Franklin Managed Income Fund Q2 2024 Commentary

Performance Review

During the second quarter of 2024, all three major US indexes reached new record highs. While the Dow Jones Industrial Average (DJIA) ended the period with losses, fervor for artificial intelligence lifted the S&P 500 Index (SP500, SPX) and NASDAQ Composite Index (COMP:IND) to solid quarterly gains. Optimism that the US Federal Reserve (‘Fed’) might begin cutting interest rates in September also boosted stocks. Out of the 11 sectors in the S&P 500, information technology (‘IT’) and communication services performed strongly, while materials and industrials were among the six sectors that experienced negative results. Large-capitalization stocks collectively rose and outperformed mid- and small-cap stocks, both of which generally declined. The Fed kept the federal funds target rate unchanged at a 23-year high during its May and June meetings and reduced its projected number of rate cuts for 2024 from three to one. The Fed’s preferred inflation gauge, the core personal consumption expenditures price index, rose in May at the slowest rate since March 2021 but remained above the Fed’s target. Moreover, the US labor market remained strong during the quarter; while the unemployment rate rose in April and May, jobs and average hourly earnings grew at a faster pace in May after softening in April. Meanwhile, US gross domestic product expanded in 2024’s first quarter at a significantly slower annual rate than in the prior quarter as consumer spending, exports, and state and local government spending grew at slower rates and federal government spending declined; conversely, residential fixed investment accelerated.

Quarterly Key Performance Drivers

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The 10-year UST note’s (US10Y) yield increased 20 basis points during the quarter, reaching 4.40% by period-end. The fund’s fixed income allocation decreased to below 58% of the portfolio by quarter-end and contributed to absolute returns. The financials, industrials and consumer staples sectors led absolute fixed income returns during the quarter. In terms of individual issuers, JBS (OTCQX:JBSAY) was the largest contributor within the consumer staples sector, while Community Health Systems (CYH) and Vistra (VST) added value within the health care and utilities sectors, respectively. USTs were the only material detractor within the fund’s fixed income allocation. The fund’s equity allocation increased to over 41% of the portfolio by the end of the period. Stocks contributed to absolute returns during the quarter, led by the IT, utilities and financials sectors. Texas Instruments (TXN) and Analog Devices (ADI) assisted returns within IT, while NextEra Energy (NEE) added value within utilities. In contrast, the health care, consumer discretionary, and materials sectors dampened equity returns for the period. Bristol-Myers Squibb (BMY), Home Depot (HD) and Albemarle (ALB) detracted within these sectors, respectively.

Outlook & Strategy

Economy: The economic growth outlook has been a major area of focus for the fund, as central banks around the world have raised interest rates over the last two years to combat elevated inflation. Central bankers around the world have shifted their stance away from a targeted fight solely against inflation in favor of a more balanced approach to monetary policy. The US economy remains resilient despite some cooling to start 2024, largely driven by a strong labor market and robust consumption in goods and services, despite the federal funds target rate increasing by 525 basis points over the past two years. We continue to monitor financial conditions as a leading indicator of future economic performance and Fed policy. The lagged effect of Fed policy has resulted in a broad tightening of financial conditions; nominal yields and mortgage rates have moved higher, while loan growth across various categories has slowed due to banks reporting higher standards for lending.

Equities: We remain selective in engaging with equities, given current valuations, as markets digest the lagged effect of monetary policy tightening, the shape of the yield curve, the cost of capital implications as rates remain higher for longer, and geopolitical risks. We have found select opportunities within the consumer discretionary, industrials, and materials sectors. Market breadth has been narrow over the last year, but opportunities are starting to present themselves below the index levels, which we feel favors active management. As income-focused investors, our asset allocation mix is driven primarily by bottom-up security selection, with a focus on company fundamentals as opposed to the direction of the broader equity market. While the capital return story differs by sector, our holdings are focused on businesses that show an ability to support attractive dividend yields and grow them over time.

Treasuries/Government-Backed Bonds: Deficit spending, combined with the demand dynamics of Fed quantitative tightening and the increase in supply of USTs, has resulted in a broad increase in the 10-year UST note’s yield thus far in 2024. Recent higher inflation readings relative to consensus expectations, along with labor market resiliency, have led to the market now expecting a later start to Fed easing, as well as fewer rate cuts in 2024. We continue to believe that the Fed will remain vigilant to ensure inflation does not return, and we continue to expect a lack of fiscal constraint to weigh on balancing budgets. We believe these factors should provide attractive yields, while exposures can help to hedge the portfolio against volatility should we see a drawdown in risk assets.

Investment-Grade Corporate Bonds: We retain a balanced view of the corporate investment-grade sector as the attractiveness of higher-quality assets has increased over the past 18 months. While absolute yield levels are still attractive for an income-generating strategy, credit spreads have contracted materially over the past year, which has marginally decreased the attractiveness of investment-grade corporate bonds, in our assessment.

High-Yield Corporate Bonds: While the high-yield market offers attractive yields, we remain balanced and selective due to the potential for higher refinancing costs impacting companies’ fundamentals. The potential for growth deceleration necessitates a vigilant approach to security selection within our high-yield portfolio, so our preference continues to be companies that have a greater degree of flexibility to deal with upcoming maturities.

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