David Sykes Head of Public Equities, TD Asset Management, explains to Kim Parlee why the COVID-19 pandemic is still a key driver when it comes to stock market uncertainty and volatility, and why at least one key market indicator may be a reason for optimism.
Yeah. So Kim, my focus is really on the equity market. And if you go back to late November, December, the Fed was very clear, indicating that they were going to begin the normalization process, as I'll call it. And so it was very clear that they wanted to begin the tapering, the quantitative easing program, eventually start to raise rates. And what that really means for an equity person is that when your discount rate of those future cash flows, because remember, an equity value fundamentally is what are the future cash flows discounted back at the prevailing interest rate? That’s how you get your equity value, that discount rates going higher. And remember, it was unbelievably low. We were actually negative real rates. And so as those rates start to slowly creep higher, that means your present value today, your discounted value is going to be lower. And so, I think it's a fundamental tenet of the equity market that you should expect equities to fall somewhat. And there's been more damage in some areas than others. But I do think it was really triggered by this normalization process that the Fed began in its communication several months ago.
There's a combination of the Fed, and then it's interesting, we don't talk about COVID as much, in terms of its impact on our economies, we seem to have gotten used to it. But I think, my understanding is that you still think "COVID" is still in charge right now when it comes to global growth. Give me your thinking around that.
Yeah. And I hope I'm not alone in this, but I might be. I really think that every time we've doubted that the virus is going to stick around, it's won out. And so I'm not sure that it's fully behind us. I hope it is. But it does seem to me that the market has a view that because Omicron and the headlines, it doesn't seem to be as severe, we're going to get through this and then we're back to normal. I'm not so sure that should be the expectation. I think there's lots of twists and turns to come. And I think one of the other big impacts of Omicron is what's it going to do to growth? Certainly it's impacted later in the fourth quarter. It's going to impact Q1 growth. And now we could be in a potential situation where you have a rising discount rate and slowing growth. And so there's a really interesting time in the market that is going to have to play out and this isn't like anything we've seen before.
What about the shift in market sentiment? Obviously, it's much different I'll say before the holidays and now it feels a lot different. How do you quantify that?
Yeah. I mean, the way to quantify it is to watch equity volatility every day. And as you noted, you know, it's been some wild moves up and down. But the way to look at that is through the VIX or some other volatility indicators, and they're very, very high. But I think that's also a bit of good news in a sense, because usually when you get that fear factor, I'll call it, at a very high level, that may mean that you've worked away some of the weaker hands and some of the longer term investors will stay in the market.
And I know that another indicator that you take a look at are high yield spreads. What are you seeing there? And just before you tell me what you're seeing, just tell me why it matters and why it's something you watch so closely.
Yeah. So Kim, I think what we're all really trying to figure out is this going to be a hard landing for the economy? Is the Fed going to overdo it? Is inflation going to be a continuing persistent problem or is this a soft landing? And we're going to see rates go up, but not too too much and we can slow things down, cool inflation. One of the things I always look at, and there's never one indicator you look at many, but one of the things I like to look at is high yield credit spreads. And that's the yield of a high yield bond over a corporate bond. And that just sort of gives you a sense of how much stress there may be in the bond market. And right now, you're not seeing a huge, huge increase in those spreads. There's been a little bit, 20 to 30 basis points, but usually when you go to these hard landing scenarios, you really, really see an increase in the spreads. And so right now, at least that one indicator, is telling you that so far things are under control.