TDAM Talks Podcast: Always Darkest Before the Dawn - Perspectives Beyond the Volatility

NARRATOR: 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.

INGRID MACINTOSH: As we record this week's podcast, the Bank of Canada has just made its sixth rate move of the year for a total of 350 basis points.

Fixed income markets have delivered a negative year-to-date return of close to 12%, and equity markets are off 15 to 20%. So, it might surprise you that today we're going to take a more optimistic view.

Joining me today to look at the future state of markets, discuss some of the bigger trends we're seeing in investing, is Michael Craig, Managing Director and Head of Asset Allocation here at TD Asset Management.

Hey, Mike.

MICHAEL CRAIG: Hi, Ingrid. Thanks for having me.

INGRID MACINTOSH: As always. So, I wanted to start off with the big question about, you know, how we're looking year-to-date. But first of all, how are you feeling about the bank's move today? Were you surprised by 50 versus 75? What are your thoughts?

MICHAEL CRAIG: I think there's been a handful of signals over the last ten days that are indicating that central banks around the world are starting to slow and ultimately end this hiking cycle.

There was a leak in the Wall Street Journal last week just before the blackout within the Federal Reserve, indicating that they may slow the pace of hikes.

There's been lots of press happening. There was an intervention, the Bank of Japan. So, today's move of 50 surprised the market. You know, I can't say we were going in with a huge, strong view one way or another. But the fact that we are starting to slow down and ultimately, we see the end of this hiking cycle, I would say within a few months, is not surprising.

I think you're starting to see material slowdowns across the global economy, which is telling you that this tightening of monetary conditions is starting to bite into the actual growth prospects across most of the world.

INGRID MACINTOSH: Let’s pull the lens back a little bit. And, you know, as we're coming in towards the end of the year and then looking forward, where do you think we stand right now? Like how are markets thinking about inflation and recessions, etc.?

MICHAEL CRAIG: Yeah, we kind of used this phrase the Fujiwara effect earlier this year. And a Fujiwara effect is when you have two cyclones approaching one another and those two cyclones in the market were inflation and the inevitable slowdown or recession.

And I think ultimately that inflationary story, while still a problem, is losing altitude. But now we will shift into some type of recessionary outcome in much of the global economy next year. Not necessarily a bad thing.

I think the markets typically be in the fore discount that they have already priced some of this in, some more than others. But that will be the story of ‘23, it will be recessionary conditions across much of the global economy.

INGRID MACINTOSH: We say that there's a pitter patter probably overlaying our mics here as we hear more construction going on around us outside as more skyscrapers go up. Okay.

So, you know, we're looking at this, as I said, we've seen bond yields at a pretty high levels here and we've seen the selloff in equity markets. When we look at what we're seeing investors and advisors doing, we're seeing some not surprising, maybe a little bit alarming trends. You know, you and I have talked about this.

We're seeing huge balances in high interest savings accounts. We've seen huge growth in clients and advisors putting their money in GICs, whether they're traditional or cashable. It really feels like a sit back or a take refuge approach.

What are your thoughts about that?

MICHAEL CRAIG: So first, a couple of things. For fixed income investors or conservative investors, I think 2022 has been worse than ‘08 for them. I mean, 2022 really is a one-in-100-year flood for conservative investors.

Bond indices at one point this year were down more than double the previous horrible, horrible year over the last hundred years. Like, you just don't see these things every day. And one thing you can learn from these types of episodes is, you know, after 2008, 2009 was pretty good. 2009 was recession everywhere and investors made huge, huge returns.

So, I would say, first off, history would tell you that when you do have these big shocks and horrible years, you typically see abnormally high returns the following year. So that's just, that's an empirical fact. The second thing is, there has been a shift into GICs.

I would say that's a fair point. Bond funds today that hold investment grade – we're not talking about kind of riskier debt - but investment grade, corporate debt or government bonds are yielding give or take 5%, which is materially higher than most GIC rates.

INGRID MACINTOSH: We haven't seen that in a decade.

MICHAEL CRAIG: And right now, if you were to buy a collection of bonds, most are trading at a discount, you know, $0.85, $0.90, etc.

So, it's hard for me to see that if we were having this conversation a year from now, that bonds will have underperformed GICs.

It could happen, you know, could happen for sure. But I'm in the business to, you know, to look at opportunity sets, and I would say that the opportunity set right now is in fixed income. I mean it really is a pretty compelling place to look at.

So that's one aspect. And the other thing with fixed income, which is important, is that the return, you know, we often as investors, I don't typically spend a ton of energy on this, but most clients should. Is that you got to think about tax.

And the return from a bond fund because of that capital gain element because bonds are trading at a discount, will be far more advantageous because a part of your return will be capital, won't be taxed as high. And so, your after-tax return has been materially higher than a GIC over the next 12 months.

INGRID MACINTOSH: And so even if, even if you could imagine rates going slightly higher between your coupon yield and your price appreciation, you have some defense against that and then potential upside from where we are. And then let's sort of go out the curve to people that are in a mixed portfolio, stocks and bonds, 70/30, 60/40, etc.

What's the outlook there?

You know, when you compare that to either taking refuge in GICs or people believing GICs potentially are a long-term investment vehicle at these rates.

MICHAEL CRAIG: So, I would think, and there is a lot of internal debate on this, and I would say that not everybody has this view, but I would say that equities should be under pressure for another couple of quarters. That manifests in a couple of ways - you could see a price decline, or you could see, you know, things going sideways.

But I would think that we're still… the economic backdrop is still starting to weaken. And it's totally in the realm of possibility that we see equities under pressure for the next six months. On a 12-to-18-month horizon, again, once you see that and again, empirically speaking, when you do see the trough in equities after a recession, you do tend to see your most powerful positive returns.

And so, while there's probably, you know, some volatility ahead, again, if we're having this conversation in 12 to 18 months, I struggle to see how a simple 60/40 portfolio has not lapped a return of a GIC. Like when I say lapped, I mean 2 to 3 or 4 times higher, you know, if you had 3% from GIC, I mean it's completely conceivable that you see double digits within a balanced portfolio in a 12-to-18-month horizon.

And that's just, you know, we're at a very you know, we're getting depressed levels. Earnings are going to start to slow down over the next six months. But we'll have that reset. And again, it's almost like that, you know, it's always darkest before dawn. And we are certainly in a...

INGRID MACINTOSH: It’s been dark...

MICHAEL CRAIG: Well, I think we are within a month or two of... as a part of me thinks you've already seen it... I think a month or two from the kind of the peak weakness of fixed income, the markets are pricing hikes into kind of February next year.

I think that actually probably comes closer to January, even December. And ultimately, bonds bottomed out three months before recession. And I think we will be in recession very soon if we're not already. On the equity side, again, some weakness ahead over the next six months. But, you know, you've got to be sharpening your pencil and looking at the opportunity set over the next half year. As again, you're going to get those once in...

You know, if an investor if the markets have kind of 7-year cycles on average, it's one of those kind of 1 in 5 or 1 to 6 times in an investment career that you really do earn a lot as you get that rebound from recessionary conditions.

INGRID MACINTOSH: And the reward for taking risks going back to the GIC narrative just to cap it off. While we're seeing much higher nominal posted rates on GICs, we still have a negative real return on them, right? Like we have to…

MICHAEL CRAIG: Well, well, well below inflation rates.

INGRID MACINTOSH: So, a negative real return and for every dollar in a GIC you're losing your purchasing power.

MICHAEL CRAIG: So, remember you... inflation right now is at six, it will come down. GIC rates, give it three or four before tax. You throw in the tax, and you're left... You know, I get people sleep at night because they know they have certainty. But you are giving up a lot of upsides or if you have horizon that's greater than 12 months. Okay.

So, let's talk a little bit about the Asset Allocation Committee then. As you as you’re a member and you manage the asset allocation strategies for TD Asset Management, what is the view and has that shifted from the WAAC's perspective. So, we went to a modest overweight in fixed income a couple of months back. We have a time horizon of 12 to 18 months, so we don't try to nail the perfect day.

We say, you know, this looks good, looks right, you know, bonds have since slowed up, but now they’re starting to rally and a fairly neutral view on equity. You know, I think that group is looking at this being, you know, a well-advanced bear market and are looking for kind of a list of conditions that we want to see mostly met that will make us comfortable, that we want to move to an overweight position in equities.

And so that would be more a currently neutral but looking for a few things to kind of, you know, check off where we can get a bit more constructive on risk within the equity, tend to favor Canada which has been, well, down this year, has been a standout globally.

Canadian market has outperformed almost all, certainly all, developed bourses on a Canadian dollar basis and most emerging markets this year. So that's you know based on... that's part of that's based on our materials and energy exposure.

Neutral in the US and then underweight international, which has been a really tough particularly in currency terms. So as a Canadian dollar investor really been tough this year in Europe or the UK or Japan. Those markets are down a lot and when you factor in the currency aspect, they're down a ton for a Canadian investor. Those areas are from a valuation basis very attractive, but yet still require a catalyst. And of course, with the, you know, the war in Europe, the ongoing political saga in the UK, they are...

They are... It is a bit challenging right now to want to take exposure in those markets, although they are very, very cheap.

INGRID MACINTOSH: Let's talk beyond asset class. Let's talk about the power of active management in a market like this and the tools that you have available to you.

MICHAEL CRAIG: So, when volatility is high, that tends to be when we thrive. I was at an investment lunch yesterday and the speaker made a very important comment and that is... it is a decade for active investors because of that increased volatility.

And we could spend the next couple of hours discussing about how the world is materially different than it was pre-COVID, both in terms of geopolitics, on trading relationships, on the kind of increasing tensions between China and the U.S.

A more challenging world does provide a much more richer opportunity set.

It also provides a lot more risk.

And so, from our perspective, you know, had a tremendous amount of tools that we can use at our disposal to earn higher returns for clients, but also manage the risk. You know, we're quite active in the options markets, right? We'll use those markets all the time to set up a better outcome for clients using insurance type strategies. And so, these are types of things that from as an active manager kind of critical to thrive in 2022.

INGRID MACINTOSH: So, it's like heading into a storm but knowing you've got all the tools and all the attire and look forward to it.

MICHAEL CRAIG: Yeah. And also, what we do, what we did five years ago or ten years ago or 15 years ago. It's all evolved today. And I would say that if we were having this conversation five years from now, you look back and say, all we're doing, these are the things that we've kind of added to our arsenal of tools that we'll see come over.

And I always have more to say about that in the next 12 months or so. More and more types of strategies or techniques that will come online. As you know, the nice thing about capital markets are always evolving, and that's also an area where we're looking at adding new things to our tool set to help with the risk and return for our clients.

INGRID MACINTOSH: You've been talking a lot as we've been talking. I want to drill a little bit into just how attractive fixed income is going forward and why, like, you know, from where we're starting today, I feel like that penalty that savers or conservative investors have had for the last 14 years is being alleviated. But what makes you so optimistic about fixed income going forward?

MICHAEL CRAIG: So, it's for income centric investors. It's really been a 12-year bear market. Your returns look okay. But the yield from those investments, particularly in the fixed income space, has been suppressed.

And it's been suppressed because of very abnormal monetary policy to stem, you know, the fallout from the global financial crisis. We essentially have, you know, there was a decision where one part of the economy healed at the cost of income investors. And that period has now passed. And while inflation is high today, it's hard to see...

I struggle to see inflation, and I don't think we're going back to the 1% era of the previous decade. But I also don't think that it's going to be anywhere near where it is today for a long period of time, because the backdrop is, well, probably a bit more inflationary. Not nothing in the backdrop is indicating that you're going to have hit of hyperinflation.

And if there's one thing you can learn from what happened in the UK recently, the bond market is back and enforcing fiscal deficit discipline on governments, as Liz Truss unfortunately just found out. So, to me, that backdrop is pretty supportive of fixed income. It's going to ensure that governments don't kind of go crazy on fiscal spending because they can't afford to.

And also right now, when we look at kind of forward projections of inflation, you know, those are in around the range of 2%. But you can buy a 10-year corporate bond right now and earn 4.5, 5%. So, there's a huge spread over an expected inflation and actual yields today. And so, to get a real return above inflation in fixed income is kind of a first in a long time. And that's why I think for investors it provides a tremendous amount of value today versus the last, you know, since I was in my early thirties, which is a long time ago. So that's kind of where the mindset is on the fixed income story.

INGRID MACINTOSH: That's feeling like some good news like I'm telling you, better fixed income, more optimistic, longer term about equities.

MICHAEL CRAIG: I think for income investors. So really, really optimistic. Now I do think there's going to be some volatility in equity. But, you know, for dividend stocks now, you know, 4 or 5%, not too bad. I think you're going to see high yields weaken over the next little while. But high yield, in about 6- or 7-months' time, high yields going to be really, really attractive.

And so, I'm you know, I'm kind of looking at this and saying the opportunity set is getting really, really rich. And it's one of those again, one of those periods of, you know, in the cycle where it's like we can make a lot of return for our clients, we've got to make sure we get it right. But ultimately, this is where it gets really exciting because you do see those opportunities are starting to unfold and that's kind of where our group is thinking right now.

INGRID MACINTOSH: I don't let anybody off on this, so I'm going to hit you now with a couple of my rapid fires. You've touched on them a little bit, but I’m going to throw them at you again to get your sense on these things. So first of all, the inflation.

MICHAEL CRAIG: Going lower.

INGRID MACINTOSH: Excellent. Pension gilt crisis we've seen in the UK.

MICHAEL CRAIG: Train wreck. Yeah.

INGRID MACINTOSH: With a warning shot.

MICHAEL CRAIG: Well, I mean, look, a lot of this was baked in with Brexit, right? I mean, if you materially rip up trade agreements with your largest trading partner and restrict the flow of capital and people between those two blocks, you by definition lower the potential that your country can grow.

And that's already baked in. And that was a political decision. It is what it is. And now you're seeing the fallout. I mean, the UK has had four finance ministers in the last four months.

So, these are capable people and all of them failed. And I think that the crazy things about recessions are... they always expose the weakest links, and this is the first one and there will be more exposed. I have no doubt there will be some degree of financial accident in the global market over the next six months.

It always happens. Always, always, always. And so, I think to me, in many ways, it's like, you know, you have a friend that does something really, really dumb and you're like, I better not do that right. And I think other countries are looking at the UK as an example where, you know, inflation is not something central banks can create or really can control, they can moderate it, but it's essentially a function of policy and the UK's policy has been horrible and now they're paying for it.

And so it'll pass and you know, cooler heads will prevail and they'll set a course... you know, they'll set a course for probably better days ahead. Still, their institutions are still very strong. But it is an example where, you know, poor policy has huge implications on a multi-year basis. We forget that sometimes, usually you need to study history to see it, but it's a real-life example of a real screw up.

I would say... this is not a political statement, just like if you want to... if you had a vote that would really hurt your wealth, vote yes. And your wealth goes down. You vote no, it doesn't. An aggregate. They chose yes, to have their wealth go down because of further political reasons. And I think the way it was framed, you should never, you should never have had a decision like that go to a vote.

INGRID MACINTOSH: As a lover of history and as given your focus on regimes. Last one I'll throw at you is the concept of déja vu. [laughs] Have we been here before?

MICHAEL CRAIG: I would say that is becoming increasingly clear that the period of the 1991, to call it 2020 was a vacation from history. And we are going back to a world where geopolitics matters a lot more, that the era of kind of everyone getting along is probably over and we should expect more conflict globally.

And that's where... and history is riddled with that. I mean this is not something new. We’re in, again, this is, it's a bit unnerving, I'll be totally... not to end on the negative. But these are things I think that are really important to take account of. And this is why this profession is fascinating. You know, as much as you have to be solid in math and economics and finance, history, sociology, political science, game theory are critical skills.

And it is, it will force investors to continue to build their various ways of thinking because I think we're going into a world where I think it's more than just the numbers. You have to understand the game and the implications of a kind of great power struggle across among countries. And, you know, whether you think about German and European energy policy or trade and high-tech goods or innovation, how it's going to be shared, it's not 2015 anymore. It's changing rapidly and you've got to be on top of it.

INGRID MACINTOSH: I think that's a great place for us to wrap up, not only our listeners getting a sense of, you know, the things we expect you to be thinking about as an asset manager and an asset allocator. But literally the breadth of considerations that you and your team are looking at every single day as we try to protect and grow the assets of our clients.

So, Michael, thank you so much for joining me today.

MICHAEL CRAIG: My pleasure. Thank you for having me here.

INGRID MACINTOSH: We'll circle back in a few months and see how right you were.

MICHAEL CRAIG: Can't wait.

INGRID MACINTOSH: For our listeners, you can find our recently published Wealth Asset Allocation Committee perspectives on the TD Asset Management site, along with more of our thought leadership and commentary.

You can also receive the latest expertise and updates from TD Asset Management by following us on Twitter @TDAM_Canada and on LinkedIn at TD Asset Management.