With three quarters down, equity markets enjoyed another robust quarter, with gains pushing many indices to new heights. Fixed income has been thriving amid easing central bank policies in Canada, the US, and beyond. Greg Sweet, Scotia Securities Director, chats with Craig Maddock, Vice President & Senior Portfolio Manager, and Wesley Blight, Vice President & Portfolio Manager, both from the Multi-Asset Management team. They delve into significant 2024 events: the Federal Reserve’s first interest rate cut in September, the market’s shift from the Magnificent 7, the looming U.S. elections, and what these developments mean for investors heading into 2025.
Speaker Key:
GS Gregory Sweet
CM Craig Maddock
WB Wesley Blight
VO Voiceover
GS: 00:00:00
Welcome to our listeners. I'm your host, Greg Sweet. Today we like to bring you a new podcast to continue empowering our clients and help them make important financial decisions. With three quarters in the books and the summer months now in the rearview mirror, it's an important time for investors to assess how they're progressing towards their long-term financial goals. Equity markets had another constructive quarter, with performance broadening helping many indices achieve new heights in fixed income continues to be performing well against the backdrop of moderating central bank policy in Canada, US and beyond.
I'd like to take some time to hear directly from our portfolio managers. We'll discuss what's happened so far in 2024 and what we can expect as we focus forward.
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. The third pivot finally arrived this quarter with a 50-basis points rate cut. Now it seems the focus has shifted from inflation to growth.
How far do you think the US central bank will go this year and into 2025 to balance its dual mandate?
CM: 00:01:16
Great question. Sometimes when you're watching movies, you ask yourself, well, they won't they. There was really never a question of will they? They were always going to cut rates and we saw that there were rate cuts coming from other central banks across the globe over the summer months and our expectation is now that we're here, now that that cutting cycle has started, they are going to continue reducing rates for the rest of the year. Both the market and the Federal Reserve have already indicated their expectation that there's going to be another 50 basis points in cuts by the end of the year. So that doesn't mean that there's going to be another one time 50 basis point cut. It just means that there are additional cuts already embedded into the price of bond yields. And the Federal Reserve had also indicated that they're going to continue to cut rates.
Rationale for that is the labour market is clearly slowing. We're seeing the pace of payroll gains are slowing down. Average hourly earnings. It's up a little bit. But it's a slowing trend for sure. Job openings in the US are falling and the unemployment rate is now back up above 4%. And then from an inflation perspective, we have to keep in mind that the Federal Reserve has that dual objective, both labor market and inflation targeting. So they are dual mandate. That's unique. So the other side of it is inflation. That's what other central banks are also looking at. Inflation is clearly slowing down with PCR falling down to 2.2% over the 12 months through the end of August. Core inflation is coming down as well at 2.7, and then CPI is now down to two and a half and it's moving lower quite quickly.
There are still pockets within the underlying factors that influence inflation overall, but those pockets are narrow in scope and are also coming down as well. And that's why from our perspective, this is just the start of what the fed will continue to do throughout most of 2025. So, policy, in our view right now, it's still too restrictive. And there is growing concern about the risk of deflation. Now this is where we start looking out beyond 2025 into a longer term where the neutral rate is. There's a lot of debate around where that neutral rate is going to be. The neutral rate is the equilibrium rate where the economy is at full employment and stable inflation is kind of a best guess for where policy and this is monetary policy specifically, is neither contractionary or expansionary. That's going to be the key focus for the next little while and where the fed is headed. It's going to take them a while to get to that neutral rate. And they're going to keep adjusting where that is based on their new economic projection. So even though we've seen rate cuts coming in, in September, we anticipate more rate cuts coming over the next couple of months. The equilibrium rate is moving up, and at September it was at 2.9% versus 2.8% in June.
GS: 00:04:14
So what do you think that means for the target rate in 2025?
WB: 00:04:14
It feels right now that maybe central banks will be able to lower interest rates without the economy falling off. Too much of a cliff with unemployment getting too crazy. And if that's the case, then they're likely going to move towards this neutral rate sometime in 2025. Of course, the risk is that, you know, there is a recession somewhere in the cards. If we avoid that deep or prolonged recession, it's likely to see that we get down towards that, a neutral rate, which is probably in that two and a half to 3% range.
GS: 00:04:48
So if we think about that backdrop, really, is Covid ultra-low rate environment, inflation, high rate environment. And now the fed is really kind of aiming for that middle ground somewhere in that two and a half 3% range.
CM: 00:05:04
They're targeting that happy ending now, which is sort of that medium ground. So we're not going back to the extreme policy accommodation. And I think that when we step back and look at longer term, where our capital market assumptions are for fixed income, they're not so much stronger than where they've been over the last several years, because the starting bond yields that are coming out of that are a lot higher than where we were back in those pandemic years 2020 through 2022.
And that means that because there's such a strong correlation between where you're starting yields are and where your forward-looking returns are going to be, that higher starting yields means that we expect to be in an environment where our fixed income is going to continue to make a more meaningful contribution to portfolio outcomes. And I know that's a bit of a segue into what's happened here today, but we think that that higher neutral rate is also good for long term portfolio contributions from fixed income going forward.
GS: 00:06:00
I want to shift the conversation to the yield curve. The ten-year and the two-year Treasury note spread was inverted for nearly 800 days, the longest in U.S. history.
Now that we've seen the yield curve normalize or dis-invert, can you explain what this means? Also, do you think that US bonds are priced fairly now, or is there an opportunity over the next few months in the space?
WB: 00:06:26
As you pointed out, rates were inverted steeply inverted. So basically 100 basis points or 1% to get paid 1% more for a two-year bond than you would in a ten year bond. And that's definitely not normal. It basically means that there's a high probability of a recession. And the reason that curve inverts in the first place is because of what we've just seen, which was central banks increasing interest rates very aggressively in order to try to slow down economic activity. And of course, to the extent they do that, if it slowed down enough, you end up with a recession. So now that the curve is dis-inverted, now you're getting paid more for a ten year bond than you would a two year bond, which is theoretically kind of more normal, but it's not really normal yet. It's only slightly upward sloping, which means that the ten years only paying a little bit more than two years not quite flat, but you know, it's a little bit better.
And when you mentioned, you know, US bonds, are they fairly priced now? I would suggest probably not really because the curve generally doesn't stay flat or even just slightly positive for very long. If we do get to that normal state, I would say the curve should be probably about 100 basis points steep, which means you should make about it 100 basis points more or 1% better return by investing in a ten year bond than a two year bond. Of course, right now the curve itself is telling us things aren't normal because we're not at that point. So, for instance, if interest rates at the front end continue to decrease as central banks cut interest rates, which is definitely our base case, and I think what most market participants would expect to happen, we should see two-year interest rates continue to come down, in which case the curve will steepen out. The problem is, is that in that environment, if the neutral rate, this equilibrium rate, which is not an absolutely known number, is a little bit higher than it was previously, then maybe as we move towards a steeper curve, it might have also happened that the ten year rate goes up in that environment, while the two year rates come down to become a normally sloped curve.
The real risk, however, is that if instead a recession does occur, there's a greater chance that central banks will have to cut rates more aggressively. So, through the equilibrium rate, in an effort to spur economic growth, Right? to get people excited about borrowing again, if that were to happen, then you'd probably expect to see the curve be really steep in that environment. In which case maybe you see a, you know, 200 basis points steep because the front end or the two years come down so much.
CM: 00:08:53
I think the one piece that sticks out in my mind is just how bond yields anticipate where they believe fed policy is going to be, where central bank interest rate policy is going to be. And then as you look across the curve, it's also looking for appropriate compensation for locking up money for a longer period of time. While the movement across the bond yield curve has been slow, I think it's been appropriately reflecting the environment that we've been in for the past couple of years. The movement over the last several months, in my view, is an opportunity for the fed to be celebrating their success in managing inflation back down towards target. So if you step back and think about the exit from the pandemic. So, we had monetary policy rates get Florida at their very low levels. Then we had inflation spiked up a huge amount. And then we entered restrictive policy territory from a monetary policy point of view. And the front end of the yield curve reflected that very well. And that you saw the front end of the yield curve move up significantly because we were in that restrictive policy territory. Then you had the inversion of the yield curve just exactly as you've described, because the back end of the yield curve shouldn't be reflecting the belief that we could be in a restrictive policy territory for a long period of time.
It just is not economically viable to remain that restrictive for such a long period of time. And now, where we're at, because you've seen inflation coming down, we've seen economic growth slowing, but not really stalling out at all. You've seen the front end of the curve move down. We haven't had a recession yet. We are anticipating. And the market is clearly anticipating more cuts on the immediate horizon that is embedded in the bond market today. And that's why you're seeing the front end of the yield curve moving down and migrating lower. And the way to look at it is the front end of the yield curve.
The two-year bond yield is lower than the fed policy rate right now. And I guess the overall point from my perspective is that central bank actions are being influenced by the bond market movement. I'm not convinced that we would have seen that full 50 basis point move down if the bond market hadn't already been pricing it in and continuing to price in more cuts for the foreseeable future.
GS: 00:11:18
In terms of equity market performance, we've seen a bit of a shift right away from the big tap, the Magnificent Seven to industrials. Do you think this rotation will continue through the balance of 2024 as the fed continues its easing cycle?
WB: 00:11:32
First half of the year, we saw large cap growth fuelled by technology. Communication services were huge winners right. But in Q3, as you noted, real estate utilities were actually the biggest winners. And tech and communications services were near the worst performing sectors. On the Mag seven four of the Mag seven, so Nvidia, Amazon, Microsoft, Google were negative, negative returns in the third quarter, you know, very concentrated, very expensive relative to long term expectations. And you change that backdrop and, you know, have interest rates come down. And all of a sudden real estate and utilities can definitely benefit from lower interest rates. Right?
They're going to benefit the most. That's to the extent that that happens. Clearly, we could start to see more and more sectors gaining strength. If you look at style value versus growth, value has outperformed recently relative to growth. You look at countries Canada actually outperformed the US in the last quarter. So, a whole bunch of things where the market has broadened out a little bit. And I would say that's really in part because of the fact that central banks have now started to cut. We are going now into a different part of the economic cycle. We can see more sectors getting some attention as people look at things that perhaps were in love for a while and realize that maybe that's the next place where they get the best return.
CM: 00:12:49
Since early June, the equally weighted S&P 500, the basket of US equities, has outperformed its cap weighted counterpart, and that is a clear indication of the broader gain in market strength over the last few months. And that's because we've seen money shifting away from those concentrated, magnificent seven stocks that had been driving the returns of US equities and even global equities for such a long period of time.
And I think from my perspective, a great thing is the increased market breadth is presenting a better opportunity for active managers to go out and select outperforming securities so that broadening universe for security selection means that there are more attractive opportunities from an investment perspective, to be able to add value relative to the S&P 500 as an example. So, I really like that broadening component and being able to add value in more ways across the full breadth of our portfolios.
GS: 00:13:51
Let's talk about the big event in November. So, we have a U.S. election looming. What are some of the potential short-term risks to fixed income and equity markets?
WB: 00:14:00
Brace for volatility I think it's probably fair, right. We saw Biden drop out. Kamala Harris took over. Two VP picks were announced. We've had two assassination attempts on former President Trump. All to say this is not your average election cycle. It seems to be a little bit crazier than normal. You know, you've got on one side, perhaps big tax cuts for corporations and tariffs on imports coming from the Republicans versus Democrats, which are really saying, you know, strong middle-class support.
Those are different policies for sure and depending on who wins, that will have an impact on the relative attractiveness of certain companies and or of the economy in general. I think you're going to see more rate cuts in and amongst the election that's oftentimes viewed as not normal, right? Oftentimes said, oh, well, the Fed's not going to make any major changes right around the election, just so that they seem impartial. I think, sadly, the state of the economy requires cuts. Just so happens to coincide with an election cycle and the Fed's made it clear they don't care what's going on with the election. They're just going to continue to do the things that they think are important.
That will create some additional political volatility around that, right. Years ago, when it was possible that Trump could get elected, we tried at that time to really dig in, to try to figure out what we A. thought would happen and then B. How we would want to position portfolios. I can say that we got the call wrong, and we got the outcome wrong. I think expect and brace for some volatility, not long-term impairment to your portfolio. Just more noise and more ups and downs in markets than perhaps normal as a result of it. But really don't try to position one way or the other and come out the other side in the 2025, you know, things will be back to normal and not a big issue.
GS: 00:15:42
I think back to 2016. I woke up that morning thinking my day was going to be very different than it actually did turn out, you know, was in Saint John's, Newfoundland. And I cancelled all my meetings for the day, thinking, I have to get on the phone and, you know, get busy having conversations and helping our advisors build confidence in this whole idea around discipline. And sure enough, markets ticked up, markets ticked up, the markets ticked up, and I was able to get back to my scheduled agenda as per normal.
So a good lesson learned in 2016. And I certainly think we can carry forward. But that really just, you know, screams for the importance of disciplined and long-term investing. Let's talk a little bit about inflation. So now that inflation has hit the Bank of Canada's 2% target, should the Bank of Canada cut rates more aggressively to avoid a recession.
WB: 00:16:26
Maybe. Canada's more sensitive to short term interest rates, basically due to our borrowing habits and our housing market compared to, say, the US, if rates aren't cut, renewing mortgages are going to cost Canadians more, right? So, think about it. If you had a mortgage a few years ago, if you have to renew today, you're likely your mortgage rate is likely to be higher than when you took out the mortgage several years ago. And that's a more of a Canadian phenomenon. So, to that point, yes, maybe you just in contrast, the US uses a lot of 30 year mortgages and a lot of people locked into those very low rates during the pandemic. They're not worried about renewing their mortgage rates today. So even if the fed cuts, it's not going to impact them directly.
The fed cuts are more likely to show up in a small businesses or others that are borrowing at the short end of the curve. The other thing, too, is a neutral rate in Canada is probably or has historically been unlikely as continues to be a bit lower than that of the US. So, you know, we talked before around the fed being somewhere between two and a half to three, you know, is Canada somewhere below that. Quite likely, yes. In which case they should likely continue to cut in a reasonably aggressive path, perhaps continuing to go faster and farther than the fed in order to keep the Canadian economy in good place.
CM: 00:17:38
I think that's very reasonable. And I think about it in two ways. One, what does the market anticipate that the Bank of Canada is going to be doing? And what do we think the Bank of Canada is going to be doing, knowing what inputs they use to make decisions. So whether they should or not, in my mind is relevant, but it's more about what do we think they're going to do and what do we think that the market thinks they're going to do that, a bit convoluted but as central bank guidance has evolved and become increasingly transparent, it's taken some of the guesswork out of whether they should or shouldn't.
They'll tell you what they're looking at, they'll tell you why they're looking at it, and they tell you where they think those economic data is going to be showing up as time goes on. And I think that's pretty interesting in terms of trying to figure out the decisions that are going to make when they're going to make them and why they're going to make them. And that's taking a little bit of volatility away. But it hasn't taken all the volatility away. And that we've seen bond yields in Canada. And we've seen definitely seen bond yields in the US move around a lot as the market anticipates what central banks are going to do in the neutral rate in Canada's probably lower than where it is in the US. And the Bank of Canada actually says that their neutral rate is somewhere between 2.25 and 3.25. In our view, it's likely going to be at the lower end of that. And that's why the market is still anticipating that there's going to be more aggressive rate cuts. We think there's going to be more aggressive.
GS: 00:19:35
So let's take it on the nose. How have equity and fixed income markets in Canada performed over the second quarter?
CM: 00:19:42
We've seen excellent quarterly results on both the equity market in Canada. So TSX performance well ahead of our long-term capital market assumptions, in the third quarter alone on the US and involving interest rate sensitive sectors have been performing really well in Canada. That's really been around real estate financials. Gold has actually done quite well also; I think part of that is connected to the potential for further inflation if rate cuts go down really quickly. That has helped to prop up the materials sector in Canada, which has, you know, is pretty big. So that's helped to support some of the outperformance that we've seen in Canadian equities.
With Canadian equities actually having outperformed the US market this quarter. And that's not something that has been achieved of late because of that continued concentration of the magnificent Seven in the US and in global stocks. And then on the fixed income side, that policy easing that we've been getting from the Bank of Canada, it's clearly been a benefit to businesses. It's clearly been a benefit to consumers. Even though debt levels are high, the ability for Canadians to service their debt is still very stable. And that lower cost of capital is increasing the profitability for Canadian businesses. That has directly translated into strong performance of Canada's equity markets. It's also going to support better consumer spending. So the expectation that we're going to keep getting rate cuts that will continue to reduce business borrowing costs and from our perspective, that is supportive of our rationale to be tactically overweight Canada relative to other regions.
GS: 00:21:24
You know, the comments that you have to share with me really speaks to the extra value that active managers bring, not only when markets are moving upwards, but also when markets are in these kind of transitionary time. So, it's always great to be able to speak to true active managers like yourselves and, and really discuss the value that you're bringing to our clients.
WB: 00:21:42
That active management piece. It's really like making strategic decisions on how to capitalize on these different market conditions. A lot of people have sort of thrown Canada away, right. The US market's been doing so well for so long, and yet Canada probably double the return of the US in just the last quarter alone. Right. Was up substantial. That's a very important thing. I think it just reminds me of the importance of being diversified right across sectors and geographies. Right. Not just all U.S technology. You need the other sectors in your portfolio to perform at different times. And sure, an active manager will increase or decrease those allocations based on their forecasts on how they think things will go and our predictions on interest rates.
As an example, we were just talking about. But those are marginal adjustments to a portfolio to improve return and or manage risk. They're not, you know, wholesale departures from one thing into the other in an effort to try to capture all of the return potential. Because unfortunately, when you do that, of course, you take on massive amounts of risk as well. So, I think it's really important to remember that it's really about allocating your capital, importantly, based on how you think markets will actually do going forward.
GS: 00:22:49
Like the discipline required to remain diversified adds an incredible amount of value for Canadian clients.
CM: 00:22:56
It's picking the right strategic mix of stocks, bonds, regional allocation sectors. Those are all intelligent, active decisions around deploying capital in the right mix. Then the next layer. Tactically, we're looking to add incremental value. The time horizon is a little bit different. And that the time horizon for our tactical decisions 12 to 18 months, whereas strategic decisions are truly meant for the long term. So, think ten years, ten years plus. And then after we've kind of had the portfolio level decisions getting into the underlying concealment, the selection of the individual securities that populate that portfolio. And then depending on the mix of those underlying fulfilment, we'll be able to intelligently add the right level of diversity. That puts the portfolio in the best position to realize the client's investment objective.
GS: 00:23:52
So, let's talk fixed income again. What's been the driving factor helping performance in fixed income. And how has this translated to the portfolios you manage? Do you see opportunities in this asset class as the Bank of Canada and the Federal Reserve continue their easing cycle?
CM: 00:24:08
We've been through some challenging times from a fixed income perspective over the last several years, but more recently, fixed income is a performance story really well. It's largely due to the expectation of aggressive monetary policy cuts coming in, and that's been driving price appreciation. As we've talked about, bond yields have fallen significantly year to date. And that's the opposite of what we were seeing in early 2022. So early 2022. We knew from a bond market participant perspective that Federal Reserve and central banks were going to start to hike prices. The bond yields were moving up significantly. That's starting place that we had with higher bond yields entering the year meant that over the long term, our long-term capital market assumptions for fixed income were strongly positive.
Now we've got this environment where we have aggressive policy cuts getting priced in, bond yields have moved significantly lower and that has propelled the bond market globally to a spot where it's made really strong contributions to portfolio performance. And we think that going forward, because we haven't moved all the way back to the lows that we had in the pandemic, from an interest rate perspective, we still got room for the contribution to be strong going forward because bond yields are still higher. So that's connected to our long-term capital market assumptions, where the return from starting yields is higher than where it's been historically. And as you get that easing cycle to continue, we think that there's going to be a further positive impact on fixed income performance, with bond yields coming down from where they are now.
GS: 00:25:47
What's in store for balanced portfolios for the rest of the year? What risk could impact that performance? Looking ahead for the balance of 2024 or maybe even into 2025?
CM: 00:25:56
I think central banks having the ability to ease policy rates further from where they are today, particularly if economic growth slows, that is a direct benefit to fixed income, and that would be a direct benefit through capital appreciation and bond prices. Current conditions are showing that central banks are moving aggressively towards those lower rates. That does support long term economic and earnings growth, which is positive for equity markets overall. And our long-term capital market assumptions have equities outperforming fixed income. I think the environment that we're in right now allows those long-term capital market assumptions to be realized. So the strategic allocation that we have is in a really good position to be able to deliver against the long term investor objectives. If we get into an economic slowdown, recession, still think that we're in a better position because central banks can be even more aggressive with their policy decisions, so they further lower bond yields. That would increase the contribution that the portfolio would get from fixed income. So, all balanced portfolios right now are well positioned to deliver strong returns, at least through the end of this year and into 2025 as a result.
GS: 00:27:16
So really, this is just us talking about the fact that fixed income is providing that level of insurance to a portfolio. That was certainly under question during its very low interest rate environment. We were in kind of mid to post pandemic as higher rate regime ends worldwide. What advice do you have for Canadians who are looking for higher returns beyond maybe what they've been finding as they've been seeking out things like GIC’s or savings accounts?
WB: 00:27:42
As long as you think out long enough, the backdrop is actually quite strong for both equities and bonds, which means switching out of GIC’s or savings accounts into a balanced portfolio. That's a very prudent thing. Longer term, of course, you've got to make sure that you understand there's this complex system, right, a lot of complexity around current market conditions. So, brace for some of that volatility. If you move from and cash into balanced portfolios, lots of factors can cause markets to move in various directions. And it's not obvious ahead of time. And that's the hard part. So having knowledgeable professionals analysing these factors on a daily basis, having an advisor to work with you to make sure that they can help you see the long term.
I think all of those things help you align your portfolio with your own objectives. And if you do that properly, I think set you up for success. And then maybe that concept of diversification having more than just one thing driving your portfolio, having stocks and bonds, having different sectors and geographies and even different active individuals scouring the world for the best opportunities and try to find them and put them in your portfolio. Having a number of those things working for you is way better than just picking one and hoping it's the right one.
GS: 00:28:52
Craig, Wes, I think that's a great spot for us to pause our conversation for this quarter. Like, thank you once again for joining us in today's discussion. The insights you share will certainly help our client’s confidence in taking action and ensuring that they're achieving their long-term investment goals.
To our listeners, I encourage you to consider what you've heard here today from our experts. We see many Canadians take some short-term approaches to their long-term investment goals. While rates have been high or attractive on an absolute term, both rates starting to climb. There’re risks emerging with the strategy that need to be considered. Take advantage of today. Work with your advisor. Assess your long-term investment objectives.
Make sure that your solutions are appropriate, aligned with your time horizon and your risk tolerance. While not a straight line, the prospect of growth in both equity and fixed income market remains positive. With the power of compounding acting like wind in your cells, there's never been a more important time to ensure that your investments are properly positioned and focused forward. Thank you for investing your time in our discussion today. We aspire to deliver advice with impact for every future.
VO: 00:29:58
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