Emerging signs of more economic stability and balanced inflation have tempered recession risks in developed markets, but still require investors to shift allocations across a range of assets and markets.
Against this backdrop, Franklin Templeton is attracted to what it calls “naturally diversifying” alternatives such as private assets, which offer the potential to earn an incremental return linked to their relative illiquidity.
These also offer a way for multi-asset portfolios to adjust to the situation where many asset classes have become correlated.
The firm therefore finds growing appeal in tying up capital in investments that are longer term in nature, and intrinsically harder to sell, to earn the so-called ‘illiquidity premium’.
“As alternatives are fundamentally buy-and-hold investments, we do not express shorter-term tactical preferences, but maintain our longer-term structural allocation to these assets,” said Wylie Tollette, chief investment officer of Franklin Templeton Investment Solutions.
For the time being, the firm’s longer-term analysis suggests the return potential from global bonds, especially lower-risk government bonds, has improved.
“Having seen policy rates rise sharply over the past year, the starting level for all government yields – with the notable exception of Japanese government bonds, even after recent increases – is now more attractive to us,” Tollette explained.
In general, Franklin Templeton finds the yields available in high-quality government bonds particularly appealing now that bonds are not so overly optimistic about an imminent reversal of the rate-hike cycle.
At the same time, amid uncertainty over the prospect of recession, the firm thinks a nimble approach remains appropriate.
“We entered 2023 with an allocation preference away from stocks, which we have retained,” said Tollette. “The level of risk premium discounted in risk assets does not correspond with the macroeconomic environment and uncertainty we foresee.”
For instance, the artificial intelligence-driven rally in US equities has seen market indexes “test the upside” of recent ranges and made the firm’s allocation preference feel uncomfortable to sustain, added Tom Nelson, head of asset allocation portfolio management at Franklin Templeton Investment Solutions.
“We believe equities have moved ahead of both the improvement in current data and our more optimistic outlook,” he added. “However, given the signs of stabilisation, we showed our nimble investment management style by trimming the extent of our caution toward stocks, while looking for assets that we assess as remaining more attractively valued.”
The firm also believes the end of the current policy-tightening environment will likely see government bonds exhibit more of a risk-dampening effect on multi-asset portfolios.
Finding new opportunities
Some alternative areas worth exploring, according to Franklin Templeton, are smaller-capitalisation stocks in the US and emerging market (EM) equities, both of which it believes have been left behind in the rally since the start of October 2022.
In the smaller-cap space, for example, Nelson expects the recent headwinds from higher rates to ease in the year ahead.
And with EM fundamentals appearing to be improving to some extent, combined with a recovery in semiconductor demand, he believes these assets are a relatively cheap way to position for any pick-up in global growth.
“Part of the appeal of EM equities is the still depressed level of their foreign exchange rates against the US dollar,” Nelson explained.