Show Transcript
With the excessive returns earlier this year behind us, a more modest return is more likely. Kim Parlee speaks with Anna Castro, Senior Portfolio Manager and lead of the Multi-Asset Portfolio Management team at TD Asset Management, on the importance of managing risk in a mid-market cycle.
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- Well, given the markets have been hovering near all-time highs, a lot of people are wondering, where are we, exactly, in this market cycle? And where are we in the economic cycle? Here to give her thoughts on where we are and what it could mean for you in terms of risk is Anna Castro. She's a portfolio manager and leads the multi-asset portfolio management team of TD Asset Management.
Anna, it's always great to have you with us. I want to start with a chart that you brought in. And if we can bring it up, this is showing right now what we're seeing is the economic cycle. And you've got a circle here of where we are in the cycle. So you think we're in mid-cycle. Why is that?
- Yeah, so mid-cycle is where we see earnings growth and economic growth peak. And moving forward, while growth remains positive, it will be moderating. So basically, not going into recession, still positive growth, but the rate of change of growth will be slowing. Typically in this cycle, growth stocks do well. But I think what I want to highlight is that the big returns that we've seen in asset classes in equities are behind us, and moving forward, a more modest type of return should be expected.
- Got it. OK, good thing to keep in mind. The heyday is over, so to speak, in terms of the big growth that we saw. I'm curious with this cycle that you're seeing right now, how similar is it to other mid-cycle markets you've seen or that have been seen before?
- So there are similarities and differences. So the similarities usually at this point, investors start thinking about the central banks coming from peak stimulus, moving from easing to tapering. So that's the similarity as to where we are now. There are some differences, mainly because of the pandemic-induced situation as well as the response.
We've had a combination of both monetary and fiscal response, as well as, because of the lockdowns and the unevenness of reopening, you've had supply chain shocks. But going back to the stimulus impact, there's a lot of cash in the system. In prior mid-cycles, you'd have ones where credit was tough to get credit. Consumers are slow to spend. And it's harder to get back jobs.
Now, you have a different situation wherein consumers have very strong demand. They have a lot of cash in their balance sheet. You actually have labor shortages. Wages are going up. And it's been quicker to get back those lost jobs. And that's why you're having a combination of low bond yields and higher inflation than you've had in the past decades.
- What is that going to mean, then, moving forward? When you take a look at what you expect in the markets over the next 12 months, should we be buckling up for more volatility?
- Yes. So as I've mentioned, we expected returns moving forward would be lower than they were before. We still prefer equities versus fixed income. But we do expect volatility to persist in the interest rate side as well as on the equity factor side-- so more sector rotations moving forward-- because the debate on the trajectory of growth and inflation will rage on.
- What does that mean for risk management? I mean, I know that's really central to your investment strategy, how should people think about portfolio construction?
- So it's very important to really look at risk factors, the changing face of risk-- so not to be attached to how an asset class is labeled. What do I mean by that? So for example, you have a situation now wherein equity markets in general are up 20% for 2021. But not all types of equities are up 20%.
But more importantly, what's more noteworthy is that bonds, the bond index, is down mid-single digits. So in the past, people think that risk has always been equities. But this year, the downside risk has been on fixed income. So it's very, very important to really look at the drivers of risk and how it's changing and have a broad set of toolkit to manage through that.
- Can you give me some examples of some tactics of how you manage through that?
- So an example that our asset allocation team has been very active on is looking at how we can use public alternatives, not just private alternatives, to have inflation protection strategies in the portfolio. And they particularly like options because options do very well when volatility and the sources of volatility are changing. Options can be used for two different ways-- you can use it to reduce risk, and one way is also to have a capital efficient way to gain the profit from upside.
And I'll give you an example on that. So one way to reduce risk is to actually have put options on core equities you would like to hold to manage through interim volatility. So an example would be having put options on technology or communication services names-- so large cap, growthy names that you would generally like but could have interim volatility because these are vulnerable to rising yields.
So what we would do would have put options to protect that and have a smoother return experience while participating in the growth that these equities offer. So that's on the risk reduction side. Another example would be to use options for upside to express a positive view. So we have a positive view on Canadian equities. Canadian equities have a nice mix of Canadian banks that are dividend growers.
It also has energy companies that would provide some inflation protection as oil price rises. So what we did is add more call options on large cap Canadian equities. And so this is a very tactical way to do that. So for example, a two-month call option can give you exposure to Canadian equities. And the capital required is only 1.6% compared to the full capital required if you wanted to buy it outright. So those are examples on how we're shifting from looking at different tools to manage risk as well as to gain upside in a very active manner.
[MUSIC PLAYING]
Anna, it's always great to have you with us. I want to start with a chart that you brought in. And if we can bring it up, this is showing right now what we're seeing is the economic cycle. And you've got a circle here of where we are in the cycle. So you think we're in mid-cycle. Why is that?
- Yeah, so mid-cycle is where we see earnings growth and economic growth peak. And moving forward, while growth remains positive, it will be moderating. So basically, not going into recession, still positive growth, but the rate of change of growth will be slowing. Typically in this cycle, growth stocks do well. But I think what I want to highlight is that the big returns that we've seen in asset classes in equities are behind us, and moving forward, a more modest type of return should be expected.
- Got it. OK, good thing to keep in mind. The heyday is over, so to speak, in terms of the big growth that we saw. I'm curious with this cycle that you're seeing right now, how similar is it to other mid-cycle markets you've seen or that have been seen before?
- So there are similarities and differences. So the similarities usually at this point, investors start thinking about the central banks coming from peak stimulus, moving from easing to tapering. So that's the similarity as to where we are now. There are some differences, mainly because of the pandemic-induced situation as well as the response.
We've had a combination of both monetary and fiscal response, as well as, because of the lockdowns and the unevenness of reopening, you've had supply chain shocks. But going back to the stimulus impact, there's a lot of cash in the system. In prior mid-cycles, you'd have ones where credit was tough to get credit. Consumers are slow to spend. And it's harder to get back jobs.
Now, you have a different situation wherein consumers have very strong demand. They have a lot of cash in their balance sheet. You actually have labor shortages. Wages are going up. And it's been quicker to get back those lost jobs. And that's why you're having a combination of low bond yields and higher inflation than you've had in the past decades.
- What is that going to mean, then, moving forward? When you take a look at what you expect in the markets over the next 12 months, should we be buckling up for more volatility?
- Yes. So as I've mentioned, we expected returns moving forward would be lower than they were before. We still prefer equities versus fixed income. But we do expect volatility to persist in the interest rate side as well as on the equity factor side-- so more sector rotations moving forward-- because the debate on the trajectory of growth and inflation will rage on.
- What does that mean for risk management? I mean, I know that's really central to your investment strategy, how should people think about portfolio construction?
- So it's very important to really look at risk factors, the changing face of risk-- so not to be attached to how an asset class is labeled. What do I mean by that? So for example, you have a situation now wherein equity markets in general are up 20% for 2021. But not all types of equities are up 20%.
But more importantly, what's more noteworthy is that bonds, the bond index, is down mid-single digits. So in the past, people think that risk has always been equities. But this year, the downside risk has been on fixed income. So it's very, very important to really look at the drivers of risk and how it's changing and have a broad set of toolkit to manage through that.
- Can you give me some examples of some tactics of how you manage through that?
- So an example that our asset allocation team has been very active on is looking at how we can use public alternatives, not just private alternatives, to have inflation protection strategies in the portfolio. And they particularly like options because options do very well when volatility and the sources of volatility are changing. Options can be used for two different ways-- you can use it to reduce risk, and one way is also to have a capital efficient way to gain the profit from upside.
And I'll give you an example on that. So one way to reduce risk is to actually have put options on core equities you would like to hold to manage through interim volatility. So an example would be having put options on technology or communication services names-- so large cap, growthy names that you would generally like but could have interim volatility because these are vulnerable to rising yields.
So what we would do would have put options to protect that and have a smoother return experience while participating in the growth that these equities offer. So that's on the risk reduction side. Another example would be to use options for upside to express a positive view. So we have a positive view on Canadian equities. Canadian equities have a nice mix of Canadian banks that are dividend growers.
It also has energy companies that would provide some inflation protection as oil price rises. So what we did is add more call options on large cap Canadian equities. And so this is a very tactical way to do that. So for example, a two-month call option can give you exposure to Canadian equities. And the capital required is only 1.6% compared to the full capital required if you wanted to buy it outright. So those are examples on how we're shifting from looking at different tools to manage risk as well as to gain upside in a very active manner.
[MUSIC PLAYING]
