TDAM Talks Podcast: After the Lift Off - Investing Through Inflation

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ANNOUNCER: TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management. 

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INGRID MACINTOSH: Inflation, interest rates, and bond yields. These are the subjects we are getting most asked about. Answering questions and joining me today on TDAM Talks, I'm welcoming Rob Pemberton, Head of Fixed Income at TD Asset Management. 

Rob, welcome. 

ROBERT PEMBERTON: Great to be back, Ingrid, lots to talk about! 

INGRID MACINTOSH: There sure is, so let's dive right in. We are recording this podcast the third week of April. Can you set us up with a view of the landscape? Where have we come so far with respect to the Central Bank's move, what does the interest rate landscape look like, and sort of where are we level setting in the yield environment? 

ROBERT PEMBERTON: Well, a lot to unpack there. And I think, first and foremost, investors should recognize that central banks have really turned their focus on inflation and their concerns about the impacts of how else we move forward on economic growth. 

So, the Bank of Canada most recently raised interest rates 50 basis points. There was a lot of talk about that being a first-rate hike of that size in over two decades. Let me assure you, at this stage, our thinking is that it won't be the last. And, 50 basis points may be the new 25, as central banks try and ensure that we get inflation expectations well anchored. And I think that's really what the goal is here.

Central banks – whether it be the Fed, the Bank of Canada, the Bank of England, the ECB, the Bank of Japan, even the PBOC are focusing more and more of their attention on inflation. And if we look at their forecasts, their inflation estimates for the next year and two years have raised across the board, irrespective of what central bank it is.

Now, there's a positive to that as well. That rise in inflation is driven by strong employment and upward revisions in economic growth. So, these two things go hand in hand and with both the employment and growth part of it being so positive, it is certainly being priced in by the markets that the economies can take a modest rise in interest rates and we expect to see that play out over the next year to year and a half.

INGRID MACINTOSH: In a moment I'm going to ask you about the drivers of inflation, but before we get to that, I know that as Central Banks start to move, people anticipate that we are going to see this cycle of rising rates across the yield curve. But can you level set for us – we've already had a fairly significant move, and where are we from that standpoint now when you look at Canada and US rates?

ROBERT PEMBERTON: So, I think it's important to break that down between different parts of the yield curve. So, the term to maturity of different parts of the yield curve have different yields in them, obviously. So, at the very front end of the yield curve, where central banks have the greatest influence on rates, we are seeing right now 8-9 rate hikes priced into the Fed. We are seeing another 6 to 7 priced into Canada. In Japan, they are actually pricing in rate hikes over the next year, which is a shock to many given what their monetary policy has been for what feels like generations now. And in the UK, they are pricing in another 6 rate hikes.

So, when looking through that lens, the front end of the yield curve is really starting to look really sharp and short rate hiking cycles in order to anchor inflationary expectations.

As we move further out the yield curve, we're seeing interest rates in the 10-year or 30-year part of the yield curve elevated certainly to what people have grown accustomed to during the pandemic. But still, from a longer-term perspective, not which I would consider to be harmful to economic growth or consumer behaviour. So, 10-year yields, in that 280 to 290 range, certainly feels high given where we've come from – remember back in August of 2021, that was 1.3? So, certainly a large move, but I think right now, if we're looking at it, it really reflects longer term outcomes. And I know that there's a lot of things that we like to talk about in the fixed income world in and around what's the terminal rate look like, what's the neutral rate, how does that play in the thinking and where we are today?

Realistically, the central banks are being given room to raise rates and that interest rate raise from a central bank's perspective is priced into the markets in a very sufficient way. The other thing that the longer end of the yield curve is telling us is that central rates can raise rates, but only to a certain extent. And then, there is the perception right now from the way things are priced out, that it will begin to have negative impacts on employment and economic growth going forward. So, while a lot is priced in, that a lot of potential interest rate hikes takes us to probably somewhere in the neighbourhood of 2.5, 2.75% from an overnight perspective – for at least the Fed and the Bank of Canada.

INGRID MACINTOSH: Ok, so let's cycle back – I promised I would come back to the conversation around inflation because as we've gone through the last 6-9 months, there's been different narratives around the root causes of inflation. It was transitory, it's structural...

Let's talk about some of the drivers of inflation and where you see us going from here. Let's maybe start with Covid and the impact.

ROBERT PEMBERTON: Well, certainly Covid continues to have an impact on supply chains globally and most recent significant outbreak in China certainly has the city of Shanghai quarantined as a result. Shanghai, obviously a large economic factor in global supply chains. Certainly, when we look at the raw base of the Chinese economy, right now, plus or minus, approximately 40% of Chinese GDP is shut in under quarantine. So, that will have a spillover effect. So those supply issues driven primarily by Covid, are going to be longer lasting as we would love to be done with Covid, but Covid isn't done with us.

So, the uneven reopening will continue to have implications on a go-forward basis.

I guess the second piece of it really to think about is the implications of the conflict in the Ukraine and what that means. Because that's going to have substantive longer-term, lingering, effects on inflation -- particularly in energy and in food.

INGRID MACINTOSH: Wow.

ROBERT PEMBERTON: And Canada is definitely known as a large grain export. So, through that context, thinking that through not only the immediate impact of the conflict as it exists, but the lingering impacts of planting later this year, or next year's planting, obviously, that carry on. So, I would expect to see heightened food inflation for the next several years. And with the Ukraine-Russia conflict also comes the Russian sanctions. And even if we see a settlement between Russia and the Ukraine on issues outstanding right now, my best guess is that those sanctions aren't going to come off anytime soon. Which, again, leads to a prolonged period of disruption from a supply factor.

So, those types of things I think are going to be impactful for a longer time period than you know, when central banks were using their transitory language, which essentially now has been completely tired. So, this persistence is going to remain. I perceive right now we'll probably see inflation in Canada likely average somewhere around 4% this year. And we may see it start to add next year, but again, we probably don't get back down inside of the Bank of Canada's 1-3% target range until the middle of '23 to the end of '23 right now, just looking at basic facts and some of the pieces that go together there. So, I think a persistence of inflation –

And if I can just circle back to central banks. Central banks have made it very clear that they can't solve supply chain issues with interest rates hikes. What the central banks are really looking at doing is anchoring longer term inflationary expectations, so that an inflation mentality or an inflation psychology doesn't set into the economy and start to influence consumer behaviour in a way that we would see it being very detrimental to longer term economic growth.

INGRID MACINTOSH: I mean that's really helpful because I think we were really following this narrative for quite some time of it being a kink in the supply chain that can sort itself through, you know, sort of like moving through the python – proverbial python – but I think as you're suggesting, it's going to be with us much longer and all the situations we are seeing around the world are only supporting that.

So, let's turn ourselves first to the Fixed Income portfolios. The teams you oversee manage over $175 billion dollars in fixed income assets. Given this backdrop, how are you looking at the tools in your toolbox to support client portfolios in a rising rate environment?

ROBERT PEMBERTON: Well, certainly, you know, the first tool in the tool kit is just interest rate sensitivity and then looking at what's priced into the yield curves, and does that make sense, and where is the opportunity? Many people listening to the podcast will have heard of the 2-year, 10-year curve inversion and the potential implications as a result of that.

2 years, 10 years inversion has predicted 6 of the last 9 recessions, so it's important to keep that in mind when people are thinking about hearing the headline news.

I think more importantly is thinking about how flat yield curves are this early in the tightening cycle. And, what that's saying to me, is we really need to be thinking about that form both a positioning perspective as well as an economic outcome perspective. So, within the portfolios right now, we're slightly shorter duration, and for those of you familiar, that means the term to maturity of the portfolio is less than the term to maturity of the broad marketplace in order to preserve capital in a rising interest rate environment. And looking at it through that lens, primarily right now prefer to be bar belled, another broad term --

INGRID MACINTOSH: - on heat term? Yeah?

ROBERT PEMBERTON: Exactly, what we really mean by that is we like to own really long term to maturity securities and really short term to maturity securities in order to reduce the volatility and protect capital in an environment where we're going to see greater rates volatility going forward. Within that structure, we prefer corporate credit, particularly in the front end of the yield curve, where the greatest clarity is for the business models in the environment that we are operating in right now. And as we move out the terms of maturity spectrum, we are moving up the credit clarity spectrum. And really, in an environment like we're in today where volatility is very heightened and the outcomes for potential pathways for economic growth are uncertain, we believe that a quality bias, in the current environment, is going to serve investors well.

INGRID MACINTOSH: So shorter duration to mitigate the impacts of the rising rate environment and use of credit to both enhance the yield, but in a way, that's appropriately compensated for the associated risk.

I'm going to take you up an altitude if that's ok and say from a Wealth Asset Allocation Perspective, how are we thinking of portfolios more broadly, and maybe speak to some of the tools that TDAM has at its disposal to support portfolio construction in this environment.

ROBERT PEMBERTON: So, for the Wealth Asset Allocation Committee, we recently met, and the thinking here continues to be around that broad diversity of potential economic outcomes and higher volatility both from a rates perspective, an inflation perspective, and broadly, a capital markets perspective.

So, in an environment like that, where we see best positioning for broad portfolios, continues to be a slight underweight to fixed income. But know within fixed income we have moved our sovereign government bond weight back to neutral from underweight and that really reflecting how much is priced into the markets now and what that means. But we still, from an overall waiting perspective have a mild underweight for fixed income as an asset class.

Continue to be overweight corporate credit, continue to be neutral inflation length, and we continue to be slightly underweight high yield simply because of some of the implications that higher interest rates mean in the volatility of those business models.

Where neutral equities overall from an asset class waiting perspective, we are maximum underweight international equities, and we are maximum overweight Canadian equities. And in the lens that we face today, with higher energy costs, higher food costs, and a rising interest rate environment, the Canadian capital markets are really set up well for that, given the exposures that we see there, the banking sector, the oil and gas sector, the ag sector within Canada. Really positive outcomes we see in that respect, and for the emerging markets space, the lens that I put on it when thinking of that allocation within fixed income – and it can be consistent across broader – is commodity exporters likely do very well, and commodity importers in the emerging space probably do really poorly over the next little while.

It's an idiosyncratic risk which I don't think you do yourself any favours for just buying in the index of that space. I think active managed is in there, is important.

Where we maintain our overweight, is in alternatives and real assets. So, where we can - private debt - clearly to us offers a great opportunity set and also real assets – so, infrastructure, real estate, commercial real estate, continues to be something that we see as being beneficial for long term outcomes in the current economic environment.

So, hopefully that frames that pretty well. I'd say we're feeling pretty neutral overall with respect to the risks that we are wanting to take in this environment of increased volatility.

INGRID MACINTOSH: And I think investors really should be focused on the long term, and I think what you really framed out for us is that, yes, we are in a rising rate environment, but we can manage that within the portfolios, and we do have at our disposal tools in the alternative space that can both enhance our yield, be inflation-sensitive, or supportive and provide broad diversification of the portfolios.

Rob, any last thoughts for our listeners who are maybe feeling concerned about the market lens, concerned about the opportunities, concerned about what the next 6-12 months look like. How are you feeling?

ROBERT PEMBERTON: Well, certainly, I think it's an environment that investors have to watch, but one thing I really caution investors on is trying to react to the headlines. There's going to be a lot of them that are going to come out, and some, pretty dire. To me, the big focus is still on the longer term and being comfortable with what your long-term goals are and being engaged in the markets that way.

Certainly, as you've pointed out, we've got a lot of tools in the toolkit, and in an environment where you're not compensated to take risk, preserving capital is a great outcome, and we are looking to do that on a real basis for clients. And that continues to be the focus.

From a risks perspective, I think the two major ones continue to be Covid – we are still in a pandemic, and what's going on in Asia continues to demonstrate the implications of that. And then, obviously the Ukraine-Russia conflict and an insogenist shock such as that is a real changer in the way we are going to have to think about outcomes, and certainly plays into that inflation pieces being more persistent and will take some time to bring back down, which is why central banks are going to act in a very sharp and short hiking cycling manner to deal with that.

INGRID MACINTOSH: Robert, thank you so much for joining me today. Clearly, your teams – your Equity teams, your Asset Allocation teams - are on top of all of the key issues and you're looking at it from every angle and listeners are gaining great comfort from your perspectives.

Thank you for joining me today!

ROBERT PEMBERTON: Great to be here and look forward to the next conversation, thanks Ingrid.

INGRID MACINTOSH: You're very welcome. And for our listeners, you can find our recently published WAAC Perspectives on the TD Asset Management Site, along with our latest thought leadership and commentary, and as always, to receive the latest expertise and updates from TD Asset Management, you can follow us on Twitter at @TDAM_Canada and on LinkedIn at TD Asset Management. 

Have a great day everyone and stay safe.