Let's Talk Investing: 2Q24 in review with the Multi-Asset Management team

Greg: 0:00

Welcome to our listeners. I'm Greg Sweet, a director of Scotia Securities Inc. Today, we'd like to bring you a new podcast to continue empowering our clients and help them make important financial decisions. We've now completed the first six months of the year and the second quarter had a few hiccups, but US equity markets saw the continuation of positive performance. Canadian equity markets were flat and fixed income made a comeback as the cutting cycle began for Canada and other developed countries. I'd like to take some time and speak directly with our portfolio managers on what has happened so far in 2024 and what we can expect for the remainder of the year. I've asked Scotia's multi-asset management team to chat with me today, and here are our special guests Craig Maddock, senior Portfolio Manager and Head of the Multi-Asset Management Team, as well as Wesley Blight, vice President and Portfolio Manager, on Craig's team. Welcome, Craig and Wes. Thanks again for being here.

Wes & Craig: 0:54

Thanks Greg, it's always great to chat with you. Thanks Greg, Thanks for having me.

Greg: 0:59

Let's jump right into it. We saw the start of the easing cycle this quarter, with the Bank of Canada being the third central bank within developed countries to cut rates. How far do you think they can go to boost consumer confidence and the economy without risking another spike in inflation?

Wes: 1:14

The anticipated easing cycle did begin this quarter and markets are currently predicting another two rate cuts this year for the Bank of Canada from current levels, and these predictions are based on an expectation that inflation will continue to fall from where we're at right now. In May, however, we saw a little rise in inflation levels up to 2.9% from 2.7% that we had seen in the 12 months through till April, and that was driven by the cost of services and the cost of groceries. Now rate cuts do aim to boost consumer confidence and spending, but that transition mechanism is slow, so the immediate impacts on consumer behavior are limited, but we will gradually see potential significant effects from an already elevated Canadian housing. There's a delicate balance between reducing rates so that the economy isn't stimulated too quickly and the impacts of leaving rates higher for too long. This becomes an even more delicate balance to strike when you factor in the additional influence of global economic conditions on the Canadian economy itself. Now central banks, broadly speaking, are expected to ease their monetary policies.

Wes: 2:27

The easing cycle began in March with the Swiss central bank cutting rates, followed by Denmark and the Bank of Canada in June. The US is in a different position, and that's due to persistent inflation and its self-sustaining economy, which has allowed it to avoid easing as early as other countries. The key factors here are pace and timing. Now, there's been a big focus on the US and its potential rate cuts, but that broader global policy trends still matter. We are the third of the G10 countries to cut, and we've also seen Latin American countries starting to cut as well. Inflation is influenced not only by Canadian central bank policy rates, but also by global economic activity. Our sensitivity extends to our interactions with the rest of the world.

Craig: 3:19

Many of the goods and services that we purchase are either imported or influenced by global prices. So, these other central banks are cutting rates and economic activity is growing in those regions. It's going to drive up the demand for their goods and services. This in turn puts pressure on the supply chain and potentially increases the cost for us Canadians, and whether we're prepared to pay those prices or not, the impact remains. Just an example we may be forced to import inflation due to strong economic conditions in other countries. Take a look at the US, when it was running hot in areas like used cars. As lots and lots of US consumers bought up new and used cars, it affected the global supply and demand dynamics and, given that they have nine times more consumers than Canada, this ultimately pushed up used car prices in Canada. And whether we actively want to influence those prices or not, the interplay between demand and supply remains a critical factor, as the Bank of Canada considers how far they want to cut rates, and how many aspects of inflation are actually outside of their control.

Greg: 4:19

Wes, you mentioned the Canadian housing market being a factor that could influence rates. I'm sure many Canadians with variable mortgages are pleased about the rate cut announcement from the Bank of Canada in June. How does the housing market weigh into the Bank of Canada's decision framework?

Wes: 4:34

The Canadian housing market is highly sensitive to interest rate changes and rate cuts can significantly impact mortgage affordability as well as demand for housing. So lower rates boost housing affordability, It leads to increased demand and the potential for higher home prices, and that's certainly a consideration for the Bank of Canada as it tries to balance stimulating the economy with preventing the housing market from further overheating. Now the Bank of Canada recognizes that housing affordability issues are also driven by supply constraints, which don't really get addressed through monetary policy alone, because we do have structural issues like zoning, labor shortages, that plays a significant role and we also have a lot of new people coming to Canada, which increases the demand significantly. Now, the other factor here I think that is important, is housing isn't the only piece of the Bank of Canada's decision-making framework. There are other factors at play as well, and we spoke a little bit about these earlier, and it's similar to how they'll consider the impacts of lower interest rates on our economy relative to the global economy. They will also look at the impacts of housing relative to the state of the domestic economy as well. If keeping rates higher excessively harms our economy more than the housing challenges, they'll likely need to accept the negative impacts of lowering rates on the housing market and specifically driving house prices further up. Now it's stated directly in the Bank of Canada's objectives that monetary policy is to preserve the value of money by keeping inflation low, stable and predictable. When you step back and think about what that means, it means that inflation has a direct impact on all Canadians because it erodes the value of money. Now additional considerations like housing, the impact and influence of the global economy. They're important, but not the main focus, because they don't equally affect everybody in the same way that inflation does.

Greg: 6:30

Craig the US may not reduce its interest rates soon. How does this impact the outlook for both US and Canadian markets, and will we continue to see monetary policy divergence?

Craig: 6:41

Well, it's unlikely that Canadian and US central banks will diverge significantly, and it's really the Bank of Canada, can't stray too far from the US Federal Reserve because, let's face it, the US economy is large and it's our largest trading partner, and as a result, their economy fundamentally influences ours. If their rates are higher than ours, there's a limit to how far we can cut rates without further impacting our currency, and ultimately, our economy, and this interdependence is quite interesting when you think about it. Now our expectations for rate cuts in Canada is based on a continued slowdown in Canada. However, I don't see the Bank of Canada being able to get past 50, maybe 75 basis points from where we are now, without a clear signal from the Fed that they'll correspondingly lower rates. You would continue to see downward pressure on the Canadian dollar if we continue to cut rates lower than the US, which could be punitive to economic growth prospects for Canada. Now, Canada is keenly aware of its strong economic ties with the US. While the Canadian economy faces unique challenges, especially, as Wes mentioned, in the housing market, our sensitivity to interest rates remains quite high. Consequently, Canadian central bank has already begun cutting rates to sustain reasonable economic growth and try to prevent a recession. However, expecting Canada to perform heroic feats by significantly lowering interest rates independently of the US, it's unlikely to happen.

Craig: 7:59

Now to answer the capital market part of your question, while central banks anticipate the impact of their policy changes on consumption, consumer behavior, business spending, the market for both bonds and stocks tries to anticipate where central banks are likely to go. For the fixed income markets, as an example, investors are trying to predict when yields are going to go down and whether that will influence prices. So, a dovish stance meaning central banks are biased to lower rates will drive yields lower and the value of a bond up. For equity markets. Lower rates ultimately mean cheaper borrowing costs for both consumers and businesses and together this can improve corporate profits through both increased demand and higher profits. So, equity markets will anticipate when federal governments are going to cut and that can stimulate markets, particularly those cyclical sectors. They benefit for you know, consumer discretionary, technology and real estate.

Greg: 8:52

We're in a very different environment today versus where we started the year. As you mentioned, inflation has eased in Canada and starting to trend lower in the US. How have things played out in equity and fixed income markets with this easing story? What performance have we seen in the second quarter?

Craig: 9:07

At the beginning of the year, there was a lot of uncertainty around the economy and whether we'd go into a recession or whether inflation would continue to decline. Many are now starting to believe that we'll avoid a recession, as growth has been quite resilient. However, inflation seems to be trending a bit more sideways than down, making that prediction very challenging to call. However, the years turned out to be very positive. The US stock market has been very strong, but there's been a bit of a disconnect. This extreme strength coming from the US and in particular, parts of the US market, seemingly are detached from the slow-moving policy decisions. Bonds have moved quite wildly this year from positive to negative and ending the first half pretty much where they started. This is the best reflection of what the market thinks about the state of the economy and, of course, possible future rate cuts. So, considering both bond and equity performance at a high level, it's evident that this year's environment differs significantly. Central banks worldwide are generally adopting a dovish stance and moving in that direction. Inflation's a bit more favorable than before. So how has this influenced markets? Well, it should have been positive, it's essential to recognize that the huge returns coming from the US doesn't necessarily feel like it's tied to policy decisions. Instead, something entirely different seems to be at play, artificial intelligence. This unique aspect unrelated to interest rates, has been propelling markets to new highs and can continue if inflation behaves unpredictably. This excitement around AI has put the focus on a few select names, such as NVIDIA, which is up around 150% at the end of the quarter. The questions are now, however, whether there's enough momentum from AI to carry the entire global stock market and, if not, will this bout of strong performance broaden out into other sectors?

In Canada, stock market performance so far this year has also been positive, but the second quarter ended kind of flat, so those results are driven mainly from performance at the start of the year. There's a divergence across sectors with energy and materials driving performance. There's also been some additional support for markets stemming from anticipated ease of monetary policy in Canada, which reduced the cost of capital for businesses relative to what we're observing in the US. Furthermore, Canada's three dominant sectors financials, commodities and energy are positioned for improvement. We've seen lower default rates, signs of yield curve normalization and robust commodity markets, contributing to this positive outlook.

Wes: 11:29

In the fixed income markets, we did see some volatility at the beginning of the year, as markets were adjusting their expectations for interest rate cuts. And with Canada now beginning its easing cycle back in June, we saw a reversal of performance during the quarter itself and year to date, we're now only slightly positive. The US has hit a few more bumps as the Fed continues to push out rate expectations and, more importantly, the market is pushing out rate expectations for the Fed. Now that doesn't mean that there haven't been pockets of strong performance in the fixed income market, spreads have come down significantly so far this year, that has supported strong performance in corporates, it's also supported strong performance in high yield and this signals to us that investors are confident in the economy, with a lower likelihood of default exactly what Craig was talking about, and a decreasing likelihood of a recession, as they're willing to move their fixed income investments into riskier segments of the fixed income market.

Greg: 12:29

We've seen the markets hit several all-time highs so far this year. In the US, much of this performance has been driven by the Magnificent 7. We talked during Q1 about the concentration of risk in the market. Is that still a concern, or are we seeing more market breadth, with other sectors participating in the bull run?

Craig: 12:46

I believe this ties back to our initial discussion around easing policy, stable economy and the absence of a real collapse. If borrowing remains accessible and people continue to be fully employed, it bodes well for other sectors in the market. Under the hood, companies aren't necessarily performing poorly. The overall US economy is in good shape, which explains the absence of a recession. However, there's a key risk facing the US equity markets today. People have priced AI stocks for perfection, leaving other sectors somewhat neglected. Even the MAG7 performance is primarily being driven by one stock, and that's NVIDIA and the excitement around AI. But just because other stocks or sectors don't appear as exciting or attractive, doesn't mean they're not generating returns. Take emerging markets as an example. Returns have been decent year to date and up slightly for the quarter, and though this is nothing compared to the remarkable performance of NVIDIA, the excitement around NVIDIA's stupendous returns shouldn't overshadow these other opportunities. As long as we continue to witness declining policy rates, various sectors will become relatively attractive. Remember the goal is to compound wealth over time, not to wonder whether buying enough NVIDIA stock today will make you wealthy overnight.

Greg: 13:57

Craig mentioned NVIDIA and its remarkable performance, which is being driven by these new opportunities within AI. Do you think that this success will broaden beyond just NVIDIA, and do you anticipate other companies will capitalize on the AI secular trend? What does this mean for equity markets?

Wes: 14:15

It's become the shiny object that's capturing everyone's attention. But if you step back and consider our local context, questions to ask are, are the companies and sectors in Canada still attractive for investment? Will they disappear or will they be taken over due to AI? It's not likely, and these companies remain investable, and we can find comfort in the fact that our economy supports robust portfolios beyond AI hype. It's not all built on just one example like NVIDIA. There's more to explore.

Craig: 14:49

I agree. Now let's shift our focus away from AI, specifically NVIDIA, and consider the broader impact of AI across various sectors. Now, while NVIDIA represented the initial wave, AI's influence extends far beyond. As we prepare our infrastructure to support AI-driven growth, other sectors, utilities, energy will play more crucial roles, and although AI won't be the sole driver of returns in these sectors, it can positively contribute to the near term. We shouldn't discount AI. It's happening and it's going to be a positive force, and while there may be bumps along the way, this forward-looking perspective contextualizes AI alongside other investment opportunities.

Wes: 15:26

The key point here is that, while AI will transform the way many companies operate, It's not the sole driver of our entire existence. Consider Nvidia, they're the current leader in AI due to its processor sales. They don't sell your breakfast cereal, they don't plan your vacation, they don't build your car and they don't act as your bank. They specialize in computer chips, which are essential for scaling up our use of artificial intelligence. But let's broaden our perspective. The world isn't solely AI driven. It's not what we live. It's not what we breathe. Your dog doesn't eat AI, it enjoys pet food. The avid golfer won't abandon his clubs to play virtual AI golf. Maybe in the winter, they want to walk the course and they want to smell the grass. AI hasn't replaced everything; it’s merely added to the landscape. Now there's tremendous excitement around new technologies, their potential impact on the future, but people invest because they don't want to miss out on the next big thing. However, this frenzy doesn't necessarily correlate with life-altering transformations everywhere. Amidst the AI buzz, other companies continue to thrive, they're creating goods and services with decent margins. Now take obesity drugs like GLP-1’s, they’re exciting too, and they don't have the exact same AI spotlight, but they've been performing really well. So, in summary, while NVIDIA shines brightly, there's a whole universe of exciting developments beyond AI that are waiting to unfold.

Greg: 16:54

We've talked a lot about equity so far and their strong first half. You also mentioned fixed income has seen, a bit of a bumpier ride this year, but the quarter has finished positively, and year-to-date results are looking much better than Q1. How has this performance translated to the portfolios you manage?

Wes: 17:10

We've seen a great first half, and as you know, we expect more income-oriented strategies to perform differently as compared to equity-oriented strategies. Now, this is true over the long term and there have been material differences year to date. Now the income-oriented strategies, they have a higher allocation of fixed income. They tend to yield lower returns relative to their equity-focused counterparts, and that's true over the long term and it's directly aligned with our long-term capital market assumptions. That has definitively been the case during this most recent quarter. Equity-oriented strategies, on the other hand, those with higher allocations to equities, have performed extraordinarily well. Performance during the second quarter wasn't quite as strong as what we saw in the first quarter of the year, but we are still well above our long-term capital market assumptions for equities in particular over a really short six months.

What that means is our long-term capital market assumptions look out 10 years and we've exceeded those in only six months. So that's a really strong first half of the year.

Wes: 18:11

On the bond side, as I mentioned returns from the Canadian universe, they've recently improved but are still a little bit negative. Our active strategies, however, have really helped us. So, in our more fixed income-oriented portfolio specifically, we hold a lower duration and an increased allocation of credit. The combination of those two active decisions have done a really great job at mitigating some of the adverse impact that was caused by rising bond yields early in the new year. Now our positioning across the yield curve, our active duration position and our overweight to credit in both Canada and across global markets has really helped to preserve capital in the environment that we've realized year to date.

Wes: 18:53

Now, going to our portfolio solutions, particularly those emphasizing equities, they've, as I described, exceeded our long-term projections just within the first half of the year. Investors have been rewarding for just doing that, staying invested. This year they've been able to capture gains from strong equity markets and, at the same time, we've been actively managing risk through our fixed income investments. It's a great example of the benefit from a diversified portfolio with both equities and fixed income.

Greg: 19:24

So that's great news. What's in store for balanced portfolios for the remainder of the year? What poses a risk for performance looking ahead to the rest of 2024?

Craig: 19:33

When we were heading into 2024, despite there being some uncertainty, long term, we felt like we were well positioned to realize our clients' objectives compared to previous years. However, if there were a slowdown in equities, it was likely going to come from weaker economic growth and in such a scenario, the starting point for fixed income alone, as Wes just mentioned, would contribute positively. Yields are currently higher than they were, so there's much more income coming from bonds than there has been in the past. Many people have already anticipated rate cuts due to a potential recession, but that scenario hasn't fully materialized yet. So, as rates continue to move lower, bonds should definitely benefit. However, if an economic slowdown were to occur, rates would likely decrease significantly further, boosting and contributing that positive contribution from fixed income. And this positioning makes the overall you know 60-40 balance portfolio better equipped to weather volatility moving forward.

Greg: 20:23

As we mentioned earlier, the Bank of Canada easing cycle is now underway and fixed income markets have benefited. Let's go a little bit deeper on fixed income. Within this asset class, what has been driving performance and is the environment ahead better suited to positive fixed income returns?

Wes: 20:40

Our expectations for easing monetary policy and now getting confirmation of rate cuts beginning, have been the primary driver of fixed income performance over the last couple of months. Now, that's led to higher bond prices, it's led to positive returns, and I think to your point, the current environment still offers attractive yields, which allows investors to take advantage of favorable starting place for long-term gain. Now, while rate cuts are still expected, it's unlikely that we're going to go back to historically low rates that we saw during the pandemic. Those were literally all-time historic lows, so we'll continue to see the benefit of that higher income, with some additional support from modest gains as rates move back down. The outlook for fixed income remains positive, with expectations for continued rate cuts and stable economic conditions. But investors should remain somewhat cautious of the potential for continued inflationary pressure, particularly in the US, and that may drive a little bit more market volatility and a potential temporary increase in bond yields. Now we don't think that's sustainable because we do see a continuation of policy easing across the globe.

Greg: 21:57

Some Canadians who got out of the market during volatility a few years ago decided to invest in GICs. We're now looking at renewal rates that are much lower than what were offered previously. What advice do you have for those Canadians, as they think about their next financial decision?

Wes: 22:12

Trying to jump in and out of the market depending on where rates are heading is ultimately trying to time the market, and that is incredibly difficult to do. I like to think about these financial decisions around time horizon and risk tolerance. If you have a longer time horizon, don't worry about the short term, think about the opportunities that lie in the market over the long term. Attempting to predict market movements is challenging, even for seasoned investors, so instead, focusing on your overall financial goals and positioning yourself to achieve those is the best practice.

Wes: 22:44

Now we recognize that interest rates are more likely to decrease than rise in the future. Now bonds will better participate in this change by a price appreciation, and when you invest in the bond and equity market, you're really stepping back and investing for the long term, so that short term timing doesn't matter as much as how long you're invested. Now, there's a phrase in our industry that says, time in the market matters more than timing the market, and this couldn't be more true. Ultimately, the decision between bonds and GICs should align with your individual circumstances, your investment time horizon and your risk appetite.

Greg: 23:24

Wes, Greig, thank you for your insights. When considering investments, it's critical to think about how long you want to invest. Guaranteed Investment Certificates, GIC’s and cash are great short-term options. However, if you want to grow your capital over many years, you'll need an investment solution that offers more return potential. That growth can help you achieve your long-term financial goals. I encourage you to speak with your advisor to find out together how you can identify the right solution for you, one that balances your risk while also achieving your growth objectives. To the listeners of this podcast, thank you for investing your time with us today. I trust the information you have gathered will help you make smart decisions with your long-term investments. Here at Scotia, we aspire to empower our clients for every future. Be well and happy investing.

Disclaimer: 24:11

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