Gary P. Motyl, CFA, Chief Investment Officer, Templeton Global Equity Group
Cindy L. Sweeting, CFA, Executive Vice President, Templeton Investment Counsel, LLC

Market performance for the third quarter varied from middling aggregate performance in Europe and North America, to outstanding performance in Asia ex Japan and emerging markets. Japan continued to under perform other regions during the quarter.

Based solely on this performance, one could be forgiven for thinking that markets behaved methodically, efficiently pricing consensus expectations of both a U.S. economic slowdown and continuing growth from a booming Asian region. In actuality, however, the combination of subprime-related losses in leveraged securitized instruments, the inter bank liquidity crisis, rising credit spreads, and the ultimate need for U.S., UK and European central bank accommodative action all made for an extremely bumpy ride in equity markets.

At Templeton we took advantage of heightened volatility to buy out-of-favor equities with solid fundamentals at what we considered attractive valuations and to reduce investments whose valuations we believed had become speculative. This discipline led us toward values in the consumer discretionary, telecoms and healthcare sectors and away from consumer staples, materials and utilities.

As yet, we have found few compelling opportunities in western financial sector valuations. Policymakers and market participants have still not determined the true extent of the subprime fallout, and toxic debt continues to surface in the global portfolios of many institutions. We do know the fallout is most acute in the financials sector, which contrived the levered securitized environment and owned the instruments.

As we look toward a future that likely includes the moderation of U.S. economic growth, global investors are focused on how international economies and markets might be affected by an American-led downturn. The strengthening of global demand and broadening of foreign economies suggest that some decoupling of Asian economies from the U.S. consumer engine may indeed occur, although the extensive amounts of productive capacity continuing to come on-stream in Asia make it difficult to imagine that those economies will emerge unscathed from declines in U.S. demand.

The staggering amounts of financial reserves accumulated during the first decade of the 21st century by emerging nations (previously dependent on the developed world to under-write their growth) should help regional markets and economies eventually gain their independence. Yet, as markets moved in step through the peaks and troughs of the third quarter, investors rightly debated how far off this independence might actually be. When the inability of the least-creditworthy American homeowners to meet their mortgage obligations triggers global equities sell off, it is difficult to ignore just how interdependent today's economies and financial markets remain.

The irony in today's market environment is that the cheapest companies are often also the highest quality. Such companies include large-cap firms with defensive balance sheets, diversified product offerings, broad currency exposure, and strong international market shares. Their businesses are generally less sensitive to domestic cyclical influences, and valuations have been attractive on an absolute basis and particularly on a relative basis. The sheer size of these companies means they can't easily be bought by private equity capital or industry buyers, so valuations have remained subdued compared to the premiums assigned to takeover targets in the current mergers and acquisitions boom.

We believe these large, internationally diversified businesses should be best suited to weather a potential U.S. economic slowdown. We use fundamental, long-term valuation metrics to screen for such opportunities, and buy only when valuations appear inexpensive relative to our estimate of intrinsic value. Despite the recent contortions of global equity markets, we have currently been finding a number of stocks we believe have the potential to offer value and capital appreciation for patient investors.

For information on funds managed by the Templeton Global Equity Group, click on the following:
FTF - European Equity Fund
FTF - Global Balanced Fund (global equity portion)
FTF - Global Equity Fund
FTF - Global Equity Income Fund
FTIF - Templeton Euroland Fund
FTIF - Templeton Global (Euro) Fund
FTIF - Templeton Global Income Fund (global equity portion)
FTIF - Templeton U.S. Value Fund