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Everywhere we look, volatility is low––but will it remain so?

07 December 2017Franklin Templeton

During 2017, volatility has been low—in stocks and in bond markets, even in indicators of macroeconomic activity.

As we look forward to 2018, our analysis suggests that many of these measures of uncertainty may increase. One example is the shape of the yield curve: a flatter US Treasury yield curve (the spread between two-year and 10-year Treasury notes, which has declined sharply) is historically not a good omen. However, this is usually a longer-term warning and, given that we are experiencing a particularly extended economic cycle, would not make a compelling case for rushing to the sidelines of financial markets today, in our view.

However, when volatility is at historical lows, perhaps you don’t need to attempt to see where the lightning bolt comes from. In a world that feels complacent and desensitized to many of the risks that we remain conscious of, perhaps it is enough to simply anticipate a change and be prepared.

Lessons from the global financial crisis 10 years on

One of the most notable features of the global financial crisis (GFC) of 2007–2009, from an investment perspective, was the way seemingly unrelated asset classes moved in tandem with each other. Correlations between these assets increased, and traditional assumptions about the benefits of diversification were called into question. Investors, by and large, were not prepared for this change.

We saw this within single asset classes, as well as across geographies and in multi-asset portfolios. Many investors believed they had an adequately diversified portfolio, containing a number of independent sector positions and a portfolio of idiosyncratic risks. However, in many cases, this proved to be an insufficient description.

As the GFC unfolded, it became clear that common factors were driving performance, namely liquidity and leverage. This “failure of diversification” prompted wider use of factor analysis across portfolios and reduced reliance on simplistic asset allocation measures. Today we can gain exposure to those factors we wish, aware of any concentrations we are less keen to hold.

Looking Forward to 2018

Those investors who have bet on markets remaining tranquil have been rewarded handsomely in recent years, encouraging other investors into strategies that are implicitly “short volatility.”

Volatility risk has become the center of attention in recent years. In an effort to construct portfolios that capture the global growth we see around us today, and anticipate continuing into 2018, we are drawn to global equity markets. But stocks are not a pure investment in growth; they also bring exposure to volatility, which has been exceptionally low by historical standards. If volatility was to return to more normal levels this would likely be a headwind for global equity return potential, in our assessment.

Central banks are struggling to balance a desire to unwind unconventional policies and normalize interest rates with a continued need for stimulus measures in most economies. As a result, we might wish to express a view that real yields will rise or that inflation will remain subdued. Similar to our view on growth, expressing these views through traditional asset classes is less simple than you would hope. Holding cash might allow you to benefit from rising real yields but also leave you vulnerable to any decline in inflation. Similarly, in a broader portfolio context, retaining some exposure to the duration factor (meaning sensitivity to interest-rate changes) can help to provide more stable outcomes.m

How we Manage portfolios in a factor-driven investment universe

In an idealized world, we would look to construct portfolios that gave us a pure expression of our views on each of the main investment factors. By doing this, we could construct portfolios with better diversification and a higher probability of producing an outcome that meets investors’ specific needs. We could, for example, use option positions to gain long exposure to the volatility factor or potentially create asymmetric outcomes.

The “failure of diversification” in 2008 was based on simplistic views of traditional asset class diversification. Some factors span traditional asset classes; for example, real yields impact bonds (obviously), but also defensive stocks and exchange rates. For Franklin Templeton Multi-Asset Solutions’ investment approach, factor-aware investing is a key component and a significant driver when developing outcome-oriented portfolios that aim to better meet client expectations.

1. Term premium refers to the extra return a buyer of bonds demands to hold a longer-term security instead of investing in a series of short-term issues.

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