On the Money with Dynamic Funds

PARTICIPANTS

Myles Zyblock
Chief Investment Strategist

David De Pastena
Vice President of Portfolio Solutions

Speaker 1: You're listening to On the Money with Dynamic Funds. From market insights and analysis to personal finance, investing, and beyond, On the Money covers it all because when it comes to your money, we're on it.

David De Pastena: Welcome to another edition of On the Money. I'm your host, David De Pastena, Vice President of Portfolio Solutions. Today we're going to take a look at what happened in 2023 and the investment opportunities and risks for 2024 to look out for. To unpack some of these questions, my guest today is Myles Zyblock, Dynamics' Chief Investment Strategist. Myles is a recognized strategist in North America. He's also regarded for his investment insights that blend finance and psychology in order to capture major turning points in the market.

He has over 25 years of experience in guiding and advising on asset allocation for a diverse set of institutional and retail advisors across North America, Europe, and Asia. Myles, it's great to have you here.

Myles Zyblock: Thank you, David.

David: Myles, let's start with what happened in 2023. It was an interesting year for investing. Can you walk us through what happened, please?

Myles: Yes, sure, David. Performance in 2023 for most asset classes was almost a mirror image of what had happened in the prior year in 2022, everything from stocks to bonds lost value. Among the hardest hit areas was that group of very large US tech companies, but the downturn wasn't just isolated to those companies, smaller companies, international stocks, et cetera. They all generated negative returns, so too did bonds. A surprisingly strong global inflation shock, followed by aggressive monetary policy tightening, seems to have been a major reason behind this period of broad-based financial market weakness.

Contrast that with 2023, last year, we saw inflation pretty much everywhere around the globe begin to moderate. By the second half of 2023, more central banks encouraged, I guess, by the progress on inflation, began to place their interest rate-raising campaigns on hold. Lower inflation and the pause in monetary tightening helped most asset classes, but so too did a better-than-expected global economic backdrop and, obviously, the buzz around the benefits of artificial intelligence.

Those lagging large-cap tech companies in 2022 were among the biggest winners in 2023. Most asset classes were up in the last complete calendar year. It was an absolute 180-degree turn in performance from 2022. As we now enter a new calendar year, not only do forecasters believe there's going to be a soft economic landing, that being growth rates in most places just under 3%. The long-term average for world GDP growth is 3.4%, so we're talking 2.5% to 3% world GDP growth.

Then inflation will continue to moderate as well. While many central banks begin to lower their policy-set interest rates, the Fed is expected to cut rates this year by 150 to 175 basis points, while the Bank of Canada is priced to lower their policy rate by somewhere around 125 to 150 basis points. If this all happens in 2024, a soft landing, lower inflation, interest rate cuts, then it should prove to be another year that will be positive for financial asset prices.

David: You talked about the proliferation of AI and interest rates stagnating a little bit. I'm just curious, what can go right, but more importantly for the listeners, what keeps you up at night?

Myles: Well, as I mentioned earlier, most analysts and investors expect slightly below-average growth to surface in 2024 in many parts of the world. Below-average growth is believed to be what will help return inflation back to target in many countries. By target here, I'm referring to that roughly 2% inflation rate that many central banks, like the Federal Reserve, Bank of Canada, Bank of England, believe is the level consistent with a healthy economy. For most economies, inflation is still one to three percentage points higher than those targeted 2% levels.

We've made lots of progress on inflation, but it's still a little too early to declare victory. In other words, the course taken for the economy and policymakers, will remain a challenging needle to thread. A period of stronger-than-average GDP growth could raise the risks that inflation reaccelerates. This might then get those central bankers off the sidelines. If inflation risks become large enough, they might even need to consider raising interest rates further from here. If growth then were to slow by too much, it would surely help to push inflation lower, at the potential cost of much higher unemployment rates and greater stress in the corporate sector.

Here we are somewhat reliant on a Goldilocks global economy, one which is not too hot to reignite concerns about inflation, but one that is not too cold to bring the risk of economic recession back into focus. In my opinion, the key to all this is the labor market. We need labor demand to moderate further to place more downward pressure on wage inflation. That's a key factor in understanding overall consumer price inflation.

We don't want labor demand to slow by so much that it begins to push unemployment rates sharply higher again. That would undoubtedly bring a new set of problems into focus and all those problems associated with economic recession, like weak household income, weak corporate profits, upward pressure on loan delinquencies. I am hopeful, though, that we're moving towards this Goldilocks scenario given what we're seeing in the global economic data. Given that there is not a lot of margin for error here, we're going to have to closely monitor the incoming data and look for any important signs of change, signs that steer us away from this base case in one way or the other, and then adjust accordingly.

David: I think policymakers have an important job following all the data that's going to be released in 2024 to make sure they engineer a soft landing and be in that Goldilocks scenario that you mentioned, but we saw 2022 as a very difficult year for bond investors, and quite recently, we've seen a bond rally. What are your thoughts on bond yields and the risks and opportunities in bonds?

Myles: Bonds had a very difficult and volatile last few years to overgeneralize here, with their values being negatively impacted by the prior global inflation shock and rapid tightening of monetary policy conditions, but this negative performance bias is reversing direction now that central banks are moving towards a stance of keeping rates where they are, or perhaps even lowering them. Moderating consumer price inflation coupled with this one-way path for policy rates, that being flat to down, puts a ceiling on the potential for a backup in yields. This alone helps to reduce the overall risk of investing in bonds.

I do think that investors have priced in too many rate cuts for 2024. I'm just not sure we'll see five to seven interest rate reductions from the Bank of Canada or the US Federal Reserve over the course of the year. When investors begin to walk back some of those rate cuts, this is going to probably lead to turbulence in the bond market. Nevertheless, I believe that any resulting price weakness in the bond market should be bought.

Usually, the best periods for high-quality bond investors happen during the 12 to, say, 18 months after the central banks move to the sidelines. As I mentioned earlier, it was about midway through 2023 when most central banks moved to an on-hold position with their interest rate policy. Assuming inflation remains well-behaved, I think that temporary periods of bond weakness are better to be bought. Maybe bond yields won't fall by as much this cycle because the central banks will be slower to ease than, say, in past cycles, given that inflation remains above targeted levels, but the risk of significant further increases in interest rates from here seems to have greatly diminished. There's, I think, a better fundamental balance supporting the bond market today than there has been in the prior few years, that's for sure.

David: It seems as though we might not have the rate cuts, we expect, and there could be volatility in the bond market, which, from what you said, could actually be an opportunity to buy in. Let's take the conversation a little bit more domestic and talk about Canadian debt. Many experts are talking about the high levels of debt in Canada, mortgage payments, delinquencies. Can you comment on what's going on in Canada, the Canadian debt, and the housing market, which is the biggest asset for Canadians?

Myles: Yes, absolutely, David. Canadian households are highly levered. Debt stands at about 182% of disposable income, which is among the highest readings on record for Canada, and it's extremely elevated relative to that same ratio seen for households in other countries. Of that total debt in Canada, about 75% is mortgage debt, so the housing market plays a pivotal role in the finances of Canadian households. Today, about 5.5% of household income is being used to service their mortgage debt. This represents a big jump from the 3.2% reading back in the early part of 2022.

Of course, the increase in household debt servicing requirements is the result of the rise in the Bank of Canada's policy-set interest rates, the burden on households could even increase from here. Why I say this, this year alone, about $190 billion in mortgages will be renewing, and at current mortgage rates, we can expect a weighted average payment shock of 32%, so that's a big increase in servicing. The $315 billion coming due in 2025, I think it experiences about a similar payment shock, but fiscal 2026, that's when renewals have the largest portion of variable rate mortgages.

Unless interest rates fall meaningfully between now and then, the payment shock could be as high as 48% on a weighted average basis. The increase in mortgage payments will probably continue to weigh, I think, on loan and revenue growth of the domestic banking industry. While there'll be some increases in delinquencies, I do believe these should prove moderate if the Canadian labor market continues to hold together. The bigger spillovers might happen in other forms of credit, like unsecured credit and auto loans.

Canadian banks, as we know, and we've been reading about, they've been working to lower the impact of these payment shocks that are coming down the pipe. They've already been giving customers a menu of options, such as increasing monthly payments, switching to a fixed rate, making a lump sum payment, or extending the amortization periods. Nevertheless, the underlying fundamentals for the big Canadian banks, is probably going to remain sluggish for a while.

David: With all the interest rate volatility we've had and the increase in interest rates, it feels as though last year something broke, and we saw some of the banks in the US go belly up. Have we really seen the full effects of rate increases? Sometimes it takes anywhere between 12 and 18 months to see those effects. Have we really seen all of it, or is there another financial crisis in front of us?

Myles: Yes, David, you're right. In March of 2023 or the first quarter, we saw the failure of some US regional banks. In that same month, we also saw, let's call it a government-sponsored bailout, where UBS purchased Credit Suisse, so there was a period of pretty severe stress in the global banking system, part of which can be tied into these sharp increases in interest rates that were taking place around the world. Again, you rightly point out, increases in interest rates take time to filter through to the entire economy.

The first signs usually appear in the most interest-sensitive areas of the economy, like the financial sector as we just were talking about, the real estate market, the auto sector. There's no doubt we've seen slowing in these areas. I suspect that economic slowing is still unfinished business. What I suggested earlier is that it's been rare to see a deep or protracted economic downturn absent sharp job losses, and I think Europe offers a good example of what I'm talking about.

Over the past, say, year to year and a half, continental Europe has experienced a severe energy shock, dislocations in trade due to the Russia-Ukraine war, much higher inflation, and much higher borrowing rates. The continent isn't growing at all, really, but it's also not in any sort of deep recession. I think one of the reasons is that the employment picture has remained fairly resilient. Again, I don't think we've seen the full extent of this slowdown that's playing out, but if the labor market holds in, I think any sort of downturn will be quite mild.

David: It seems as though as long as people have jobs and keep paying their mortgages and spending money as they normally would, we might be okay, but what about commercial debt? It feels like there's another bubble there. Is this the next big thing?

Myles: Yes. The issues in commercial real estate are definitely troublesome, especially in some segments like office property, where vacancy rates in the US have moved to 19.6%. Now you go, what does that number mean? It's the highest reading we've seen in the history of the data that goes back to 1980. I think the structural challenges like working from home have combined with higher borrowing costs to generate a lot of heartburn in the commercial real estate and the office sector in particular.

For me, the biggest worry is that inflation reaccelerates well before it moves much closer to that desired 2% level. An aggregated measure of world consumer price inflation shows that inflation has declined from 9.3% at its peak back in late 2022 to 6.3% more recently. If a lot of central banks around the world, let's just say they begin to reduce interest rates this year as investors expect, it could lead to even stronger activity and renewed upward pressure on inflation from an already elevated level of inflation. Higher inflation affects all segments of the economy and the values for all financial assets, mostly not in a good way, as we saw back in 2022.

David: Myles, you and I have talked about hedge funds and alternatives for a while, and some were even saying the classic balanced 60-40 portfolio was dead, but with bond yields hovering around 5% with a volatility buffer, do we really need to add alternatives and hedge funds to a portfolio? Are they necessary now in this world of higher interest rates?

Myles: That's a really good question, David, one that we field quite often. Our work on portfolio diversification leads to a pretty strong conclusion that its benefits increase the most by including more asset classes, not less. Sure, one can diversify their stock allocation by owning some small caps, large caps, maybe some international equities, et cetera, et cetera, but if equities get into trouble for whatever reason, most of these stocks will fall together. Remind yourself of what happened in 2022. The same can be said about diversifying within the bond market. Again, these are still important, but they're not the entire solution to a well-diversified portfolio.

I think that diversifying across asset classes offers a bigger benefit for portfolios. In order to get more cross-asset diversification, we need to consider alternative asset classes like commodities or liquid alternative strategies, or as you mentioned, even hedge funds. More pistons built into that portfolio engine, raises the odds that the engine continues to run, even if one of those pistons begins to misfire, so keep in mind that a better diversified portfolio prepares someone for unexpected changes in the economy or financial market landscape.

If we had a crystal ball, there would be no need for diversification. We'd know exactly what to buy and sell. Nobody has a crystal ball, so we do need a well-diversified portfolio, which includes stocks, bonds, and alternative investments.

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David: Thanks, Myles, for all the gold nuggets. I think you've given us a lot to think about for 2024.

Myles: Thanks so much for having me on. It was a pleasure.

David: This is another edition of On the Money, and on behalf of all of us at Dynamic Funds, we wish you all continued good health and safety. Thanks for joining us.

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