On the Money with Dynamic Funds

PARTICIPANTS

Romas Budd
Vice President & Senior Portfolio Manager

Derek Amery
Vice President & Senior Portfolio Manager

Derek Amery: Welcome to the podcast. I'm your host, Derek Amery, Vice President and Senior Portfolio Manager and Co-Head of the Core Fixed Income Team at Dynamic Funds. It is my pleasure to have the other Co-Head, Romas Budd, Vice President and Senior Portfolio Manager joining me today. In this episode, we'll be discussing the recent rate cut by the US Federal Reserve and we'll explore its potential impacts on the economy, both in the US and here in Canada, while unpacking what it means for investors and for the broader financial landscape.

Announcer: You're listening to On the Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders.

Derek: Romas, welcome.

Romas: Thanks, Derek.

Derek: Let's start with the recent development that has been top of mind for many investors, namely the US Federal Reserve's announcement of a 50 basis point rate cut to begin their monetary easing cycle after two and a half years of tightening policy. In your view, was this move anticipated by the market?

Romas: Right, Derek, the Fed ended up doing 50 basis points. We know the markets were waiting for them to start the easing cycle, and we certainly got that with a bit of a bang. Now, they've framed it as a recalibration, so we shouldn't read too much into it, but it is the first rate cut in two-plus years. Now, as far as why they went 50 versus 25, it looks like the focus right now is on the fact that the US economy is slowing somewhat, and inflation has come closer to target.

They're trying to get ahead of what they feel will be some labor market weakness going forward. In fact, that's what they've talked about. Now, that's not without its own risks, because if the labor market stays tight and they end up cutting as much as the market has already discounted, they might have to stop prematurely or even reverse course. The market's gone a long way. The market expects the Fed to cut all the way from 5% to 3% by June of next year. That's very dramatic. We do think we have to be careful about that.

As active managers in the bond market, we are concerned that maybe the markets per se are getting a little bit ahead, in other words, pricing in more than we're going to see from the Federal Reserve Bank of the US and the Bank of Canada.

Derek: You talked about the fact that the Federal Reserve has an explicit dual mandate of both price stability and full employment. Maybe just expand a little bit on your thoughts in terms of what you think their decision to go 50 basis points implies for their thinking on the balance of risks between that price stability objective as well as that full employment objective. Where do you think the balance of risks lies between those two objectives?

Romas: It's pretty clear that they're focusing on the fact that they're going to see some labor market weakness and overall US economic weakness, perhaps below what they consider potential growth rate of 2% or 3% versus inflation, which has come down quite significantly if you look over the last couple of years from about 8%, 9%, even down into that 2.5% annualized rate. We do have to be careful. One thing I will keep coming back to that we're really not at 2% sustainably yet. We have other issues. We have some strikes going on.

This idea that labor will be very weak, and they need to get ahead of it may end up being perhaps a little premature from the standpoint of the Fed and the Bank of Canada, both moving in that direction. We've had, as people would know, Air Canada strike, a pilot strike where they got a big settlement. We're potentially looking at the dock workers in the US going out in October, looking for big wage increases. It's not clear to me that labor is quite as weak as Jerome Powell and the Federal Reserve at this point is portraying it to be.

Derek: You touched on what the market's expecting in terms of the path of policy in the US. Maybe talk a little bit about what your views are in terms of how you think the evolution of policy will unfold relative to what the market's discounting. We've seen on a number of occasions over the last two and a half years where market expectations seem to diverge, at times maturely from the guidance that we've been given from the Federal Reserve.

Maybe talk a little bit about what your expectation is for the path of policy and how you think that lines up with either the Fed's guidance and/or what the market's currently discounting.

Romas: Well, look, we are definitely in a cutting cycle, there's no doubt about it, all around the world. The Fed is following Europe and Canada. We cut already a number of times before they even cut their rate even once. The issue for me continues to come back to how aggressively the market is discounting going forward. The expectation that we're going to be all the way down to 3% from 5% today by June, I think a lot of things have to just fall into place perfectly, as in growth slowing, the labor market slowing, unemployment rate perhaps taking up a little bit, but inflation remaining very well controlled close to that 2% level to get to that 3%.

I'm in the camp that, sure, we're going to get a few more cuts by year-end and then we have to reevaluate. I would not be surprised if the market's gone too far with how many cuts are expected, which means, also, people have to be careful with how they're investing because as we're all well aware, the market discounts things well and ahead of time. The market's already been discounting a bunch of rate cuts well ahead of time. That's already priced in.

If that doesn't happen, of course, the markets, that would be bonds and stocks, would generally be disappointed. There would be some risk being invested on those markets at this time just in an aggressively long fashion.

Derek: Perhaps touch on what all this means for Canadians. Do Federal Reserve policy decisions have an effect on the Bank of Canada's decision-making process?

Romas: For sure, we're seeing an impact in Canada. The Federal Reserve is giving the Bank of Canada more room to cut if they're cutting at the same time. Our economies are very correlated as people are well aware. The most recent surveys in Canada, it is having a positive impact on people's confidence going forward here. In fact, the economic optimism rose to the highest level in more than two years in Canada, according to a Bloomberg Nanos Canadian Confidence Index. Really, Canadians are feeling a little bit better.

There's been a little break with mortgage rates coming down, especially for those that own houses on variable-rate mortgages. It's also just an improving confidence that growth will be better going forward. Just generally, it lifts people's optimism and improves spending. We saw definitely a bump-up in retail sales in Canada in the last couple of months as well. Now, again, it is kind of a virtuous cycle. As rates come down, the optimism builds.

Sometimes that goes too far, and all of a sudden, you have to cut the rate-cutting cycle short because optimism has picked up. Certainly, we don't think we're completely out of the woods and people should be careful, certainly about where they're investing and how much debt they have going forward.

Derek: We talked about the explicit dual mandate from the Federal Reserve. While the Bank of Canada doesn't have an explicit dual mandate, we certainly have inflation targets here in Canada and we certainly have an implicit objective of strong and stable employment. Maybe talk a little bit about your views on how both the inflation and unemployment risks are unfolding here in Canada.

Romas: The view is pretty similar to the US, except I'll say that the Canadian economy is a little slower. The labor markets are a little weaker. The unemployment rate has gone up a bit more. It's nothing really to worry about. We're not talking about the dramatic types of levels we would see in a recession. Generally speaking, the Bank of Canada sees a fairly good outline going forward where they can continue cutting at the moment, but our biggest concern is the labor markets and the lack of productivity in Canada could still put pressure on inflation in a more secular sense.

In other words, it's going to be difficult to get 2% inflation on a sustainable basis, which is their target. If we can't get there, we're probably not going to get down to those 2%, 2.5% type interest rates that we were at a few years ago.

Derek: You often say that you like to go where the data takes you. Maybe touch on one or two indicators that you believe perhaps the market is either ignoring or is underappreciating in terms of its impact on the direction of financial markets going forward and that investors should keep an eye on.

Romas: One of these is wages, salaries, and the strength of the labor market. That's one of them. I don't think that people are focusing on that enough. As the average Canadian would read in the papers or in the media, they are seeing that there is workers trying to catch up from the fact that the cost of living has gone up quite significantly over the last three years. Even though the current inflation rate year over year might be fairly small, people have a lot of catching up to do to where they were.

If the labor market is on the strong side, you're going to see some perhaps outsized settlements for a while, and that's going to likely feed through to prices and inflation, even though right now we've come down quite a bit. That's one I don't think is being focused on enough. Another one is food generally and prices of groceries. Apparently, they are edging back up again. I don't see a lot of data on that yet. Not as much data as we see on wages and salaries, but we're seeing it at the edges. It's something we are keeping an eye on.

The third one is a big one, government deficits. There's almost no focus on it right now. In the US, we have a big election. Neither the Republicans or the Democrats are really putting forward any type of program to bring down the deficit. Of course, deficits means two things. It means spending in the economy, that's where the money goes, but also borrowing a lot of money. The fact that the deficits are as high as they are could eventually prevent yields and interest rates falling as much as people would like to see going forward.

Until we deal with the deficits and the total debt in the economy, I think we've got a bit of an issue there getting back to the kind of interest rates we had two, three, four years ago. Those are the types of things I'm looking at that I think are not getting enough play right now in the markets.

Derek: At Dynamic Funds, we're passionate about the value of active management of portfolios. Maybe touch on a few of the benefits that you see from being an active fixed-income manager in the current interest rate environment.

Romas: This really is the type of environment, in my opinion, that you do want to be invested with an active manager. Passive mandates and passive-type funds do very well when it's in one direction. By that, I mean mostly up, of course, because people want to make money. Now, we had a long secular trend of interest rates and yields coming down, even though we cycled up as well, but generally speaking, interest rates and yields came down all the way from late 1980-ish all the way to 2020.

That was a beautiful downtrend in interest rates and yields where passive-type mandates would do very well. They don't carry cash. They're fully invested. Bonds were going up because yields were coming down. Now, we think we've transitioned to a different type of environment. We think we're transitioning more to a trading range-type environment where passive doesn't really win in that scenario. They're always fully invested. They don't take opportunities when interest rates come down to raise some cash and vice versa get more invested when yields go up.

The index itself is a lot more weighted to lower-quality credit than it used to be, so you're taking a lot more credit risk in a passive mandate versus active. If the active manager wants to reduce credit, we can as we have right now. The overall interest rate risk of a portfolio that we measure by using something we call duration of the index has gone up almost 50% over 20-somewhat years. An index fund or passive mandate today is significantly more risky than it was 20, 30 years ago. People might not be aware of that.

Again, as an active manager, we take care of those decisions for people. We've been successful doing it over a number of years where we adjust things like duration. Are there advantages going to the US market versus Canada? What are corporate spends doing? Derek, you could chime in on these types of things and the sector allocation. There's lots of things and lots of opportunities for active managers right now, which again is what we focus on through a number of funds that we manage, but it's a perfect environment for it.

That's what we're paid to ferret out basically and adjust. Of course, selling areas that are expensive and buying areas that we believe are cheaper. Now, for most people, when we look at fixed income, we probably say they need an allocation to cash or short-term bonds, perhaps focus on corporates, a focus also on another allocation to income and corporates, and also an allocation to tactical longer-term bond investing, which is what I've been talking about.

Derek: I think just generally speaking, the overall focus on managing risks, on employing fundamental research to manage those risks in a portfolio, again, those are the benefits of active management that I think are even magnified further in the type of market environment that you just described. Romas and I are very fortunate to co-lead the Dynamic Core Fixed Income Team. With 14 investment professionals and almost 50 billion in AOM, the team manages a wide range of strategies, including funds, ETFs.

We have mandates that focus on short-term income. We have mandates that focus on credit. We have mandates that focus on tactical duration management. All these are different types of strategies that we feel should be included in a well-diversified fixed-income portfolio. With that, thanks very much for joining us. 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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