How to think of volatility as an opportunity

Yasmine Raso

Senior Journalist, Financial Newswire

23 May 2023

Franklin Templeton’s research division, Franklin Templeton Institute, has released new insights for investors on how to turn market volatility into an opportunity for more secure and quality returns.

Head of the Institute, Stephen Dover, said as central banks around the world attempted to curb inflation this caused a raft of market volatility particularly in the US Treasury yield curve, because of uncertainty in outlooks for inflation, growth and potential recessions.

Dover said investor uncertainty has also not been helped by the recent stress experienced in the banking sector, which “serves as another reminder that when central banks tighten, ‘stuff happens’”.

“In short, monetary policy uncertainty, financial fragility and hard-to-predict outcomes for growth and profits confronted investors,” he said.

“But the solution is not despair. Rather, the appropriate response (at least in our view) is to take advantage of what is on offer—including higher fixed income yields at shorter maturities—and complement that approach with judicious allocations to risk assets, particularly when volatility offers opportunity.”

Dover recommended investors turn towards high-quality corporate bonds with less than two years’ duration, after seeing five per cent returns on near-cash vehicles including money market funds for the first time in almost two decades.

“Money market funds and short-duration, high-quality bonds may seem an uninspired choice for many investors, but there are times when they make sense, above all when volatility is high, uncertainty prevails, and fundamental risks (i.e., recession) loom for corporate credit and equity markets,” he said.

“That is not, however, to say that portfolios should be 100% parked in instruments of less than one year in duration. Not only might that be tax inefficient, but it also misses our second key point.

“Specifically, by holding onto a larger fraction of interest-bearing and highly liquid assets, investors can act nimbly when opportunities present themselves. High volatility and market dislocations, which are historically probable when the Fed and other central banks are tightening aggressively, create more attractive entry points for stocks, government bonds and corporate credit. When bought at discounts, those assets typically offer outsized returns for investors.”

Dover also highlighted that short-term money market and shorter-duration fixed income returns are becoming more desirable for investors after an aggressive tightening cycle led by the US Federal Reserve, with the environment becoming more unfavourable for equities.

“But that’s not the end of the story. By taking refuge in safe, attractive yielding positions at the very front end of the yield curve, investors can also be prepared to seize opportunity when it presents itself.”