Short and sweet: putting cash to work in a volatile market

This article was produced in partnership with Franklin Templeton.

Cash often represents uncertainty for investors. By holding onto cash, they may miss out on potential opportunities and jeopardize their long-term objectives.

Historically, some of the most uncertain periods—such as interest rate hikes, inflation, and disappointing earnings—have been crucial moments. Looking back, these events frequently offered ideal times to reallocate cash within client portfolios to better meet their goals.

Today, with an unprecedented amount of assets in money market funds and an attractive cash yield environment, clients might be hesitant about reinvesting their cash or uncertain about the best way to do so. As of mid-December 2023, according to the federal reserve, US money market funds alone held almost US$6 trillion in assets, an increase of over 60% since December 2019.

While maintaining cash reserves is crucial for unexpected emergencies, having too much cash can be a barrier to achieving long-term goals. Clients might need a gentle push to shift excess cash into investments that are more aligned with their long-term plans. Cash rates do not benefit from falling yields in the same way that many other risk assets do. For instance, fixed-rate bonds see price appreciation when yields decline.

In a discussion moderated by Franklin Templeton’s Head of Canada ETF Product Strategy, Alex Lee; Naveed Sunderji, portfolio manager and research analyst at Franklin Fixed Income and Adrienne Young, senior vice president, portfolio manager and director of Credit at Franklin Fixed Income detail how cash exiting money market funds is likely to move to shorter-term bonds.

Inflation trends in Canada and the US

 “We've seen a significant decline in inflation metrics since their peak in 2022. However, recently, there has been a divergence between Canada and the US,” Sunderji explained. In Canada, discretionary goods, such as clothing, footwear, and household equipment, have experienced a notable retraction. In contrast, US inflation is more broad-based, with shelter, medical care services, and transportation services contributing to higher rates.

The economic growth patterns in Canada and the US have also started to diverge. Historically, these trends were closely correlated, but recent developments have shown distinct paths. “In the US, growth is driven by government spending on infrastructure, the Inflation Reduction Act, and strong consumer spending supported by excess savings, wealth effects, and a robust labour market,” Sunderji noted. Business investment and net exports also contribute to US growth.

In Canada, however, growth was initially driven by government spending and a strong housing market. Higher interest rates have since pressured home purchases, with some easing due to interest rate cuts. Despite being more leveraged than their US counterparts, Canadian consumers are still spending less. Significant immigration has masked underlying economic issues, leading to softer GDP growth in Canada.

Drivers of economic growth in the US

Young, added insights into the labour market's role: “In the US, unemployment has ticked up slightly to 3.9%, with wage inflation around 4%, complicating efforts to reduce inflation to the Fed's 2% target. In Canada, unemployment has risen to 6.1%, and wage inflation is closer to 3.5%, which gave cause for the Bank of Canada’s June 2024, 25 basis points rate cut.”

Due to the divergence of growth between Canada and the US, the roadmap for future rate cuts by the Bank of Canada remains unclear.  In this environment, active management in fixed income can play a critical role in helping to mitigate risks while taking advantage of opportunities. 

Opportunities in Canada are in ultra-short-term bonds

At Franklin Fixed Income, the focus is on two popular short-term fixed income strategies: the Franklin Canadian Ultra Short Term Bond Strategy (TSX: FHIS) and the Franklin Canadian Short Duration Bond Strategy (TSX: FLSD).

Of the strategies, Sunderji highlights, “Our Franklin Canadian Ultra Short Term Bond Strategy (TSX: FHIS) starts with our money market securities, which represent the cash and cash equivalent aspect of our portfolio. These securities are composed of high-quality commercial paper, bankers' acceptance notes, and provincial bills, making up roughly 35% of our total holdings.^[1]

“These assets are crucial for providing low volatility, stability, and liquidity to the fund. They enable us to take advantage of potential opportunities as they arise on a day-to-day basis and help us avoid being forced into selling in challenging market conditions.

“The liquidity provided by this 35% allocation in money market securities also allows us to have exposure to corporate bonds, which offer higher yields and give us the flexibility to include more corporate bonds than the benchmark. Additionally, we have a securitization bucket consisting entirely of triple-A rated senior debt, further enhancing the stability and quality of the fund.”

Investment approach

A short duration bond fund is attractive right now because, at the short end of the curve, investors are seeing the best yields since the Great Financial Crisis due to the inverted yield curve. This means investors don't have to extend their time horizon significantly to benefit. We believe short duration bonds offer real opportunities. This duration, typically around two to three years, is more advantageous than ultra-short bonds.

However, as Young points out, the economy is entering what Jamie Dimon (CEO of JPMorgan Chase) has referred to as the most complex and dangerous period since World War II, as noted in his annual letter to shareholders. There is significant uncertainty due to trade friction, AI, climate change, energy transition, and rapid fiscal and monetary policy changes. Young believes this will lead to a recession in Canada more so than in the United States.

The key advantage of Franklin Canadian Short Term Bond Strategy (TSX: FLSD), is its leverage to manage risks and uncertainties while also giving investors the potential of capturing the upside.

Young says, “We anticipate outperforming the Canadian short duration benchmark because of our diverse levers. We invest in Canadian dollar government and corporate debt, typically overweighting corporate bonds for better risk-adjusted returns. We also invest in Canadian ‘maples’ (US bank bonds sold in Canada) for better yields, preferring diversification into US banks over Canadian ones due to their exposure to Canadian corporates and mortgage holders. Additionally, we buy US insurance company SABNs, high-quality secured bonds with comparable yields to Canadian bank bonds but with higher credit ratings.

“We invest in junior preferred securities from top-quality Canadian issuers, which are not included in the Canadian index but offer excellent compensation. Diversification outside of Canada is crucial due to the Canadian bond market's limited scope. The US market provides access to sectors like aerospace and defense, engineering and construction, technology, and pharmaceuticals, which are not available in Canada.

“Our portfolio typically has about 25% in US dollar-denominated bonds, but only 10% exposure to non-Canadian currencies after hedging. Currently, we favor the US dollar as a natural hedge for the Canadian economy.”

Looking at FHIS specifically, the fund has consistently outperformed its benchmark^[2]. Whether over the short term (one, three, and six months) or from inception to one year, the fund shows consistent outperformance, generating alpha through active management. This demonstrates consistent outperformance both in the short term and the long term.

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^{The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market.}

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