Michael Craig, head of asset allocation at TD Asset Management, shared his insights on equity and bond markets with The Globe and Mail.Lubin Tasevski/Supplied
After a rapid year-end rally in the S&P/TSX Composite Index, gains in the new year have been more modest. Persistent inflation is creating uncertainty in the markets. A higher-than-expected December inflation report removed hopes of an early rate cut announcement by the Bank of Canada.
To get a sense on where markets may be headed, The Globe and Mail recently spoke with Michael Craig, head of asset allocation at TD Asset Management TD-T. His insights on equity and bond markets may help investors position their portfolios for success in 2024.
Over all, what is your call on stocks versus bonds in 2024 and what led you to that decision?
On the bond side, as we stand right now, in terms of rate cuts, the market is probably a little ahead of itself. The typical bond fund right now is yielding 4.75 per cent. Our expectation is bond yields are 25 to 50 basis points lower by the end of the year, that would add another [two to four percentage points]. So in fixed income, I think it’s not unrealistic to have an expectation of a total return somewhere between 6 and 8 per cent this year.
With stocks, broadly speaking, markets started out pretty tepid this year. But failing a material recession, which is probably a 25-per-cent probability, if we get that 75-per-cent probability, I think high single-digit, low double-digit returns in stocks is probably the most likely outcome this year and that would definitely be led by the U.S. market.
Major stock markets globally have started the year at or near record highs, including the Dow Jones Industrial Average and the S&P 500 in the U.S., Germany’s DAX, and Japan’s Nikkei, which is at a multidecade high. In what markets do you have overweight and underweight recommendations?
The way we’re positioned right now is we have an overweight in the U.S., underweight in Europe, and we’re just a little bit above neutral in Japan.
What about the Canadian stock market?
Neutral. I don’t really have a strong view one way or another. Right now, you’ve got reasonably attractive dividend yields and free cash flow yields. On the energy side, I think for oil, there’s definitely more upside than downside. And banks are facing increasing non-performing loans, but are at the low end of their historical valuation range. A lot of the negatives about the Canadian consumer have been priced into the banks. The problem right now is that our economic growth is struggling, and interest rates are very restrictive for the level of productivity of our economy. So, I think it’s going to be a bit of a struggle, certainly for the first half of the year. If the Bank of Canada starts cutting rates because inflation moderates and we don’t have a recession, that’ll be very bullish for the Canadian market. If we’re cutting rates because we’re in a more serious deterioration on the household side, then it’s going to be a challenge for banks. But, I would say much of this is priced in. If you’re looking for a longer-term, dividend-paying growth-stock position right now, I think banks look really interesting. But, I don’t necessarily believe they’re going to be outperformers over the next 12 months.
When we spoke last year, you said you wouldn’t be surprised if the S&P/TSX Composite Index was unchanged in 2023. It was a great call. You were right for most of the year, up until November when the stock market surged. What returns might investors see for the TSX Index this year?
I think the TSX is fairly inexpensive. It’s going to take us a little bit of good news to get a reasonable return. We’re going to have to see financial conditions ease. I’d be a bit more sanguine on the TSX probably in the second half of the year. And return expectations, you’re getting dividend yields of three and change, a little bit of earnings growth, so if we get a total return around 8 per cent on the TSX this year I think that would be a pretty solid showing.
What about growth versus value stocks, which style do you favour?
We own both. We love growth stocks that have real earnings and we like value stocks that also have growing free cash flow and aren’t value traps. I don’t think it’s one or the other. I would take the quality grouping from each and own that versus betting on one versus the other.
So, in the fourth quarter, our tactical sector bets were technology and energy – one is growth and one is value. Energy is really interesting, I think, and I wouldn’t be underweight technology, you’ve got a multiyear thematic trend with AI.
Expanding on that response, how do you define quality stocks?
Two things, sound balance sheets, so not in financial distress, and the demonstration of growing free cash flow year-over-year.
Any thoughts on the fourth-quarter earnings season?
It’s probably going to be pretty sluggish. What I’ll look to is for companies that post mediocre earnings, what the price response is. If you have mediocre earnings but the stocks don’t sell off, it’ll be a good indication that the markets start to look toward better results in the in the quarters to come.
Let’s shift over to fixed income. Where do you see investment opportunities?
Real interest rates are quite positive right now so I think government bonds are still quite interesting.
Investment-grade credit – you can buy blue-chip U.S. corporate bonds right now with yields north of 5.5 per cent. To me, that’s a really interesting investment. It’s an investment where returns will look okay and I think returns versus risk will look pretty good.
We’re not excited about high yield here because we are going through a slowdown, marginal companies will come under a little bit of stress and the high-yield market isn’t pricing in any type of normalization of default rates.
In terms of maturity, where is the place to be invested?
The belly is the place to be, right around the five to 10-year.
What do you see as the greatest risks to stock markets or what catalysts do you believe may lift equity markets?
The near-term risk is that inflation falls and central banks either cut too early or cut too late. The timing is going to be very tricky.
If you wait too long, you risk a hard landing, hard recession. Because companies’ revenue basically stalls out. Financing becomes very challenging. That’s when companies cut labour to save costs and that’s when you get a big spike in unemployment.
Central banks are very aware of the 1970s when they raised rates when inflation got hot and then they cut too quickly at the first sign of stress and inflation sparked up again. My fear is that they say we’re not going to make that mistake again, and they’ll make one that creates a more material recession by holding interest rates too high for too long. If they are not convinced that inflation has returned to target on a sustainable manner they will continue to run highly restrictive monetary policy. That’s probably the biggest risk.
In a balanced portfolio in that world, bonds return double-digits because bond yields will fall precipitously, and prices will rise. Stocks don’t do well in that environment whatsoever.
On the positive side, investors have materially invested in money market like-instruments. I think as rates get cut and GIC rates start to fall, it’s certainly possible you get a bit of a real push of cash into markets, driving prices higher.
Earlier, you gave me your underweight and overweight recommendations for developed markets. What about emerging markets?
There’s certainly the negative China story. China’s been really struggling, trading at tremendously discounted, depressed price-to-earnings multiples. The biggest problem in the Chinese economy is the imbalance between the production of goods and the consumption of goods.
On the positive, India’s growth is accelerating. Many parts of India are modernizing. That market has been very strong. And I would also say that Mexico and Brazil also look interesting. Mexico is benefiting from reshoring. Economies around the world have been fairly depressed, Mexico has been a big outlier, as well as Brazil because of its natural resources.
With the Bank of Canada expected to lower interest rates later this year, does that bode well for small-cap stocks over large-cap stocks?
It does. Again, all bets are off if we go into recession. But, but by and large, that would be strong for early cyclicals. A lot of small-cap stocks are financially constrained. Lower policy rates would be quite supportive.
In recent weeks, there’s been a lot of excitement around Bitcoin ETFs. Is this a new asset class that you have an assessment on?
First, we don’t invest in bitcoin.
Bitcoin is trading like a speculative asset and is trading off risk sentiment. Many will disagree – I still don’t believe it has a place in a portfolio in terms of diversification properties. I don’t know what the cash flow from bitcoin looks like. And many would say, well, that’s the same thing as gold. I say the difference is gold has 5,000 years of history of showing it to be a very useful asset during tremendous crises or stress.
Can you identify any place where you have an outlier call?
There’s a broad consensus of U.S. dollar weakness this year. I’m not so certain that’s going to come to pass. I don’t have a huge bet that the U.S. dollar is going to scream higher but it’s not something I worry about hurting our returns. I don’t think there’s any catalyst to see the Canadian dollar rally materially from here.