TDAM Talks Podcast: Beyond Fixed Income and Equities - Navigating the Market Inflection

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.

INGRID MACINTOSH: Hello and welcome to this week's edition of TDAM Talks I'm your host, Ingrid McIntosh, here at TD Asset Management. And today we are going to be talking about asset allocation. Here at TD Asset Management. We manage over $100 billion in managed solutions or asset allocation strategies, where our portfolio managers marry many of our disciplines, equity, fixed income alternatives together to meet the needs of our clients.

Today I have the pleasure of being joined by Jing Roy, Senior portfolio Manager on our asset allocation team, and Jimmy Xu, also a senior portfolio manager on the asset allocation team. Welcome both.

JIMMY XU: Happy to be here!

INGRID MACINTOSH: I am so happy to have some fresh voices here to speak on the podcast today. Both of you have been with TD Asset Management for quite some time. You’re real leaders. You're well known on numerous venues: BNN Money Talk. You speak frequently at client events. But before we get into this podcast, I'd love to let our audience know a little bit more about you.

So let's start with you. Can you tell me a bit about you and your background and how you contribute on the asset allocation team here at TD Asset Management?

JING ROY: Sure, I'd be happy to. I'm a member of TDAM’s multi-asset portfolio management team. With a team approach, we manage global strategic, tactical and absolute return asset allocation strategies for TDAMs managed solutions.

I have been with TDAM for close to ten years. Before that I studied finance, economics and math in school and I cut my teeth as a sell-side equity analyst and rotated through a very long list of sectors. And as the years went on, my coverage moved to sectors with a stronger macro underpinning. So that's a huge blessing for me because it allows me to work out how to integrate bottom-up fundamental analysis with the top-down perspective that we require in the asset allocation team.

INGRID MACINTOSH: Yeah, really bringing so many different lenses to the decision-making framework based on your background. I saw you speaking recently about options with Greg Bonnell on Money Talk. Great clip. Can you tell our audience a little bit more about you, your background and the role that you play with respect to our asset allocation team?

JIMMY XU: Sure, Ingrid. I absolutely love options. Coming from an engineering background in math and I think options in particular is the most perfect mathematical instrument that an asset allocator can use. If you think about it, what an option entails - it has stock risk, which is fundamentals. Interest rate moves, impact asset pricing, which is macro. Volatility is really a manifestation of market behavior.

So you put all that together wrapped around in one neat instrument. It becomes really powerful. And on the asset allocation team options is a very important tool that we use to manage not just risk, but also to take advantage of market dislocations.

INGRID MACINTOSH: And I think that people often think about asset allocation as the the long only classes, the equities, the fixed income, the alts. But really options are another tool that you have to gain, reduce, etc. the exposures. I can imagine you telling that story and I feel like you're playing a video game and you've got all these different leaders and you're just the happiest you've ever been.

So, let's boil it down a little bit. Let's start talking about what we're seeing in the markets, how we're playing things out. I know there's been a lot of focus on bank of Canada finally maintaining its policy rate at the last meeting. What do we think, Jing, with respect to hikes - are we done? Are we going further? What's the sort of the view of the asset allocation team right now?

JING ROY: So right now, what we're seeing is that we're closer to the end of a tightening cycle, which is something to celebrate. What it means for the equity market, and asset market in general is now we're past a peak expansionary phase and slowly inching towards slow down and finally slipping to a mild-moderate recession phase that we're looking to experiencing towards the end of this year or beginning of next year.

So this is all caused by the tightening credit condition that's part of the end outcome of a tightening cycle. So that's what we were expecting. So here's the good news As we approach peak rate, the bond equity correlations start to work again. Unlike last year where bond and equity go down in sync, it was very hard to manage risk in the portfolio, especially for conservative investors.

INGRID MACINTOSH: But this year, Bonds will start to work because the growth will start to slow down. And we're looking at yields that haven't been this high in the past 20 years. So, it's very attractive. Yeah, I really think about there's been, you know, ever since the financial crisis of 2008, we've had this like structural penalty on savers where you really couldn't be at the low-risk end of the spectrum.

Now we've had this meaningful correction in yields which was painful to ride through in 2022 and to your point, we saw both both asset classes going against us, but now we've seen that repricing in fixed income and the outlook is is looking better. Can you talk about the Asset Allocation Committee's view with respect currently for our listeners to fixed income and equities?

I know we're still maximum overweight fixed income, but maybe a little bit more of the view there.

JING ROY: We are maximum overweight, fixed income because that's the best asset class on the risk-adjusted basis and from a total return perspective. So maybe put it in a context of broader asset class where we have our choices, our picks from. The biggest contender, of course, is the equities.

Now the bad news in this cycle is that equities actually will have experienced a tug of war because right now the markets start to price in a rate cut expectation which supports the valuation multiple of the equity. By the same time, you're facing the kind of revision downwards a cycle of downward revision for equity earnings. So those are opposing forces which makes equity return a bit more challenging in this environment.

As a result of that. It's better to be in fixed income where the return is more stable, and the yield is very attractive. So you've got the yield plus you've got potential for rates to move lower from where they are here today, providing that that capital benefit as well, the fixed income continuum. I know we recently had David Sykes and Justin Flowerday on our podcast and David was reiterating the view with respect to fixed income but also, you know, hopefully later this year and early next year, there's going to be a series of signals that we see when that will tell us, Yep, it's time to be back in.

INGRID MACINTOSH: And I certainly think, you know, we've seen a lot of investors sitting on the sidelines, sitting in safer asset classes, even going to cash, waiting the storm out. So I like the language that you're using, showing and sort of peak rates and maybe coming to a little bit more visibility. That is that's terrific. Jimmy, can you talk a little bit more about sort of that equity outlook and the views of the Asset Allocation Committee?

JIMMY XU: Sure. If you think about what's happened this year and you just focus on the headlines, there's a lot of worry, a lot of concerns when you actually look at equity returns this year, S&P 500 TSX Index are up in the mid-single digits. I think that's pretty respectable for a four-month period of time.

INGRID MACINTOSH: If it weren't for 2022.

JIMMY XU: Yeah, absolutely. Obviously, we're coming off from a very, very low base. But when as you dig a little deeper, especially looking at S&P 500, the breadth of this rally has been very poor. It's just been centered around technology stocks. Now, sort of that the average S&P 500 stock has actually not done very well. And when we look forward, I think that's very complementary to what Jing has said is that our outlook for equities - it stills remains cautious.

When we look at things like future earnings, we continue to expect that to decline. Look, valuations, especially compared to fixed income equity, doesn't look cheap at these levels. When you put these two things together, we're expecting very muted returns. But obviously it's not going to stay like this forever. It always seems darkest before dawn when we look forward.

If there are a couple of things that we're looking at should become more comfortable in adding risk to our portfolio, in particular equities. And obviously one is inflation. That's been a hot button topic over the last year or so. Now we will continue to see inflation to continue to decline in a more sustainable fashion for equities to get - for us to become more comfortable in equities, we also need to see a risk blow off.

Things kind of look pretty calm. We had the VIX index trading at around 17, which is the long term average. We'd like to see that spike as well. It's like a final wash out of positioning, shake it off so we can start we can start fresh. We need to see financial conditions to continue to improve. Its tone improved a lot this year after some of the banking crisis that we saw in the US.

But we need to see that to be more sustained. So once these things are put into place, then we'll be more comfortable in adding equity risk. Certainly now, today, is probably not the time for us.

INGRID MACINTOSH: So again, managing huge portfolios, huge asset allocation portfolios in markets that are probably lacking some liquidity, I'm going to ask you the question first, Jimmy, because you're going to tell me how much you love options.. We're going to talk about how do you manage your exposures and how can you manage to be nimble against this kind of landscape and this operating model within.?

JIMMY XU: That's a really great question. If you think about what we're focused on, it is we're trying to not get influenced by short term noise. We have the very strong, a disciplined investment process. We look at where things are-not just where they're now, but really where they're going three, six, one year to year out. And that really grounds us in how we shift our portfolios where we need to be.

But on a shorter-term basis now, I really have to go back to options - it can add a lot of value. You can make you can add value in options in markets that don't go anywhere. We can make, add value, in markets where trends are both up and down options market give you the flexibility to do so. And that's a very important part of our toolkit within our asset allocation team.

INGRID MACINTOSH: Yeah, so you're talking about it from a return adding, but also maybe talk a little bit about the risk benefits, how you manage risk with options.

JIMMY XU: Yeah, so options can give you great levels of protection. So there are times where you see markets get really nervous and a certain behavior happens in the market and you can buy protection on the downside where you're worried about market sell off and those protections can sometimes pay 7 to 1, 8 to 1. So imagine your house catches on fire, you have that protection in your portfolio and then they give you basically your replacement value and that's the value of options that gives you in a time where there's lots of uncertainty.

INGRID MACINTOSH: Yeah, it really is Certainly in this type of landscape, having a wide toolbox like that's incredible. I'm talking same sort of question to you. How do you think about it? How do you stay nimble in a market like this?

JING ROY: I think philosophically we're very differentiated because we have to avoid being very deterministic. We have to look at the probability of a change in probability of different range of outcomes.

So with that process and mindset in mind, that gives us a foundation to being nimble and use appropriate tools to express our view. So everything we do has a purpose in mind and for an asset allocator, it's great that we have a very wide toolkit to use. Option is one where we can use option to structure a certain structure where you can strip out the constant predictable component of the cash flow and then leave the volatile part out.

INGRID MACINTOSH: And that's something we can structure nicely for investors. And second, because we have a wide toolkit, some of the assets are not publicly available. So infrastructure, for example, it's tapping to a secular trend of energy transition and some of the capital structures on those infrastructure deals are very attractive and not not susceptible to interest rate hikes.

JING ROY: So those are kind of the tools we can use to make sure that we preserve capital in this kind of a transition period. And then we have the full force behind us when it's time to take risk.

INGRID MACINTOSH: And I think that's really differentiated for us here at TD Asset Management: the equity, the fixed income, the alternatives, be it infrastructure, be it private debt, be it, you know, real estate globally.

So many other tools that we can add to generate uncorrelated outcomes relative to the more traditional asset classes that people would have access to and then to dynamically manage them through the market. With the information we have and the tools we have. That's really such a compelling, compelling start. I love this conversation. So whenever I do my podcast, I'm a little bit known for the “Lightning Round.”

INGRID MACINTOSH: Are you ready for it?

JIMMY XU: Absolutely.

INGRID MACINTOSH: Oh, word or maybe a couple at you. But thematically, it's just sort of I want to get your quick reactions because some of these are hot button topics. First of all, Jimmy - “GICs” and the trend towards GICs as an investment vehicle?

JIMMY XU: So, if I were to have a one word response, it would be suboptimal. But let me expand on that. So, if you're an investor and you know you have cash needs within the next six months, next one year, a GIC with 5% interest or it's absolutely fantastic choice. I'll take it. However, most investors are not in that place and our role as portfolio managers is not just to be enough of a status quo.

5% seems attractive, but how do we do better? I think within fixed income, your offer that opportunity, you get similar yields, but you also get the potential for capital appreciation as interest rate. If interest rates come down, as we would expect, not only does that give you a capital gain, but also can protect you against other parts of a portfolio that may have a little bit more risk.

So GICs - if your saving grace, but we can definitely do better.

INGRID MACINTOSH: For the long term investment outlook. That is a short term. And I mean, even today they're just barely covering inflation, which means every day you're sitting there, you're losing the purchasing power of your dollars. Again, let me give you a sticky one Jing: “Canadian home prices”

JING ROY: “Time Correction” - Let me expand on that. I think the process for normalizing to a level that's consistent with the interest rate outlook, it it will take time because most of the mortgages are basically interest only and people can extend the maturity of those mortgages.

So the point of reckoning will be extended also it’s very manageable unless the employment start to crater. There's a good saying if this just you know, if you keep your job, it's just a recession, but it's the end of the world if you lose your job. So the housing outlook, it really is that delicate dance of population growth from immigration, the household income resiliency coming from the unemployment, a number you will receive and the policy rate.

INGRID MACINTOSH: And I think now that we're seeing more visibility on the right path, I think people's confidence is improved. And even beyond that, I think we've taken a lot of the steam off of what we saw in the COVID peak. But I think even there's that to your point, there's that demographic, demographic tailwind in Canada that's going to continue to support us.

I can ask you both this next one, and I'm going to declare a personal bias because my husband's a geologist. But Jimmy, where are you on “gold?”

JIMMY XU: I think gold is very correlated right now to other asset classes. So if you look at the recent rally that Gold had and look at the drivers, it's a function of lower interest rates. It's a function of lower US dollars, which is partly also a function of lower interest rates. So in terms of gold, it's looking a lot more correlated to fixed income than than what people are used to. 

INGRID MACINTOSH: And your outlook going forward from here?

JIMMY XU: But I think if interest rates continue to decline from these levels and if the US dollar continues to decline from these levels, you should see gold continue to rally. But there's a lot of crosscurrents. Inflation starts to pick up again. Central banks need to reprice their interest rate expectations. Then it's a totally different, different narrative.

INGRID MACINTOSH: What about you Jing?

INGRID MACINTOSH: Where are you on gold?

JING ROY: Constructive. Let me expand on that. Gold typically outperforms when the real growth start to taper down and the financial conditions start to loosen. And there could be two reasons why financial condition can be loosening. One is policy mistake you cut too early - the growth is still hot and inflation's still hot.

INGRID MACINTOSH: The other is that the growth is truly slowing down and the central bank is cutting rates in sync with that slowdown in inflation. So in those two scenarios, both would work and more near-term. When we look at the gold's appeal as an alternative store of value, especially when we come to the saga behind the debt ceiling, which puts the full faith of the U.S. dollar in question, I think that in the short term, I'll give “gold” you a nice boost like that.

Oh, look, I'll let my husband. So now I'm going to give you another tricky one here, guys. And for our listeners, we are recording this on Tuesday, April 25th. So there is a little bit of a bias here in terms of what we already know. But Jimi, what's your call on the (Toronto Maple) Leafs?

JIMMY XU: It's funny you say call. So as an office trader, someone who loves options, I think the optionality of the Leafs in the second round, the option has gone deeper in the money.

INGRID MACINTOSH: Okay, What about you Jing, are you a hockey fan?

JING ROY: Leafs all the way,

INGRID MACINTOSH: Leafs all the way. There we go. Great conversation. Thanks, guys, so much. And it's really been a pleasure to have this conversation. See how your different backgrounds or different perspectives bring such incredible tools to our asset allocation team on behalf of our clients. For our listeners, you can find our most recently published Wealth Asset Allocation Committee Perspectives on the TD Asset Management site, along with more of our latest thought leadership and commentary.

And as always, you can receive the latest expertise from TD Asset Management. Follow us on Twitter at “@tdam_canada” and on LinkedIn at TD Asset Management. Jimmy and Jing thank you so much!

INGRID MACINTOSH: Thanks for having us.

INGRID MACINTOSH:Thanks everyone. Have a great day.