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Global markets have had a positive start to the year. But the year ahead likely won’t be without risks as economic conditions deteriorate. David Sykes, Chief Investment Officer at TD Asset Management, discusses the opportunities and challenges for markets and TDAM’s strategy for managing uncertainty.
Transcript
Greg Bonnell: Let’s talk about the start of the year — was a pretty strong January, the best for the S&P 500 apparently since 2019. Obviously, there are still concerns out there and perhaps the central bank has some of the concerns as well. What should we be thinking on that front?
David Sykes: Yeah, so a very strong start to the year. I think — if I think about growth, though, globally — if I look at Canada, the United States, we’ve had relatively weak GDP numbers. The consumer’s hanging in but investment — housing has been an area of weakness. We’ve had a big inventory build in the US, that’s probably not going to continue. Globally, if we look at Europe, PMIs have been slow. There’s that — a reopening in China, which is a positive, but net-net, I think, we’re seeing slowing growth. And the real question on the market’s mind is this mild recession or is this a hard landing?
Greg Bonnell: Yeah, the outlook on growth — I mean, the IMF got a little more constructive this week, but it still seems to be a moving target maybe on a daily basis. When I try to figure out what people are saying in terms of a chance of a recession, it seems to change on this every day.
David Sykes: Yeah, it literally does. And I think it’s very much dependent upon how many more hikes and how long do we stay at a certain level. And I think that’s really going to be incumbent upon the inflation data. We’ve seen it come down — was 9.1% in the US, we’re down to 6.1 on the headline, core numbers are a little bit lower. I think the next few months are really going to tell us because of the base effect what’s happening. And I do think you’re seeing that general trend downward, but the jury is still out. There’s some issues in the services sector where wages and salaries are continuing to remain high. You see goods prices coming down, transport costs have come way down, but there’s still this overarching doubt, I think, in some investors’ mind have we really, really solved inflation, getting it back down to that 2% target.
Greg Bonnell: I think Chair Powell keyed in on that today is when we’re watching this part. Clearly, housing and other areas of softened, but we’re watching the services. So if that becomes sticky and that becomes harder to work on, does that mean that perhaps we start to believe the Fed more than the bond market terms that we’re going to get rates to a certain point, and we’re going to leave them there for a while, and they’re here to stay?
David Sykes: Yeah and I think that’s really that would be different than expectations of the market. And I think that is the risk here. I think — I’m not sure it’s the base case, but I think for us the risk is you’re seeing wages and salaries being sticky. And I think the expectation is, you point out, the market expects a cut. What if we look at some numbers — you look at job openings in the United States as an example, there are 11 million job openings that came out in data this morning. In the labor force, there’s something like 6 million Americans looking for work. That ratio is usually 1 to 1 right now we’re at about 1.8, 1.9, so you’ve got a lot of people who are looking for work, but there’s almost two jobs available for every person who’s unemployed. That’s going to give some power to labor that may mean that wages and salaries are a little bit sticky and lasts a little bit longer. And I think if that scenario plays out, that’s the big risk to the market. Rates a little bit higher than we expect for a lot longer we expect — I don’t think that would portend very well for corporate earnings and for valuations in the market.
Greg Bonnell: Let’s talk a bit about that because, of course, the central banks are grabbing all the headlines in recent days, but we’re in the thick of earnings season. What is the impacts here or the possible impact on earnings?
David Sykes: Yeah, so one of the things we have to make sure we understand is that there was a lot of hiking last year by central banks — Fed, Bank of Canada, all around the world. It takes time. There’s a lag effect here. We haven’t really seen the teeth of those hikes kick in yet. But I think it’s fair to say in the fourth quarter in the US earnings cycle you’re starting to see some of that. Revenues are holding up. We’re expecting about 4% revenue growth year-over-year. Earnings growth is actually negative 2% — expectations. We’re doing a little bit better. We’re probably flat to down slightly year-over-year on earnings. But the concern we have is on the margin side. You’re starting to see margins compress. And I would also say in terms of forward guidance, there aren’t a lot of companies who are saying, yep, it’s going to be a great year and we’re taking up our numbers. We really feel strongly that 2023 is going to be a fantastic year for corporate earnings. So I think from our perspective we still think there’s some downward revisions that come in those numbers and, of course, ultimately equity markets are driven by earnings and the growth rate of those earnings. And I think we haven’t seen the full extent of those downward revisions yet.
Greg Bonnell: And that gets me thinking about valuations. I mean, what you’re willing to pay for those earnings? Are they being fairly reflected in the state of the market right now?
David Sykes: Yeah, I think for us they’re a little bit on the high side. If we looked at earnings expectations for 2023, it was $250 plus or minus about a year ago. It’s been ratcheted down now to about $230. That’s going to give you a multiple in the market of about 18 times. That compares historically to something like 15 to 16 times. So you can say we’re a couple of turns on the earnings, a bit expensive. But I think a better way to look at it is relative to a risk-free rate and all of a sudden with this backup in yields, bonds are competitive now. And so if we looked at the inverse of that PE multiple — let’s look at the earnings yield, it’s about 5.5%. That sounds attractive. But when you compare it into a 10-year US Treasury that’s 3.5%, you’re only getting 200 basis points of equity risk premium to dip your toe into equity. So from our perspective, I think on that basis valuations a bit rich as well.
Greg Bonnell: We just talked about the landscape and the backdrop for us as investors, let’s talk about the investment strategy for this year.
David Sykes: Yeah, so from TD asset management perspective, I think it’s fair to say that with the backup in yields, we’re actually favorably dispersed — we’re favorably positioned towards fixed income. I think from our perspective we view it as a situation where yields are attractive. You can put together a fixed income portfolio high fours, low fives in terms of percent, in terms of yield and so we’re overweight fixed income, we’re overweight government bonds, but also overweight high quality corporate debt. Not quite there yet on high yield, I think the spreads have a little bit further to widen. On the equity side, we’ve got a modest underweight position — modestly underweight Canada, lots of issues in terms of debt at the consumer level in the country, concerns about housing. Likewise in the US, we talked about valuations. We think they’re a little stretched, we think we could see some more compression there. We do like China. We’re overweight China on the reopening play. I think we’ve seen lots of good economic data there and valuations were very reasonable to cheap. So overweight on the fixed income side, underweight on the equity side. And then in our alternatives business, I think that’s a really important area for investors to focus on. Not necessarily available to all investors, but if we think about real estate, industrial real estate, multi-unit residential, office, we think that’s a very important part of a portfolio in addition to our private debt offerings and our private mortgages. And so we’re roughly neutral that space, a little bit underweight on the domestic real estate side. There may be a few bumps in the Canadian economy, but we’re quite positive on private debt and overweight on the mortgage side.
Greg Bonnell: Obviously as a strategy after the year that we had last year, the fixed income portion makes a lot of sense for the reasons you laid out. You got a coupon that’s actually giving you a nice yield. You’re looking at the end of the rate hiking cycle. What are the risks to that strategy? There are always risks, right?
David Sykes: Yeah. So, look, there are always risks. And I think in my mind they’re basically two big risks. The first risk is the risk of what we don’t know. We didn’t know that COVID was coming. We didn’t know that all of that stimulus was going to lead to skyrocketing inflation. So there’s always the risk of the unknown unknown. But I think to me the big risk is really inside the labor market. The issue here is, is labor going to continue to be so strong? Right now unemployment — after all these Fed hikes, after all the Bank of Canada hikes, unemployment in Canada is at 5%, and the United States is at 3.5%. That’s really where the inflation battle is going to be won or lost. And I think the big risk here is labor markets stay tighter for longer. Wages and salaries are a huge component of services. And if that continues to move higher, I think we’ve got real concerns for higher rates and what that does for valuations as we go throughout ’23.
Greg Bonnell: So you got a base case. You got some risks there. If an investor is trying to figure out how to put it all together to protect themselves, particularly after last year — I see a lot of people are just like I just want — I just want to do all right this year. How do you do that? How do you protect yourself?
David Sykes: So to me it always sounds trite and it sounds simplistic, but if we’re talking about the next three hours, three days, three weeks, that’s a real difficulty. But if we’ve got a reasonable timeframe as a long-term investor, I think it’s a much better environment today than it was, say, two years ago. Valuations, when the market was at all-time highs, were not reasonable. I think today the way you protect yourself is really three things: It’s quality, quality, quality. It’s quality corporate bonds. It’s quality equity investments that companies generate cash, return that cash. And the same thing on our real estate side, it’s class A office, it’s making sure the underwriting standards of our private mortgages are very well-covered. It’s quality, quality, quality. Most investors I find with a long-term perspective, that’s what they’re after, and that approach will get you to their goal. There are ups and downs but a lot less volatility than other paths you could choose.
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