overcome rising costs from long-term liability burdens and increasing spending mandates.

Team Leaders: Ronald Sanchez, Cindy Rudbart, Eric Reynolds

About the Equity Strategy Group
The Equity Strategy Group is comprised of teams of Fiduciary Trust portfolio managers that each focus on one of the ten broad business sectors.  These teams collect, review and filter research from sources around the world including the work by Franklin Templeton analysts. Each team acts as the focused “eyes and ears” for a sector of the global economy and is accountable for providing their colleagues with timely, high-conviction investment ideas. The teams recommend an overall weighting for a sector: Underweight, Marketweight or Overweight relative to the benchmark, often the S&P 500. At Fiduciary Trust, each portfolio is constructed to achieve a client’s specific investment goals, income needs and preferences. Due to this customization, individual client accounts may have sector weightings that differ from the indicated recommendations.

This communication is intended solely to provide general information. The information and opinions stated are as of February 1, 2012, and may change without notice. The information and opinions do not represent a complete analysis of every material fact regarding any market, industry, sector or security. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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Pulsifer_Mackin.jpg"The fundamentals of many companies look quite strong, but until the conditions that increase investor confidence begin to pervade the economy, stock prices, in our judgement, will remain volatile."

--Mackin Pulsifer, Vice Chairman & Chief Investment Officer

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