Investors are facing a tremendous amount of uncertainty, weighing heavily on stocks and market sentiment.
Even before Russia’s invasion of Ukraine, there were days of extreme market pressure as investors contemplated the next moves of the U.S. Federal Reserve and other central banks amid spiking inflation.
But Michael Craig, head of the asset allocation and derivatives team at TD Asset Management, argues that the current market volatility can be a positive, as it reinforces “market discipline.”
And in a recent interview with The Globe and Mail, he provided a cautiously optimistic outlook for longer-term investors.
The following is an edited and condensed transcript of our conversation.
There are significant crosscurrents that investors have to contend with right now, the Russia-Ukraine war and rising interest rates. How are you navigating these risks and market volatility?
Wars are destabilizing. So in our portfolios, we’re a bit more risk adverse, we have puts and short strategies to manage risk.
The core risk right now is that we’re going through a tightening cycle, which will be a very sharp one. That’s my bigger concern of the two.
I go on the adage, stability breeds instability and instability breeds stability. 2021 was a year of incredible stability - too much - our biggest correction was less than 5 per cent for the S&P 500.
Now we’re in a period of instability but this is reinforcing market discipline. It’s making people aware that there are risks.
But for us to re-engage and have a more of an aggressive equity position, I’d like to see a bit more weakness first before I get comfortable there.
Given that you see a tightening cycle as the core risk right now, what do you expect the path of rate hikes by the Bank of Canada to look like?
I think this is going to be a different cycle than in the past. Historically, it has been one hike a quarter. This time around I think it will be sharper in the beginning and then perhaps a bit of a pause.
Before getting into what regions you favour, how do you determine your allocations to certain markets? What key metrics do you look at?
On the high level, there are six building blocks that we focus on: valuation, credit conditions, inflation, growth expectations measured by PMI (Purchasing Managers’ Index), market sentiment so is the yield curve up or flat and what is the bond market telling us, and the last would be labour so where are we in the hiring cycle.
Some of these things are actually counterintuitive, so when there is a lot of unemployment, when it’s falling that’s actually a very accretive environment to invest in stocks because you can add people and you are not facing wage pressure. PMI is another one where you want to buy when PMI’s are troughing, not when they’re peaking.
Based on your analysis, what regions look attractive to invest in?
In the last six months, we’ve actually moved more capital into Canada for the first time in a long time to overweight Canada. So financials and energy sectors make up call it 50 per cent of the market. Canadian banks have a lot of positive sensitivity to rate hikes so when you get rates hikes they make a lot more money as long as those rates hikes don’t become restrictive to economic growth. Dividend yields of Canadian banks are call it around 3.5 per cent, not a bad place to be. On the energy side, our Index is very energy intensive and we also have a lot of high cost oil, which at US$100 oil makes a lot more money than it does at $80 or $70 so there’s a lot of convexity there. Also, it trades at a material discount to the US market.
Is it just Canada or are there any other regions that look interesting to you?
We’ve been tiptoeing into China from a fairly underweight position and bringing it back to neutral. Their central bank is easing now after a year of really tepid economic growth. Chinese consumption will be serviced by Chinese companies. It’s a very different world than investing in North America but we’ve got people on the ground there with management teams in Hong Kong. It’s a fairly inefficient market and a lot of managers, not just our team, have added a lot of alpha just because of the inefficiency of their stock market.
There are no other regions where you are overweight or bullish on?
We’ve been pulling back risk for some time. A year ago, on a range of 10, 10 being the most bullish on equities, we were probably nine and a half. Today, it’s more like a five and a half.
When did you become less bullish?
Late in the third-quarter and fourth-quarter of last year.
And why? Because you anticipated a rising interest rate environment?
A handful of things. One is the inflation story was remaining fairly sticky. You’ve got to understand, interest rate volatility means volatility everywhere - that’s the core discount factor of all financial assets. We sold down small-caps, sold down growth stocks as well. Our earnings models were pointing to a material slowdown in earnings growth this year, more so than consensus, to single-digit growth so we thought it was prudent to harbour some gains.
Did you increase your cash allocation then?
The bulk of the shift was really moving more into value than growth.
In addition to financials and energy, are there other sectors or sub-sectors that you like?
Most commodity markets are now in deficits. If you think about the ESG theme, part of that theme is building infrastructure that’s going to be able to withstand a hotter world and be less carbon intensive so that’s bullish for copper and lithium. With the Russia-Ukraine war that will give a bid to gold stocks and the TSX is pretty much the only global bourse where you can get any exposure to gold.
What areas of the market should investors avoid?
Financial conditions are tightening so you’ve got to be really careful and own quality tech companies - companies that have no issues operating through a less accommodative financial environment. You have to be very wary of companies that are one bond issue away from default.
Avoid junk stocks. People may think, well I should always avoid junk. After a recession and we come to an earnings recovery, junk stocks tend to do very well. You don’t want to own low quality companies right now.
For now, stick with large-cap stocks over small-caps, which has been in play for 14 months now.
Does the flattening yield curve concern you?
Not yet. It’s flattening and that’s a headwind but we’re not inverted yet. Call it an amber light right now, something to pay attention to but it’s not an issue quite yet.
Could we see a recession?
Our work would probably signal a one in five chance of a recession in the next 12 months.
The critical question is, ‘What does inflation look like by the summer’? I think we are going to get to 100 basis points in the overnight rate pretty quickly and the question is, ‘What is the speed after that’? They could hike rates by 50 basis point, they could do nothing.
One argument for more aggressive rate hikes is that inflation hasn’t resulted simply because of COVID, supply bottlenecks or labour shortages but it’s due to the rising money supply and that won’t be so easy to fix?
I would push back against that pretty hard. Money supply has been rising for years now. The reason we haven’t had any inflation is because velocity has been falling.
When you transfer wealth from governments to households, particularly households that are not in the top 10 per cent of wealth who tend to spend most of what they have, that’s been supercharged money, and the money comes right back into consumption so you have this lift in velocity. Unless you believe that there will be continued transfers of wealth from government to households, which we don’t think there’s going to be, it’s hard to paint a picture of continued excessive aggregate demand.
Where do you think the S&P 500 Index and the S&P/TSX Composite Index exit the year at?
I think 4,600 on the S&P 500 is probably doable. The TSX I am more sanguine about, 22,000 to 22,500.
That’s a conservative value for the S&P 500 given that it’s had a pullback. You don’t see a strong bounce back?
No, you won’t get a resumption of the bull market until the Fed stops hiking. An 18 to 19 times price-to-earnings multiple gets you between 4,000 and 4,500 and I think 19 times is a more realistic discount factor.
I still think we are in a structural bull market for equities; it’s just that last year the TSX rallied 30 per cent, the S&P did 25 per cent. When we have excessive returns, generally, you are going to pay it back in the next investment period. Our capital market assumptions have a 10-year average return for stocks of somewhere between 6 to 7 per cent.
What are your key takeaways from this earnings season?
Misses have been massively punished, which tells you how skittish investors are right now. There have been rising costs, and a lot of companies are having to reinvest, just in terms of building out their businesses, and have been punished for it, which I think is a very short-term way of thinking about it. You want companies to reinvest. So those have been the three major themes that have come out of this earnings season.
Talking about inflation and the earnings season, what companies have pricing power in this inflationary environment?
For the most part, companies have been able to pass on costs so far because household are actually in a pretty good financial position, unemployment is very low, there have been material wage gains, more government transfers so household balance sheets are in good spots so for the most part costs have been passed on - non-sustainable - but so far so good.
For retail investors managing their own portfolios, what buy discipline should they have?
First off, before they even get to that, they need to understand what they are trying to accomplish and understand what their risk appetite is.
Whether you are a trader or investor, both require tremendous discipline and you have to be prepared to invest a chunk of your waking hours doing this. It’s a lot harder than it looks.
What do you think is the biggest mistake that investors make?
Not understanding what they are buying, Bitcoin is a good example.
What’s your position on crypto?
We don’t invest in them on behalf of clients, not so much for the lack of belief in the technology; it’s more because the range of returns is so broad. I never want to be in the situation where I had to go back to clients and say that we made this investment and lost everything.
Cypto aside, let’s talk about blockchain, this is the biggest innovation since the internet, I would think. There’s a lot of industries that will be disrupted through it. It’s a completely new way of harnessing data with much more security by the way. So in a world with increasing hacking, cybertheft, etc., I think this is a pretty interesting way in of combating that.
What secular themes do you think should be on investors’ radars?
No matter what you believe about oil, ESG will be a super trend. Alternative energy will be an area necessary for survival.
What recommendations do you have for fixed-income investors?
First thing I’d say is that you are in a far better position than you were 14 months ago. Investing today means that you are getting much higher yields than a year ago, as prices have come off. There is a lot more value in the bond market today than a year ago.
Our advice is to understand the role of fixed income in your portfolio. Government bonds can be a tremendous diversifier, essentially it’s a recession hedge. We use corporate bonds to gain a bit more income in a very challenging market.
You don’t think there is more pain to come in the bond market?
Yeah, maybe in the next month but I think in a year’s time you feel okay about it. Put it another way, we are in a bearish fixed-income market but I’m fairly neutral now.
What concerns you most in the medium-term?
I think the 2024 U.S. election is going to be brutal. Assuming Joe Biden doesn’t re-run and you end up seeing two candidates who are quite far on the political spectrum, left and right, it’s going to be messy and markets won’t like that at all. I would start worrying around this time next year.
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Jennifer Dowty