PARTICIPANTS
Mark Brisley
Managing Director and Head of Dynamic Funds
Derek Amery
Vice President & Senior Portfolio Manager
Mark Brisley: You are tuning in to On the Money with Dynamic Funds, a podcast series that delivers access to some of the industry's most experienced active managers and thought leaders. We're sitting down to ask them the pertinent questions to find out their insights on the market environment and navigating the investment landscape.
Welcome to another edition of On the Money. I'm your host, Mark Brisley. Has there been a day in 2022 where we haven't heard about soaring inflation, rising interest rates, war in Europe, and energy crunch? Probably not. All of these have seen valuations plunge across all asset classes in 2022. I guess we could describe 2022 as a simple tale of inflation shock causing rate shock, which in turn is threatening recession shock and potential credit events. All of that, to summarize that inflation shock probably ain't over. The low inflation of the last four decades does appear to be over and a new era of sustained inflationary pressures and rising bond yields is upon us.
Investors who weren't around for the high inflation, low-growth environment of the 1970s are actually seeing a loss in purchasing power for the first time in many of their lives. Now may be the perfect time to prepare for and understand more about how rising interest rates are affecting client bond portfolios. It's also a good time for us to emphasize a key point. Over the long haul, higher yields can mean more income from the fixed income portion of client portfolios.
To unpack some of the issues of the day, I'm joined by Senior Portfolio Manager here at Dynamic Funds, Derek Amery. Derek brings over 20 years of investment industry experience to our Core Fixed Income team with a focus on Canadian fixed income portfolio management and is a member of a team that manages close to $42 billion in fixed income assets for the retail, institutional and private client channels. Derek, can we start with you speaking to some of the issues facing investors, in particular on central banks attempting to walk the line between combating inflation while also keeping us out of a recession?
Derek Amery: Thanks, Mark. As you pointed out, I've been doing this actually almost 30 years. While I've been doing it for the better part of three decades, I am certainly one of those investors that wasn't around in the '70s or '80s for those peak inflationary periods and the impacts that they had on markets, but I have certainly seen a number of market cycles and I hope to help you unpack, as you say, some of the issues that investors are facing, particularly in fixed income markets.
We talked about inflation leading to recession fears. I guess if I had to say maybe the biggest issue that investors are facing is that walking the line, as you described it, between combating inflation and keeping us out of recession, if I use Chairman Powell's own words, he talks about the narrow path to a soft landing. While I'm one of the most optimistic bond managers you'll ever speak to, I would say that that path is getting narrower by the day.
I do a monthly survey of the portfolio managers on the Core Fixed Income team at Dynamic, and at the moment that survey has recession risks at just a little under 50%, and I might personally shade that a little bit higher. At this point, I would say that recession is probably in our base case. Again, I'm usually one of the more optimistic portfolio managers but, again, I'm looking at the outlook now and questioning whether central banks will be able to navigate that line and keep us out of recession, as you say. I think that's probably the biggest issue.
As Myles Zyblock, our chief strategist has talked about, recession brings with a number of challenges for investors. One kind of simple way that he puts it and I think it's quite useful, is that if we can avoid a recession, then the necessary and sufficient conditions for a market bottom is simply to have a shift in monetary policy. However, if we don't avoid a recession, then you need both a shift in policy as well as an improvement in the macro fundamentals. I would argue that if we are going to go into a recession, and as I say, that's likely even odds at this point, we may be some ways away from seeing both a shift in policy as well as an improvement in the macro fundamentals.
Even in the absence of a recession, we are going to need to see a policy shift before we can have markets on more firm footing. On that front, I think that it's difficult to envision that we're going to see a policy pivot in the next few months, anyways, given the strength of the labor market, the persistence in inflation rates, again, both headline and core inflation, and we'll talk probably a little bit more about that. It's tough to imagine that we're going to see a pivoting policy that, as I say, would be at least a necessary if not a necessary and sufficient condition for markets to rally on a sustained basis.
If you look at policy expectations for the Fed Fund Rate in the US, at the moment, the market's expecting to see a terminal rate in the four and three quarters to 5% range, and that the Fed Funds Rate will stay above 4.5% through 2023. Given where policy rates are today, that doesn't really, in my mind, fit the definition of a pivot or even a pause in policy rates. I do think that the hopes that the markets have had periodically over the last couple of months for a fed pivot, obviously, those have been a little bit early and have proven to be a little overly optimistic.
I would argue that we're still, for the foreseeable future, in a policy-tightening environment, and that's going to present challenges not only for financial markets but, ultimately, it's going to be a challenging environment for the economy and we're likely to see a growth contraction at some point in 2023.
I guess the other issue that's kind of related to that is what we're seeing in Europe. Obviously, you would expect to see quite a difficult environment in Europe for the next 12, maybe even the next 24 months. That region is likely either in recession or very close to a recession. The energy crisis is taking a tremendous toll in Europe and there's a good chance that the energy crisis situation will actually be worse next winter than what it is going to be this winter.
That's putting a lot of pressure both on fiscal and monetary policymakers in Europe. We saw kind of an example of that in the UK where you actually saw fiscal policymakers looking at stimulative policies while, obviously, the monetary policy authorities are continuing to take out stimulus.
You had fiscal and monetary policy kind of working at odds with one another. I think you're likely to see the same kind of dynamics more broadly in Europe. Obviously, not quite the same situation as what you had in the UK, but clearly with what you're seeing in energy prices and the toll it's taking on both consumers and businesses in Europe, you're likely to see increased pressure on policy makers to try to address and shoulder some of that burden. You're likely going to have fiscal policy measures that are more stimulative in nature, while at the same time you're going to continue to see the ECB and the Bank of England continuing to look to remove monetary stimulus to try to combat inflation.
Again, that kind of tug of war between what you're seeing on the policy front in Europe is likely to mean that you're going to actually have to see higher policy rates in Europe to combat inflation than you would otherwise have seen in the absence of fiscal stimulus. That's, obviously, going to continue to be a very challenging or a more difficult and even more challenging environment for the European economy. Overall, as I say, I think the biggest issue that investors are facing is how to navigate what is likely to be a recessionary environment in most developed markets.
Again, I would argue, and again, I'm not trying to sound too pessimistic, but I would say that markets probably haven't fully priced in that recessionary scenario. Earnings outlooks that have come down or still, I would say, overly optimistic. We will likely see an earnings contraction next year and that's not yet in the consensus forecast. I would say, similarly, if you look at risk premiums, whether they be in equity markets or in credit markets, obviously, they've improved and they're pricing in a certain percentage of probability of recession, but I would argue they're not fully pricing in a recession.
I think both overall on the outlook, I'm still defensive. On asset class valuations, I would similarly be defensive. I think those are probably the biggest issues in my mind that investors need to try to, again, unpack, as you say, and try to navigate.
Mark Brisley: One of the subjects that's probably hard for a lot of investors to separate is the Wall Street versus Main Street idea, where inflation pressures having an impact on portfolios but, certainly, on household balance sheets as well. It wasn't that long ago, we were talking about whether this post-pandemic inflation was transitory, The Fed is clearly admitted that that was just a wrong assessment and that, ultimately, their delayed policy response, as you outlined in a recent commentary, to that persistently high inflation was a mistake. If we look at things now, in your opinion, where do you think we are in terms of inflation being at a peak or is there more room to go?
Derek Amery: Where we are now is, central banks trying to avoid going to the last stage of evolution in inflation where you move from being persistent to being entrenched. Obviously, that's the worst stage of that evolution that you can get into. I would argue that the recent data would suggest we've, hopefully, seen the peak at least at headline inflation, albeit barely, headline inflation has moderated a little bit. Again, and most of my comments will focus on US inflation just being how important it is for driving global financial markets.
Obviously, we have seen the data roll over a little bit at the headline level. Many leading inflation indicators would also appear to support that hypothesis. You've got commodity prices that have declined as have break-even inflation rates. They've also come down. You've had shipping and freight costs have also kind of moderated. Retail inventory levels are on the rise. The inventory sales ratios would point to a moderating of inflation pressures going forward. There are signs that the worst in headline inflation is behind us.
Having said that, obviously, it wouldn't take too much of a rebound in energy prices as we've seen in the last two weeks or kind of ongoing upward pressure on food prices to nip that moderation in headline inflation in the vibe quite quickly. Where I think the outlook gets a little bit more problematic is the outlook for core inflation that certainly has yet to peak. If you look at core US CPI, it printed 6.6% for September last week. That clearly has not peaked. Moreover, if you look at the six-month annualized rate of US core CPI, it was running at 8.5% last month.
Clearly, that's at worrying levels for the Fed. When you look beneath the surface at some of the underlying drivers of that high core inflation, you do see risks that it could be more persistent then, obviously, most of us as consumers and, certainly, as central bankers would hope for. One of the biggest components for core pricing is shelter costs. The biggest weight in shelter costs is rent and particular owner's equivalent rent. Again, there's been a lot of debate about how they calculate the owner's equivalent rent. We can talk about that another day.
What we've seen in recent months is that owner's equivalent rent, that, again, makes up about a quarter of core CPI, has been very highly correlated with housing affordability and, therefore, mortgage rates. With mortgage rates at 40-year highs and affordability at record lows, essentially, people who just can't afford to buy a house are forced to continue to rent. That's keeping upward pressure on owner's equivalent rent within the CPI measures.
Yes, the housing market is slowing. We are seeing housing prices decline and that's, ultimately, going to feed into owner's equivalent rent into shelter costs and into core CPI, but that's going to happen with a lag. That element, of course, CPI is at risk of being more persistent that we'd like to see it. Similarly, unit labor costs are also worryingly high. Look at some measures like the employment cost index running north of 5%. The Atlanta Fed has a wage growth tracker that it measures and it's showing wage growth just below 7%. Obviously, these are pretty concerning numbers with respect to fears that the Federal Reserve would have a better wage-priced spiral, which again, is a key driver of that going from persistent to entrenched inflation, is that wage-price dynamic.
The central banks are going to be looking and have been very clear that they would like to see more slack in the labor market as a way to moderate inflationary pressures. Really on that point, we haven't really seen a lot of signs to date of moderating in the labor market and getting to a better demand-supply balance that you would need to see to moderate some of those labor costs. The unemployment rate in the US is at record lows. You haven't seen a meaningful pickup yet in the weekly jobless claims numbers. There's still almost 1.8 job openings for everyone employed person in the US, and we also haven't seen that participation rate get back to levels where it was prior to the pandemic.
Again, all those are pointing to what are likely to be some stickiness in labor costs. Then you add that to the stickiness in shelter costs. Again, it could be an environment where core prices may mean we may not have seen the peak there. Again, it leads into what may be a more important question, even if we have seen the peak in inflation, what do central banks do if we see inflation rates moderate from the headline level at 8 and the core level at 6.5, What happens if they moderate but 4.5 to 5 and then plateau there, what's their reaction function to the fact that, yes, we've seen the peak in inflation, but it remains persistently above or well above their 2% target level. That could be a difficult environment for the Federal Reserve and other central banks globally in terms of how they balance those risks to growth while still combating, hopefully, not yet entrenched inflation.
Mark Brisley: You talk about a difficult environment for central bankers and policymakers, so you think the environment going down channel then to the retail investor and just how difficult it has been. I saw a chart last week, I think it was from Bloomberg that talked about a period where both stock and bond indices being sort of in similar territories, only three times since 1926 up until 2022, I think being 1931, 1969, and now this year where they've both been in negative territory at the same time. That's really putting pressure on portfolios. When we think about the retail investor, we leave the equity portion of their portfolio to one side. When they're thinking about fixed income going forward, how can they best navigate this?
Derek Amery: As you said, obviously, the stagflation or low growth high inflation environment is a difficult one for all asset classes. Thankfully, that's not an environment that we've been in very often. In terms of how to best navigate the fixed-income market at the moment, my advice would be, again, I would at this point continue to stay defensive and if possible stay liquid in order to take advantage of opportunities that I see as we move through 2023. Again, while I've been arguing why the environment for fixed income, at least in the near term, might remain challenging. I think there are going to be some tremendous opportunities in the asset class at some point next year.
As I talked about in terms of what the policy expectations were with the terminal rate now expected to be, again, in the neighborhood of 5% and the policy rate remaining above 4.5% for most of next year. That's a dynamically different environment from where we were just a couple of months ago where the market was expecting the terminal rate to be only 3.5% and to see rate cuts in the neighborhood of 3 or 4 rate cuts next year. Again, I think that that was the market getting well ahead of the Fed. At the moment, those policy expectations that I just described, where they are currently, I think are much closer to what the reality will be.
With it, we've seen, obviously, bond yields move higher in concert with those policy expectations. While that's, obviously, been a challenging environment for returns this year, obviously, we're much closer now to what I think is fair value in the rates market with US 10-year yields in the neighborhood of 4%. I think that's much more closely aligned with what we're going to see on the policy side. I think as we move through next year and as the market begins to anticipate a more realistic timeline for a shift in policy, that we're setting up for yields to decline towards the second half of next year.
I think you're going to want it as much as possible try to keep your powder dry to take advantage of that. Similarly, on the credit side, well, I think there is risks that credit valuations could widen a little further. As we move into a downturn, if you look at where credit spreads are historically, we're at levels that are very good risk reward entry points in a non-recessionary environment.
Again, I think we're getting to the point where the markets are pricing in a much more realistic scenario, both for policy as well as for the economy. I think that's going to set up fixed-income markets with some opportunities next year, both on the rate side as well as on the credit side. As much as possible, again, just in the very near term, I think it would be prudent to stay defensive, but I think you want to position yourself to take advantage of these opportunities the early part of next year when, I think, the outlook for fixed-income markets are going to be much more positive.
Mark Brisley: That's an interesting point. When you say defensive, staying liquid, keeping some powder dry, as you put it. On the other hand of that, cash is compelling, GICs are kind of compelling right now, but I don't think you're suggesting either that you just stay completely out of the market. It's just be ready for opportunity.
Derek Amery: Yes, as I say, I think it's being ready for opportunities that are going to present themselves from a investment horizon in the very short term. You can stay liquid, maybe stay in cash, but you want to have the ability to not want to lock in that liquidity in a product necessarily like a GIC where you don't have the ability to exercise on those opportunities as they present themselves because I do think they're going to present themselves in very short order here, particularly, when you look at what an investor's time horizon should be.
Mark Brisley: Which is kind of another way of saying, don't go long on liquidity.
Derek Amery: Exactly.
Mark Brisley: I guess I wanted to ask you then from a portfolio management perspective and as a professional investor, where are you seeing opportunities for fixed income?
Derek Amery: Well, as you pointed out, we're actually looking at the most attractive yield environment for fixed-income investors that we've seen in 15 years. If you look at the average yield to maturity for the broad Canadian market, it's around 4.5%. If you're looking at Canadian investment grade high-quality corporates, you're looking at a yield to maturity on average of about 5.5%. In the US market, add 50 basis points to those numbers. You're looking at around 5% on average for the aggregate US market, about 6% for high-quality corporates in the US market.
Overall, it's kind of cliché but income is back in fixed income where if you can earn anywhere from 4.5% to 6% or 7% in some higher grade corporate bonds, that yield backdrop, I think, is obviously more attractive than it's been in a long time. I think, for most retail investors, that would be a pretty attractive yield environment, income environment, again, for high-quality investment grade fixed income markets to yield, to be able to earn yields, as I say, in the 6% or even 6 plus percent area. Again, I think there are opportunities, shorter dated, high quality investment grade corporate bonds come to mind as an area of opportunity. As I mentioned, I think the overall rates market and the policy expectations are, again, much more in line. I think we're much closer to fair value in the rates market as well as in the credit market. As I say, as we move a little bit into 2023, as we get closer to the market getting ahead of that policy pivot on a timeline that I think is realistic, again, the fed pivot hopes that we've seen this year were too early, but as we move into next year, I think they're going to become on a timeline that's much more realistic. I think you do have the opportunity to see those yield levels come down and, obviously, generate some capital gains as well as that income in fixed income. As I said, near term, the opportunities, I would argue, to stay prudent and stay a little bit cautious, but I do think that there are opportunities developing in fixed income into next year that you want to be able to take advantage of as an investor.
Mark Brisley: Is that the framework then for a silver lining in all of this, or is there a bigger piece even?
Derek Amery: No, I think you're right. Again, you can say that you can earn decent income in fixed income now. Whereas, that was a much more difficult conversation to have, just a couple of years ago. Again, being able to earn mid to higher single digits in investment grade fixed income space, again, is compelling. The fact that you can see both credit risk premiums narrow as well as the rates market rally, obviously, that is a very powerful combination for returns in fixed income. I think we're much closer to being in that kind of environment than we've been for quite a while.
Mark Brisley: One area, I know, you and I both agree on is, some of these scenarios, they're complex, they require a lot of due diligence and advice. I think dealing with a qualified financial advisor to talk about how portfolio construction is being determined right now is a key piece in all of that. A final question to that note, as the retail investor and many of our listeners are sitting there thinking about what you've discussed today, maybe it's a good time to just say, why do bonds still matter in a diversified portfolio, especially given where we are in the current cycle?
Derek Amery: As you pointed out, the environments where all asset classes perform very poorly have been very few and far between. I think that if you look at most scenarios going forward, it's likely to be an environment where some combination of fixed income equities alternatives is going to perform very well and, certainly, going to perform much better than as performed this year.
Again, as you pointed out, it's only the fourth time in the last 60 years essentially or 80 years where all asset classes have performed as poorly as they have. I would argue that the outlook that I have going forward is one where you're going to want to continue to have a well-balanced portfolio that includes, as I say, fixed income equities and alternatives. Fixed income with where yields are today with where risk premiums are today, as I mentioned, I think fixed incomes poised to deliver much better total returns than we've seen this year and, thereby, be able to contribute much more positively to the overall performance in a balanced portfolio.
If we're still going to see a recessionary environment next year, that may be an environment that still presents challenges more broadly to risk assets, but it would be an environment that could be very positive overall for fixed income. If we do see a more meaningful slowdown in growth in a more meaningful decline in yields, you could see the fixed income portion of your portfolio generating the line share of positive returns and a balanced mandate. I think with income levels where they are with the potential for capital gains from lower rates as well as narrowing risk premiums, again, I think fixed income should continue to play an important and a key part in a balanced mandate. As I say, next year, you may see fixed income being the asset class that helps deliver some of the best returns.
Mark Brisley: As I said, there was a lot to unpack here, and I think you've given us a really good overview of where we are currently. For all of our listeners today, I think the next logical step is to talk to your financial advisor about how your portfolios are currently positioned and where you can glean some of those opportunities. Really appreciate the time you spent with us today.
Derek Amery: Great. Thanks very much, Mark.
Mark Brisley: To all of our listeners, thank you for joining us as well. If you would like to get any more information about what we've discussed, please feel free to visit us at dynamic.ca and, as always, we continue to trust heavily on the fact that we believe in investing with advice through the services of a qualified financial advisor. We hope everyone is continuing to stay safe, and we look forward to speaking with you all soon.
You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic, and our complete fund lineup, contact your financial advisor or visit our website at dynamic.ca.
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