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By Vaneet Chadha, CFA’s articles Director of Style Premia/Volatility Management Franklin Templeton Investment Solutions; Jose Maldonado, CFA’s articles Portfolio Manager, Systematic Strategies Franklin Templeton Investment Solutions; Miles Sampson, CFA’s articles Lead Asset Class Analyst Franklin Templeton Investment Solutions.
There are reasons to be cautious in many markets, but low volatility and high/sustainable dividend stocks can help mitigate risk while providing income and equity exposure. The Franklin Templeton Investment Solutions Team weighs in.
We recently wrote about potential opportunities to be found in US small cap and emerging market stocks. These areas of the market have historically been more volatile than developed market mid- and large-cap stocks,1 but we find them compelling at this time.
As a rule, we have always been selective in our risk budgeting; this is perhaps even more important when the macro environment is as uncertain as it is today. At the asset allocation level, we still prefer a defensive posture. And with a less-sanguine view on international developed markets in general, it may make sense to favor defensive equities, which could also help neutralize risk from other portfolio selections. There are certain factors we prefer to help buttress relative performance should things turn south, or even trudge sideways. These include the low volatility and high, sustainable dividend factors. Further, hedging foreign currencies against the US dollar can help improve returns when the dollar appreciates (relative to those foreign currencies).
A challenging macro environment
From a macro standpoint, there are reasons to be cautious throughout international markets. Uncertainty abounds when trying to forecast central bank policymaking.
For instance, determined to cool inflation (which has been sticky in services), the European Central Bank raised interest rates in September, despite a dismal growth outlook. The eurozone manufacturing Purchasing Managers’ Index (PMI) level is very low compared to the world’s (43.5 vs. 49.1).2
The story is a bit different in Japan, as the Bank of Japan has expressed conviction that inflation is transitory and has so far avoided raising rates. But with inflation high and stickier than anticipated, it may have to tighten over the coming quarters. This is unfortunate timing, as Japan’s manufacturing PMI is at a seven-month low and currently in contractionary territory (48.5).3
For more information on our regional outlooks, please refer to our Allocation Views. In general, many central banks will look to keep rates high if inflation stays elevated and economies do not fall into recession. Should recessions materialize, central banks would have room to ease monetary policy. However, recessions are generally an unfavorable environment for stocks. We find ourselves questioning whether disinflation and/or policy easing would be a more potent driver of stock prices than the growth outlook.
Why low volatility and high dividends? Why now?
We think a combination of the low volatility and sustainably high dividend factors proves to be a helpful screening tool for equities, particularly when the macro environment is as uncertain as it is now.
We advocate for a dividend process that includes a focus on earnings and profitability. This increases the likelihood that a high dividend yield can be sustained, in essence providing an assessment of company fundamentals.
The low volatility factor, when applied to price, does not give direct insight into the fundamentals of a company. But when earnings volatility is screened (both realized earnings and analyst forecasts), another stability component is incorporated, which we believe can improve the odds of lower drawdowns in declining markets.
This approach could result in stocks that exhibit a “smoother ride,” with underlying companies that appear to be well-managed and financially sound. Over time, the aim for equities of this type of defensive exposure is to outperform on a relative basis, should market cap indexes drop, while providing meaningful income.
Exhibit 1A and 1B: International Low Volatility, High Dividend Stocks Have Outperformed in Down Markets
Exhibit 2: Currency Hedging Produced Stronger Returns During These Downturns
Exhibit 3A and 3B: Annualized Return and Volatility Profile
We believe that combining companies with high dividends – and the earnings to back them up – with those that have exhibited low volatility over time can be a useful way to lower the risk of an investor’s equity sleeve and produce appealing income. This can potentially help balance out the volatility of other equity exposures, such as US small caps and emerging markets – a sort of bar-belled approach that maintains equity exposure and can provide the additional benefit of income potential.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
International investments are subject to special risks, including currency fluctuations and social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Dividends may fluctuate and are not guaranteed, and a company may reduce or eliminate its dividend at any time.
Diversification does not guarantee a profit or protect against a loss.
Active management does not ensure gains or protect against market declines.
Footnotes:
1. As measured by standard deviation, using the Russell 2000 (for US small caps), MSCI Emerging Markets Index, and MSCI World Index as proxies. Inception dates of the Russell 2000 Index and MSCI Emerging Markets Index were utilized to determine the comparison time period. The standard deviation of the Russell 2000 Index versus the MSCI World Index was calculated from March 31, 1986 – September 30, 2023. The standard deviation of the MSCI Emerging Markets Index versus the MSCI World Index was calculated from June 30, 1988 – September 30, 2023. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
2. Source: S&P Global.
3. Ibid.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
