Implications for markets as the Fed signals support for higher rates

- The prospect of higher interest rates in the United States continue to loom large over the markets and recent inflation data may do little to change that sentiment. My next guest says one thing is for certain, that the US is in the late stage of the economic cycle, suggesting there is downside risk on the horizon. We're joined now by Brad Simpson, chief wealth strategist at TD Wealth. Lovely to have you here.
- Thanks for having me.
- So I guess, let me start this way, as we enter the end of February, what's surprised you so far about 2023?
BRAD SIMPSON: Boy, where do you want to start? There's been a lot.
[LAUGHING]
KIM PARLEE: About the markets.
- OK. Yeah, about the markets, just keep it on the mark-- OK. I think, unequivocally, that-- I mean, a minor surprise just how well fixed income and equity markets have. But I started with the minor, and the second part of that is that if I broke that down, equity markets started to rally in October of '22.
KIM PARLEE: Mm-hmm
- I don't find that all that surprising, you know? It'd been a really-- you're going to get kind of a blow off. But what's happened in January, and the rally that we've gone through, and what has been rallying, that I find really surprising. And I don't think I'm alone in that.
But when you look at the environment that we're in-- and we published our portfolio strategy quarterly in January, and it was called "Right Here Right Now." And really what we meant by that is that the market and the world that we're living in, we're going to see some real extreme times of negativity--
KIM PARLEE: Yeah.
- --and extreme periods of optimism. And both of them are going to be quite fictional, right? And as we moved into January, fixed income markets were trading on fact-- late stage economy, interest rates starting to move down a little bit, obviously concerned about fall-out inflation and a recession down the road. Equity markets went to fiction. And that's what surprised me. So I think we have a chart here that kind of hits that home.
- We have two charts.
- Oh, we have two. All right. All right.
- Let's bring it up. So yeah, this is the-- I think you've got a chart here looking at the laggards for '22--
BRAD SIMPSON: Yeah. Yeah.
- --which powered ahead in '23.
BRAD SIMPSON: Right. Right, so I mean, all we're showing here is-- what we said is we said, OK, let's look at the performance for this year. And said, well, the thing that performed the least well was the things that performed really well in 2022.
And what performed well in 2022? Companies with good balance sheets, good business plans, great earnings per share prospects down the road, kind of late stage defensive-- that's was really what was moving the market. What was going down, and in many ways, you're leveraged, really no earnings, or if you did your earnings were a long way away, or you were really paying up for them. You know, these names got lowered down in 2022 50% to 70%.
This year they're up 15.3%. The ones that were the leaders last year, they're up 1.3% roughly in there. In our quarterly, we said here's the things that we're concerned-- that we think you need to be concerned about, and that would be growth, inflation, a recession, what's going to happen with interest rates, what's going to happen geopolitically. You kind of go check, check, check, check, check. Any of those concerns, they're no different now than--
- Yeah.
- Right? And so-- but the process that the market went through, October it started out, OK, what if it's not a hard landing? What if it's a soft landing? I mean, I love this. I wish we could--
KIM PARLEE: The no landing.
- Right. Right. And that's when we moved into the fictional world. Wait a minute, we can have a no landing.
KIM PARLEE: Yeah.
- How good would that be?
KIM PARLEE: Yeah.
- And so the extent of that, I mean it-- I know we've talked about this in the past, and I've written about this an awful lot. I think that quantitative trading kicks in, and we start cycling through what we think a business cycle could look like, but it could go through it in a week. I think that the force of that, of what we saw and how quickly it turned to that, I find that surprising. And I think investors need to step back and think about that a little bit.
- I want to bring up the second chart that you brought too, because you've got to look here at, I think, drivers of total returns. One thing I'm amazed at is I think that the impatience of the market. Like, you talk about these fictional--
BRAD SIMPSON: Right.
KIM PARLEE: It's because cycles take time.
BRAD SIMPSON: Right.
KIM PARLEE: Social media does not have time.
BRAD SIMPSON: No.
KIM PARLEE: And so that's been the disconnect sometimes.
BRAD SIMPSON: Yeah. Yeah, no, I mean, I think there was a survey in our elevator at my office where--
KIM PARLEE: Very scientific, yes.
BRAD SIMPSON: Yeah, where you get your news. TikTok, you know?
[LAUGHING]
Right? It's pretty quick, is all I'm saying.
KIM PARLEE: Yes.
BRAD SIMPSON: And so what we're showing here is, of course, is the reminders we like to think about is why we're talking about right here right now, is because of these extremes if we get into. I wanted people to be mindful of that when you're allocating, if you're allocating the equity markets, you're thinking about, ultimately, earnings per share growth. That's where the total return comes from. This PE stuff, and, oh well, rates will go back down, so I can all over-- I'll pay up for things. That stuff doesn't carry returns over a long term.
KIM PARLEE: Yeah. And earnings are coming down right now.
- And that's the-- and that's the irony, right? Is the rate and earnings are coming down. And if you started to want to put valuations on this, you can kind of look at a scenario analysis for equity markets, and you could kind of go-- your best case scenario's around 4,200 for the S&P. We're kind of there. Your base case scenario is probably around 3,600, which is with earnings coming down and trying to adjust for that. That would seem to be a meaningful place. And your worst case would be somewhere around 3,200. You can't draw a lot of a scenario that would say that 4,200 for the S&P 500 makes a lot of sense.
- Let's talk a bit about-- and you have been talking to us about making a case for bonds.
- Sure. OK. And first, for the equity market, when we're saying things like that, we are underweight equity markets.
KIM PARLEE: Mm-hmm.
- But we think there's lots of great opportunities out there to be able to invest in. And really what we're saying is that you got to go where the businesses are and where you're going to make money when you're in a late stage.
KIM PARLEE: Yeah.
- And so you'll have this noise around that, and then the underweight just kind of tells you the story if we're cautious. And so there's different strategies and hedging strategies you can do in that.
KIM PARLEE: Yeah.
- And we think that being allocated there makes a lot of sense. What surprised me, and then on the fixed income and allocating there, is, quite frankly, it's just the mass movement into term deposits, GICs.
KIM PARLEE: Yeah.
- Now, I understand moving in, because the yield is high. And we've seen yields in term deposits that we haven't seen in a decade. And so that makes a lot of sense to me.
But the challenge investors have is they don't understand how fixed income markets work. And they kind of seem difficult, right? But at the end of the day, you can build an investment portfolio using bonds that have that same sort of yield to it, but with a lot of other attractive benefits that give an investor a lot better opportunities than that.
- Like what?
- Well, the starting point is that if I'm going to buy a term deposit, I'm purchasing that because I know when I purchased it what interest rate I'm going to get, when the maturity is. I can go out and I can buy a traded bond and do the exact same thing. Now, when interest rates go up, value of bonds go down. That's what we saw last year.
Bonds, if I want to buy a bond that is trading below its issue value, par, they all mature at $100, right? So you know when it matures, no matter what, it's going to mature at $100. So if you go out today, there's lots of bonds you can buy below par, like $92, $93, $94, that are going to mature at $100. That move to maturity, that's a capital gain.
KIM PARLEE: Yes.
- Right?
KIM PARLEE: Which does not happen in GICs.
- Which does not happen in GICs. The other side of the coin is that if interest rates go the wrong way-- let's say they start going up, and you say, oh, I'm going to lose on my bond, not so. If you own it directly, matures at par, and you get your money back.
KIM PARLEE: Mm-hmm.
- Right? So that is a benefit into itself, the capital gain part and the taxation. And the fact is that that liquidity, if you're going to get your money out of a GIC-- I mean, you can if you really want to push it, but then you have to bust your way out of it. And then the person who's going to pay for it-- you're really going to pay for that. You're going--
KIM PARLEE: Right.
- It's not going to be advantageous to you. That's not how fixed income markets work. It's liquid. You can get in and out of it a lot easier.
- It is easy. It is liquid. I would say it's the biggest market in the world.
BRAD SIMPSON: Yes.
- So there's that, but also--
BRAD SIMPSON: Yeah.
- --they're not quite as easy, I'd say, to trade for the retail investor as equities are.
- No.
- And that's maybe part of the problem. So how does somebody think about it? I mean one way too, they can talk to an advisor, and advisors can manage it for you.
BRAD SIMPSON: That's right.
- But what are some other ways?
- Well, I mean, it's difficult. It just flat out is. It's difficult.
KIM PARLEE: Yeah.
- It's difficult to gain access to that. And I mean, you can, and there are some direct ways to do it. But it's not as simple as just going out and making a call and saying, I want to buy an equity.
KIM PARLEE: Yeah.
- But nonetheless, I mean, we're spending a lot of work on doing this, because I mean, when I was starting my career in the early 1990s, this was a lot of how you built your fixed income portfolio. It's kind of laddering things up one through five to six years in corporate bonds, trading at a discount. You knew if interest rates went down more, you'd get a capital gain. If you knew they went up, you could hold it to par, and then you could sell it and get it back again. And you could go through this cycle of doing that.
It has a lot of that feel here to that today. And so we are overweight fixed income, and we're overweight fixed income for a reason. We think that ultimately interest rates are going to likely stay where they are and trades within a range bound here, let's say, for the next year. Now, we saw the 10 year US Treasury move 50 basis points yesterday. That's a lifetime move.
KIM PARLEE: Yeah.
- Right? So we're going to continue to see that sort of volatility in bond markets. We're going to continue to see that sort of volatility in equity markets. But the 12 to 18 months out, you're not going to start seeing a cycle where interest rates have a trend of moving downwards. If you're wrong, you own the bond against maturity, you have your money, out you go.
KIM PARLEE: Right.
- If you're right, you have a capital gain, you have your interest that you made, you get your capital gains, you've got the tax implications with it. And those, what we like to say, optionality, those different benefits or features of it make that a much more attractive investment than I think than-- and I think you just got to do a little bit more digging and work.
- And I guess the risk to this, as well, too, is if rates continue to rise--
BRAD SIMPSON: Yeah.
- But for people who play poker or things--
- Yeah.
- --you could even look at just kind of the probabilities of this happening.
- Right.
- We've gone up high.
- Right.
- But I mean, rates could still go higher. I mean, that is something that can happen.
- Right. There's two sides to look at that. So in this laddering that I'm talking about and buying them at a discount, if they do rise, it's not going to impact you.
KIM PARLEE: Right.
- Second one is that when you're doing investment, you're right, we're thinking about probable outcomes.
KIM PARLEE: Yes.
- And so we're publishing an article tomorrow. Really imaginative title. We fired our creative team, and we decide to call it "Bonds Versus GICs."
[LAUGHING]
I know. Rivets you. But at the end of the day, we actually walk through their scenarios where if interest rates go down, if interest rates go up, if credit spreads-- credit is if credit spreads widen. So what happens when they widen? The price of the bond goes down, because there seems to be more risk in it.
KIM PARLEE: Right.
- We look at all those risks, almost every kind of risk scenario you can think of, and you kind of come to it and go, yeah, but it matures at par, and you get-- and so there's, in many ways, there's a lot of structural reasons today why this is part of somebody's fixed income portfolio. And remember, when you're coming at it from my perspective, this is all about have an investment portfolio that is driven by a wealth plan, driven by your asset allocation, utilizing a philosophy for making decisions. And for us, this is part of that portfolio approach, which in our philosophy of doing things, which is based on adaptability, it makes a lot of sense in an environment like this.
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