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The risk of recession grows as the U.S. Fed continues its war against inflation. Michael Craig, Head of Asset Allocation, TDAM and Scott Colbourne, Managing Director, Active Fixed Income, TDAM, weigh in on what to expect for equities and fixed income for the second half of 2022 and beyond.
Transcript
– What can we expect for the second half of this year and beyond. Joining me is Michael Craig, Head of Asset Allocation at TD Asset Management, and Scott Colburn, Managing Director Active Fixed Income also at TD Asset Management. Gentlemen, got some big issues before us to throw out there. Obviously, a bit of crystal balling saying what is to come for the second half of the year and beyond.
But let’s start with what we had today, maybe I’ll start with Scott, in terms of the inflation print. I mean, it’s hot and maybe, it might have been a bit cooler than expected but 21% still pretty odd.
– Yeah, and it’s consistent around the world right everywhere. Headline inflation is very hot here. I think I’m going to try to spin it slightly positively, we’re starting to see or think about the peak in headline inflation here.
So you’re seeing inflation expectations come down a bit, you’re seeing some evidence of demand, I don’t like to use the word destruction, but slowing growth globally. And then that’s going to eat into the headline inflation, as well as reduce supply chain pressures around the world.
So I’m going to take a slightly positive, we saw it less than expectation. And I think we’re going to see this is the peak here.
– So a peak of inflation, Michael, is that going to be good enough for investors? It would be nice to see a peak because we’re all living through this. It either affects our portfolios or it affects our everyday lives — gasoline, food. But do the markets take much ease if we come in at 7.9% next month?
– So I think the fall will be very indicative of where we kind of finish the year off. It really is a race now between how quickly inflation can roll over back to the 2% target, versus how quickly growth is slowing. And the risk is that if growth slows rapidly but inflation stays a bit buoyant, we’re in for a volatile second half of the year.
So that to me is the key thing, there are certain aspects of inflation that are certainly going to come down. Commodities are broadly speaking off their highs. You’re seeing gasoline prices drop across the board. You are seeing tremendous slowdowns and growth.
But there are parts of inflation that are going to remain sticky like rent. And that’s going to lead to — by the end of the year inflation is still going to be running at 4% year over year, 5% year over year. So we’re not out of the woods yet. The key is that race between growth and — slowdown and growth versus slowdown inflation, in terms of how the markets trade next to the while.
– Now if I was a central banker, I would hope to be seeing peak inflation, to see is start to come down. But still they’re being very aggressive, and we’re expecting further aggressive moves, not only from the Fed, which will be next, but then from the Bank of Canada in September. So Scott, in terms of when they might stop all this?
– Yeah, I think they are close towards the end, 3 and 1/2, 3 and 3/4 is sort of where the markets have priced, in both Canada the United States, 2 and 1/2% is where we are here in Canada. So we’ve got another percent or a bit out of the Bank of Canada, between now and the year end.
They want to get above what they consider neutral, or a little bit more, and then reassess and, to Mike’s point about reflecting on the persistence of inflation, the underlying stickiness of inflation, wages, shelter, healthcare inflation, so that type of thing. Reflect on how persistent it is, and then we’ll see whether next year, and what’s priced in for next year, and the year after, in terms of cuts, whether that’ll even play out or not.
– And that is the real wild card, it’s so much we kind of know how it’s going to play out this year, in terms of policy. The bond market actually is looking for three cuts next year. Bond market’s basically telling you, we’re going to go into recession.
– That’s what I’m saying, if we’re talking about cutting, then we’re talking about the R word, so let start with the R word.
– So the challenge with that though, is that, I don’t think they have a path to cut unless you’ve seen inflation back on a two-handle. And so this is really the challenge, if inflation does roll over, and we see it on two-handle might be a bit aggressive, but really moderate then I think that can play out.
But the risk is that we actually do go into a hard slowdown or some type of recession, and the central banks don’t have the room to cut, because inflation is still buoyant and that would get you into somewhat of a stagflation environment. That is a very challenging environment and you’ll likely see very inverted curves. Ultimately they will cut, but the question is that timing. Is it Q2 next year, is it Q4? Because again, it goes back to that. They’re not going to take the foot off the gas until they see inflation really, really pushed lower.
– Now when we got that 100 basis point hike from the Bank of Canada, they talked about the fact that, OK, we’re going to front-load all of this, in the hopes of getting that soft landing. Obviously, if we’re talking about a hard recession we’re not talking about a soft landing, how tough is the soft landing? I mean, what size of a ship am I trying to land on top of the dime.
– It is so hard to land. It’s a narrow window, a narrow sidewalk to land on a size of our economy, let alone the US economy on a soft landing basis. So I think, when you’re looking out and thinking about the R word, you’ve got versions of that globally.
The Achilles’ heel in Canada is housing and our over levered household sectors, so do we have a balance sheet recession, as people really pull back. That’s the classic Japan balance sheet recession. The US is sort of slightly different, Europe’s another version with being squeezed by energy.
And then we don’t talk a lot about it, but China is definitely out there. It’s the second largest global economy and they just had a second quarter GDP print that was flat. And they have a property sector that’s really struggling. So you’re going to have R, but it’s going to be different versions of it globally.
– And probably not — you think about previous recessions, where you had materially higher unemployment rates. I’m not so certain this time around you’re going to see employment, unemployment go back to 6% or 7%. So from an employment standpoint it actually might not be that brutal.
And it’s going to be different people will be going through different versions of this recession. Like if you again, if you’re over levered and you’re just barely making mortgage payments and you’re on a variable rate mortgage, it’s a challenging environment, if your employment is geared to housing. It’s going to be a tough market, but other areas of the economy, probably not the end of the world.
Because I don’t think based on labor markets so tight today. And we’ll likely see it open up, and we’ll like to see unemployment rise. But I don’t think it’s going back to that the 2008 type of unemployment situations that we saw 14 years ago.
– Final thought on this topic. Is Canada at the whims of the global economy? You mentioned China, Scott. I mean, there are big global forces for our small open nation.
– Yeah, we’re a small open economy, and we’re buffeted by the winds. And obviously what has been a tailwind is commodity prices, and that is and has turned, and do we get much relief? I mean, you can dig into that more thoroughly.
But I think that we’ve seen the peak in commodity prices. And there’s going to be some firmness. But that’s going to turn from a tailwind to a headwind for sure. So Canada is going to struggle globally. And so I in fact — we were a leader, in terms of thinking about monetary policy and getting out ahead of the Fed, and had 100 basis points. But I think we’re going to be lagging the Fed shortly.
– So let’s dig down to equities. Let’s dig down to fixed income. I’m going to start with you, Michael, on the equity side. We’re pretty much sticking to the thick, I’m going to call it thick. We’re deep in the earnings season, at least in South of the border, some concerns about the strength of the US dollar, how is that all playing in?
– So earnings season has been a bit choppy, JP Morgan came out with some concerning comments, less buybacks, et cetera. I think the thing with this earnings season, is what we’re looking for is this where CFO, CEO, start kind of throwing out everything, and using the opportunity to really take down expectations. Markets already traded down this year, we’re trading at 16 times.
That hasn’t really happened yet to an extreme. And I would say that, before you kind of get really bullish on equities as we go through this period is, the Street is still looking for pretty solid earnings growth in ’23. We think that’s probably not realistic.
And so that’s probably the last thing you want to see is actually an earnings recession, or earnings traded down for ’23. And then at that point, the stock markets look a lot more interesting in terms of getting committed to. I think through the summer tradable rally, volumes are pretty light. But again, I think we’re going to be in quite a volatile environment as we come into the fall.
So still challenges, valuations are far better than they were. And thinking if you’re really not focusing on the next 12 months, it’s probably not — these are actually interesting times to look at equities. But I still think there’s some volatility ahead.
– If we don’t get those earnings revisions to the downside as we’re sort of concerned about heading into this earnings season, is the pain just further down the road, are we kicking the can down the road?
– 100%, Yeah, 100%, I mean, again, if magically inflation traded back to 2 by October, which it won’t, and the central banks really took their foot off the gas, in terms of hikes and perhaps that can play out. But our sense is that you’re going to have to see some degree of re-rating lower as we go into ’23 and really take those expectations down, and then we’ll start to look at a basing in terms of volatility and stock markets.
– All right, Scott, this whole idea of the balanced portfolio that is perhaps if the equity side isn’t working the way I have my fixed income side as well. As you said off the top of the show, been a tough year, in terms of the fact that we see the equities pullback. And then we see the fixed income pullback as well. I mean, what’s happening in the space and where are we headed?
– Yeah, I mean, I think that was a once in a multi-decade sort of regime shift. We had this inflationary impact in a low growth environment. And rates and central bankers were aggressive. I think we’re finally at the point where it’s reasonable value. And somewhat similar to what Mike saying is like, look, we’ve rerated fixed income. We’ve got yields — let’s say 10 year yields in both the United States — between 3% and 3 and 1/2%. Probably the top here for a while. And I think it makes sense to rebalance.
I mean, you use fixed income for a variety of reasons in your balanced portfolios. And one of them is to diversify against the volatility on the equity side. And while we didn’t get it in the first half because of unique backdrop, I think it’s playing a role again. And it behooves investors to start at least nibbling here.
I mean, the fall is going to be volatile, right? We don’t know where inflation is going and where core inflation is going. And we still have some rate hikes to go. But it makes sense to start nibbling, for sure.
– I want to put you guys against each other to certain degree. I know you’re colleagues, I know you’re friends, but the terms of — I think the fact that we’re actually starting to see some yield now does make bonds interesting, perhaps more interesting than they’ve been in a long time. But then you’ll have people say, hey, why can’t I just be in an equity with a pretty handsome dividend yield? That could give me some capital appreciation. So fight it out, guys. I don’t know who wants to lead.
– Yeah.
– Well, a few things here, right? If you’re trying to build wealth, equities are typically going to be your driver of choice. The reality is that all in fixed income yields are 4 and 1/2% when you include corporate bonds, whatnot. That’s really attractive. I mean, we are at levels of yield that we haven’t seen in 10 years. So it’s an interesting time.
I think there’s still a degree of volatility in both, but I think there’ll be more of volatility in equity markets. So, I mean, I’m kind of copping out here.
– Yeah, he’s giving it to me.
– I spent my entire career with the equity for the long run. And I think one thing to think about is obviously the allocation between equity and fixed income, you don’t want to be 100% equities. But I’d like to make a pitch for high yield, right? And high yield is 8 and 1/2% nowadays. And that favors comparably to a 6 and 1/2% dividend yield.
When you look at the volatility of high yield over time, it gives you a fraction of the volatility. Maybe a third of the volatility of the equity market. So if you’re really wanting to be out the risk curve, and risk curve and fixed income, it makes sense to actually start legging into high yield. And that is very attractive, more attractive than some of the common dividends.
– Whether we’re talking equity, whether we’re talking fixed income, where’s the risk right now? Obviously these are volatile times. I was talking with someone recently who said, we could devise a strategy if only we knew where we were at this moment. This seems to be the hardest thing from day to day. And I sit on my desk and I’m looking at the move and saying, where exactly are we right now?
– I would think there’s a bit of risk in long dollar positions, quite frankly. The US dollar has moved a long way. There’s still lots of people who are quite bullish on it. Again, as soon as you get a sniff that the US — the Fed’s ahead of most central banks, excluding Canada. As soon as you get a sniff that they’re going to pause, I think you see a big, big rollover in the dollar.
Euro is trading at parity. Dollar yen is trading at like — I don’t know, I don’t think I’ve been alive since — well, maybe I was four when the yen was last this high. So to me, that’s a risk in the market that investors should be mindful of, is that the US dollar is very, very elevated.
A lot of risk aversion. And as soon as you get those interest rates differentials starting to narrow, I could see the dollar come — I don’t think it’ll happen next week, but if I were to think next couple of years, to me that’s one where it doesn’t make a lot of sense up here.
– Scott, it’s always been my understanding that the bond people, either they are the smartest in the room, or they say they’re the smartest in the room. So you take a look at the bond market and what’s happening, what is it telling us about what’s really going on in the world?
– I think it’s telling you to not overthink things. And actually it is a hot summer. I would try not to over trade and overthink things. I think we’re going into potentially a challenging second half in terms of trying to discover where we’re going. There’s a lot, as Mike said, a lot of consensus trades out there. Long dollars, long commodities, short yen. Really negative on Europe.
And so you could see some of that unwind and contribute to rallies, trading rallies through the summer. Don’t over trade, don’t over position it, certainly, from a longer run point of view. I mean, if you’ve been underweight fixed income, kudos to you. And you should be starting to nibble away. But I honestly think it’s time to step away from the markets a bit during the summer.
– All right. The summer doldrums. Do you agree with that, Michael?
– Well —
– Here we get the friction.
– The bond guys in their summer khakis. Look, one thing I would say is that the 20-teens were an interesting decade. A lot of limited dispersion. Everything kind of worked. And I think we’re in a far different world today. Whether it’s geopolitics or commodity security, I mean, the next guest will talk about the lack of commodities available in terms of supply, in terms of populism, in terms of ESG and global warming.
There’s a lot of risk out there. This isn’t to be too bearish. I just think we have to reset our expectations about investing. The biggest thing about investing is avoiding big mistakes, avoiding defaults or bankruptcies. And I think it’ll be a period where people who think through that, investors will do quite well.
There is, I think, a lot of pitfalls ahead of us. And that’s kind of how we’re thinking about the next 10 years in terms of — I think the opportunities, that’s great. The valuations are far better today, just by definition. But they are telling you that there is much different risk today. The markets are going to price that risk, but remember that risk is still there.
And in a world where — look, we might be talking about lower inflation next year. And we might be talking about high inflation by 2025. Because the supply of goods is much tighter. So things to think about longer term, I think, over the next decade.
– Great discussion, gentlemen. Really appreciate you joining us today.
– Thank you.
– Our pleasure.
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