After delivering solid performance in the first half of 2023, markets pulled back in the third quarter. On the latest “Let’s talk investing” podcast, Greg Sweet, Scotia Securities Director, chats with Craig Maddock, Vice President & Senior Portfolio Manager, and Wesley Blight, Portfolio Manager, both from the Multi-Asset Management team. They discuss the key takeaways of 3Q23, and their thoughts on where things will go from here.
Speaker Key:
GS Gregory Sweet
CM Craig Maddock
WB Wesley Blight
VO Voiceover
00:00:00
GS Welcome again to our listeners. I’m your host, Greg Sweet. Today, we’d like to bring you a new podcast to continue empowering our customers, helping them make important financial decisions.
The third quarter of 2023 is finishing, and financial markets were interesting, as always. After some solid returns early in the year, markets pulled back a bit in Q3. Right around now, Canadians are receiving their third quarterly statement. This is a good time to check in and see the progress we’ve made towards our goals. It’s always nice to hear what’s going on directly from our portfolio managers.
Once again, we’ve called on our Multi-Asset Management Team. Today, our special guests are Craig Maddock, Senior Portfolio Manager and Head of the Multi-Asset Management Team, as well as Wesley Blight, a portfolio manager on Craig’s team. Welcome, Craig and Wes. Let’s get started.
00:00:51
Performance is solid year-to-date, but there was a pullback in Q3. Craig, what are you making about the events of Q3, and what were some of the key drivers of performance.
CM It’s always a pleasure to be here with you, Greg. Year-to-date returns across the portfolios we manage have been positive, but not without some ups and downs. We saw declines in most major stock and bond indices in the third quarter, although there were some areas that performed pretty well.
And we have been fairly cautious throughout the year, and have kept our portfolios positioned defensively, and in Q3 we were quite happy that we made that decision. We’ve managed to continue to make money for our investors and have avoided some of the bigger pitfalls seen in the market recently. That’s something we in the multi-asset team strive for, so, naturally, we’re pretty pleased about that.
The biggest events for markets in the quarter was that inflation has been pretty resilient, and central banks have made it pretty clear now that they’re going to keep interest rates elevated until inflation comes down to their target levels. Now, while that’s consistent with our view, most people that expected inflation and rates to normalise a little sooner than that. So, the idea of rates being higher for longer is a notable change in expectations. The result is that there was a sharp rise in interest rates.
00:02:03
This has caused investors to reprice stocks and bonds based on these updated interest rate assumptions. Now, this was particularly impactful for longer-dated bond portfolios and more rate-sensitive stocks selling off. Now, of course, all of this has increased the probability of a global recession in the next year.
However, in terms of good news, while government bonds moved lower, high-yield bonds performed quite well. And with oil prices moving significantly higher, a nearly 30% increase in the quarter, thanks to production cuts from OPEC+, the energy sector performed quite well, which helped energy stocks in the US, but was particularly helpful in Canada, since the energy sector has such a significant impact here. Even when there’s bad news, there are some positive reactions to markets somewhere.
GS So, super interesting change expectations on interest rates higher for longer. This has been a topic that’s been in the news a lot lately. So, let’s take a minute and really walk through what that means for our customers. This is maybe back to the basics for some people, but maybe a helpful reminder of how this works. Wes, what do you make of the impact of higher interest rates?
WB Basically, elected governments are in charge of fiscal policy, so that’s taxing and spending. Central banks, like the Bank of Canada or the US Federal Reserve, are non-partisan organisations that are in charge of monetary policy. So, that’s basically controlling the monetary supply in order to maintain economic stability. And knowing that inflation and deflation are really destabilising for an economy, the main goal of central banks is usually to maintain a low and stable rate of inflation.
00:03:38
And for the US Federal Reserve, the central bank in the US, they’re also tasked with keeping an eye on employment levels. The main tool for all central banks is to do this controlling by changing interest rates. And that’s a little bit like stepping on the gas or the brake on a car. By changing rates, they can provide incentive to increase or decrease economic activity.
And in terms of the actual mechanics, they usually have a key interest rate that they can change, and the rate that they charge banks to borrow from them. And when they change this rate, the new rate slowly filters through the entire economy. And as an example, when they increase their key rate, banks will correspondingly increase their mortgage rates, car companies will increase car loan rates, and so on.
The impact from these higher rates from the central banks aren’t immediately felt. And it takes time for borrowers to renew their mortgages, or companies to refinance, etc. And what that does is, it means there’s a lagged impact for higher rates from central banks.
Now, when rates move lower, companies and individuals are given an incentive to spend more money. Think back to the pandemic. Rates were floored to their all-time low to enable economic growth during the shutdown. And then, correspondingly, when we got into the reopening, monetary policymakers, so, central banks, wanted to make sure that there wasn’t going to be any impediment to the corresponding recovery.
00:05:07
It’s cheaper to borrow money at that point in time to buy a new car, but it’s also cheaper for a large company to borrow money to expand their business, open a new production facility, buy new equipment, open a new branch in a different region, or hire people.
And naturally, the same thing happens in the other direction. When it comes to investing, we calculate what we think a stock, or a bond is worth based on a series of expectations. For stocks, that includes what kind of sales growth we think a company might have, what kind of costs they’ll have, and ultimately what the cash flows in that income will be.
We forecast the numbers out into the future, and because of the time value of money, remember that a dollar today is worth more than a dollar in the future. We then discount back the future numbers to see what they’re worth today. That feeds right into our valuation calculations.
Now, the discount rate we use is based on the company’s cost of capital, which is directly impacted by the interest rates that are set by central banks. So, when rates go up, the cost of capital goes up and slows down economic growth. And in turn, it puts downward pressure on stock prices.
00:06:15
Now, when it comes to bonds, when rates go up, bond prices go down. And when rates go down, bond prices go up. And that’s because bonds that already exist are paying a fixed interest rate to investors. When market rates go down, investors can no longer buy bonds paying the old higher rate. And the older bond is now relatively more valuable.
So, the actual price is just based on math. The older bond and a new bond have to be priced so that an investor is indifferent to buying either of them. If they were mispriced, investors would immediately buy the more attractive bond, driving the price up to where it should be.
And that’s the basic impact for interest rate changes on stocks and bonds. Although there’s lots of nuance in there, as well. For bonds, the price impact of rate changes is greater for bonds with more term, and greater for bonds with a lower coupon rate. There’s less of a cushion.
And for stocks, the impact of rate changes is greater for some industry sectors than others. Industries with companies that generally carry higher debt loads usually feel a bigger impact, because the cost of capital is more influential. And higher dividend-paying stocks are usually heavily impacted, since the dividend becomes more or less attractive when the yield available on a bond changes.
Growth stocks are usually more impacted than value stocks, since they usually have more of their value derived from earnings and cash flows generated far into the future, which are discounted back in today’s dollar for valuation purposes. There’s less of a valuation cushion for growth stocks relative to value stocks.
00:07:51
GS That was a really important refresher, and I think really helps us understand the mechanics behind what’s moving both stock and bond prices. So, we saw rates move higher, and more and more investors are expecting higher for longer. So, what does that mean for us looking forward?
WB The third quarter is a good demonstration that things can change pretty quickly. We know that central banks are committed to reducing inflation, and as we’ve been experiencing, the path of inflation doesn’t unfold exactly as expected. When things change, it happens in a hurry. And everybody believes that at some point inflation, and therefore rates, will normalise at a lower level than where we’re at today.
The trick is that, by the time it’s obvious, the market will have already moved. So, the prudent thing to do is to get invested in the right strategy and stay invested for the long term. For bond-heavy portfolios, so those portfolios that have a higher allocation to bonds, and actually for all portfolios, but more meaningfully for bond-heavy portfolios, we’re really keen on our ability to participate in future performance that is really appealing compared to where we have been over the past number of years.
And even if yields climb a little bit more from where we are today, over the coming years, investors can do really well here. For investors with a long-time horizon, with today’s starting yields being so high, this may turn out to be a great time to be buying bonds.
00:09:18
GS You know Wes, as I reflect on this, it kind of reminds me of something that I have said for a long, long time: if you do not like the rising costs of being a borrower, then maybe – where you can – become a lender. In particular terms, you know if you’re feeling the pinch of higher mortgage rates, think about allocating some of your investment dollars to bonds, where those yields are becoming much, much higher. Craig, what other topics do you see as important as we look forward?
CM I think you guys have the right idea with some of the themes you’ve already touched on. Markets, they’re going to continue to be fast-moving, and they’re going to throw us an occasional surprise. The best way to be prepared for the unknown is to be prepared for different scenarios, and to set up a well-diversified portfolio that can achieve your investment goals under a variety of circumstances.
So, we’re keeping our eyes on things like China. That’s certainly been an interesting area lately. And, of course, China’s one of the world’s largest economies that’s really driven a lot of the world’s growth over the last 20 years. And growth has slowed down in the last year. Real estate sectors slowed down, but an increasing tension between the US and China.
And while it’s highly likely that China’s growth rate will pull back from what we’ve seen in the last couple of decades, it’ll still surpass what we’ll see in most of the rest of the world. So, for me, it still remains a very important place to invest, and it’s also going to be a big driver of the global economy, both in terms of supply and demand.
00:10:26
And, of course, geopolitics remains important and can change the state of the global economy at the margin. India was one of the countries with positive stock performance in Q3. We’re going to continue to keep an eye on things there. And then, of course, conflict continues in Ukraine, and the recent turmoil in the Middle East, and these will obviously continue to warrant observation on our behalf.
The stock and sector level, we remain biased towards quality and growth, but only marginally so. The recent run-up in very large growth stocks has been one of the few anomalies in an otherwise lower return year. And while we’re not going to sell out of all of our winners, we’re going to continue to rebalance our portfolios by redistributing the gains, the parts of the portfolios that are most likely to perform in the next phase of the business cycle.
And we’ll continue to closely follow the path of the global economy. Some of the news we see will inform our long-term fundamentals. Some of it’ll be short term in nature, and maybe just noise that won’t affect the long term. But, as always, we know that stocks and bonds will fluctuate in value. We also know that they generally go up in value over time.
We just completed a review of our capital market assumptions, and similar to what Wes mentioned, we’re currently in a period of heightened uncertainty. The recent repricing of both stocks and bonds gives us really good starting points for long-term returns. So, our long-term portfolio expectations are actually slightly higher than they were just a year ago, and we still think there are good investment opportunities available.
00:11:45
Volatility’s probably going to increase from here in the short-term, resulting from some of the economic ups and downs ahead, but we’re planning for that, and we’re managing our portfolios more defensively than normal as a result. Our philosophy, it’s to build great portfolios, ones that our customers can invest all of their hard-earned money in. That means we need to build our portfolios for the long term but take into consideration all that the world can throw our way, and adapt as needed.
GS This sounds like a lot of your views on the market continue to align with what our advisors have been telling our customers. We’ve been telling them to stay invested, think long term, not to worry too much about the day-to-day fluctuations of the market. We’ve been telling them to focus on their investment plans and to talk to their advisor about making sure their plan is optimised for their investment needs.
Craig, Wes, I’d like to thank you so much from both me and our customers. This kind of conversation can really help provide our customers with the knowledge and the confidence to tackle these big issues, leading them to make smart decisions with their long-term investments, and ultimately helping maintain the health of their long-term financial plans. So, thank you so much for your time today.
To all the listeners of this podcast, I want to thank you for investing your time in this discussion today. Our goal is to lead with advice and help our customers for every future. Thank you so much for spending your time with us today.
00:13:10
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00:14:49
