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Franklin Templeton: investors must seek out the right risk

US small cap and emerging market stocks look attractive compared with so many risky assets across the rest of the equities universe.
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It’s more important than ever for investors to determine which stocks are expensive and which have lagged the broader market rally over the past year or so.

In short, the Franklin Templeton investment solutions team believes there are opportunities in US small cap and EM stocks due to their attractive valuations and growth catalysts.

This targeted optimism contrasts with the fund house’s view of many other risky assets, which it believes are priced too optimistically.

As a result, while the firm remains slightly defensive at a portfolio level, it is exploring some rationale for performance lags.

“Ultimately, we believe much of the bad news is priced in and catalysts are on the near horizon. We think these two assets [US small cap and EM equities] offer positive asymmetry and are a smart place to add risk in multi-asset portfolios,” said Tom Nelson, head of asset allocation portfolio management in Franklin Templeton’s investment solutions team.

Keeping sentiment in check

Investors have been buoyed by an improving macro backdrop in the US, amid resilient growth, a strong service sector activity and a stabilising manufacturing environment. As a result, the probability of a soft landing has risen.

However, riskier assets already started to rally in October 2022, ahead of both the current and projected macro environment, believes Nelson.

“In our view, most risky assets are pricing in macro expectations that are overly optimistic,” he said, pointing to continued uncertainty over what lies ahead next year.

This mispricing of risky assets is a key reason why Franklin Templeton remains slightly defensive at the portfolio level. “We favour fixed income over equities, where it is now relatively easy to find high-quality bonds yielding over 5% with little duration or credit risk,” Nelson added.

Finding the gaps

Where he does see an opening for investors is in equity pairings that historically perform well in scenarios like today – where growth is beginning to improve from below-trend levels.

And with US small caps and EM, he is unsurprised to have seen them lag.

For example, he explained that US small-cap stocks are generally more sensitive to higher interest rates, due to a larger amount of variable rate debt and weaker balance sheets. Plus, these companies are less exposed to the artificial intelligence promise.

In EM, meanwhile, risks like China’s current economic struggle and the weak global manufacturing environment seem to be largely priced in. “Valuation ratios, like price-to-earnings or price-to-book, suggest these assets are attractively valued,” said Nelson.

Growth drivers

The selective opportunity that Franklin Templeton sees for multi-asset portfolios is not just about valuations. Nelson also points to some key catalysts developing in support of US small caps and EM equities which he believes markets have yet to fully reflect.

“Typically, performance for small-cap stocks one year following the Fed’s final rate hike in the cycle has been robust,” said Nelson. Further, he added, small-cap stock performance has historically benefited from falling inflation.

In EM, measures of relative growth like manufacturing PMIs suggest stronger growth for emerging nations than their developed counterparts. “Disinflation is prevalent across many EM countries after strong rate hiking cycles,” he explained. “Over the next year, we expect policy easing to be more supportive compared to developed markets.”

Part of the Mark Allen Group.