Markets sell off as volatility spikes on inflation and growth worries

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- When it comes to the markets, things have been anything, though, but normal. Of course, our definition of normal may have been changed by low interest rates over the past few years. But inflation is now running at a 40-year high in the US, which will likely keep the Federal Reserve on the path of aggressive rate hikes. 

Just a week ago, the Fed hiked rates by 50 beats and the market initially rallied but have spent most of the sessions since sharply lower. Michael Craig is the Head of Asset Allocation Derivatives at TD Asset Management. He joins me now in studio. 

Not fun to talk about these markets right now. But it's nice to see you in person. It's been a long time. Maybe let's just talk about-- we'll back up and give the big picture. But when I look at even the markets today, inflation numbers came out, inflation ran hotter, I think, than expected. And that's part of the theme of what's happening in the markets right now. What are you seeing? 

MICHAEL CRAIG: Yeah. This is really important you break down that inflation number. Rents continue to be quite sticky and high. And that's a really-- that's very problematic. It's something that doesn't really moderate quickly. But a huge chunk of the inflation number today was airline fares up massively year over year, like 31%. 

And I think that will pass as we get to the end of the summer. This is much more of a cyclical indicator. So my sense is that we are in the peaking, if you will. Never clear which month to put it on, but we are probably hitting the past of the peak of a period of inflation as we go into the rest of the year. 

KIM PARLEE: But it doesn't mean that inflation is coming down. It just means that maybe it's not going to continue to go up, or how do you feel about it? 

- Yeah, it's about rates of change, really. So if you think about this inflationary episode, it's very different than the '70s, which a lot of people like to compare it to. This has been very manufactured. You've had material problems of supply chains around the world. So we know that. And we've had a huge surge of demand as we transferred a lot of wealth to households and they bought stuff. And so, you saw goods consumption go through the roof. 

And now you're going to see services consumption in the summer go very hot too. This will pass, though. It's one of a sugar high than a kind of sustained period. I think there are arguments to be made about long-term inflation and what that looks like. But I think over the next 18 months it's going to materially come off as we hike rates and really tighten financial conditions. 

- Well, let's talk a bit. We're going to get into asset allocation and what you see for each class and in just a few minutes. But maybe just-- the NASDAQ's already in a bear market. S&P 500 getting close. I mean, what do you see over the next 18 months? And maybe, what are the currents, crosscurrents that are driving what's happening? There's just so much going on. 

MICHAEL CRAIG: Yeah. So let's talk about where we came from and where we're going. It's been an awful start to the year, particularly for balanced fund investors, because both bonds and equities are off materially. Fixed income is off 10%. Never seen in my lifetime. And I'm not that young. 

KIM PARLEE: [LAUGHS] 

MICHAEL CRAIG: So really, really challenging. Today was fascinating though. Because last week or so, you've seen fixed income start to moderate. Hasn't really sold off. Today was interesting where you had a bit of a sell-off on what you should see on a number like that. And then through the rest of the day, the long end of the curve started to rally. And what I think that's telling you is that the financial markets are starting to-- inflation is kind of yesterday's news. 

And they're starting to really price in a material slowdown in growth. And whether that's recessionary or 1% growth, give or take, that's going to be the story of the next second half of this year. And the bond market is starting to give you whispers of that. And the stock market is definitely waking up to it. Because you saw, again, stocks were actually doing OK this morning, finished the day deep in the red. 

- But where are you going to see that show up in terms of data, in terms of the slowdown? Because that is the story. Is economic growth going to turn over? And again, people get caught up in whether it's a recession or not. It's slower. Where is that going to start to show up? 

MICHAEL CRAIG: I think you start looking at of things that are very interest rate-sensitive. So I would look at housing prices, which are still-- year over year will continue to be higher because they are up so much. I would expect that to level off, if not fall. Mortgage applications, retail sales, auto sales, those will be some of the-- durable goods, those are some of the things I'll be looking for as people really start to retrench and pull back spending. 

Look, the cost of financing is a lot more than it was a year ago. And I think that's going to start to bite consumers. And you'll start to see that really manifest over the next six to 12 months. 

- What about the volatility? I mean it's [LAUGHS] been something else. Right? I mean, there's a lot of people pretty tired watching these markets right now. 

MICHAEL CRAIG: It's a bit of a head-scratcher. I think sometimes we think that the market's full of fundamental rational long-term investors. It's not. There's lots of financial innovation that's happened that has created some distortions, whether you have certain levered ETFs, for example, or risk parity funds in the US that have used leverage to amp up returns as a result of the low interest rate era. These types of investors are forced to deleverage. 

And I think the way assets are trading is very much-- the smell of it is very much of a deleveraging. People are just grossing down, sell what you can, risk control, et cetera. It's not because I don't like XYZ company or et cetera. So it's hard as an investor. You're kind of caught in the storm, if you will. It will pass. But I think that's really the story of what's causing this volatility right now. It's not fundamental investors who are running for the exits. 

- And maybe just for those that are-- maybe want to have a longer-term perspective, I mean, we're saying it's going to be choppy, it sounds like, for the next little while as the market digests everything. But this isn't motherhood and apple pie. People need to keep in mind their longer-term goals in terms of what they really need to do because it's going to be choppy. 

MICHAEL CRAIG: Our ability to be able to forecast what's going to happen tomorrow is zero. Our ability to forecast in one month is not much better. But our ability to really forecast five years out, it's actually pretty good. Because over time, stock markets and bond markets start to trend to economic fundamentals. And so it's easy for you to say, don't worry, in the long-term everything's going to work out, because the path is the challenging part. 

But it is true when we do our capital market assumptions and look to what we expect over 10 years and look at how we've done in the past, it's usually pretty good. And I would say right now, a typical investor should expect 7% to 8% from equities for the next 10 years. And bonds-- look, a year ago a fixed income fund would have given you a third of the yield that you could get today because of the backup in yields. 

And so big complaint last 10 years has been, there's no yield. There is more yield in the bond market today than there has been in 10 years. And so I think investors-- I know it's been awful. It's been a really tough time. But particularly for income-centric investors, it hasn't been this good since pretty much pre-financial crisis. 

KIM PARLEE: Interesting. I want to get into the asset allocations. But before I do-- crypto, I know this is something that TD is not involved in. But to me, it's another thing that's been introduced into the market which causes more stability right now. I mean, I think it's been halved depending on what crypto you're looking at. Do you have any sense for the impacts of how that could show up? 

- Yeah. It's a bit of a hydra. It's very different than it was three years ago. I think there's a few things here, though. We're going through a tightening of financial conditions. The weaker asset classes tend to do the worst. I think crypto is telling you that this was very much an asset class that was driven off excess liquidity-- free money, if you will. 

The fear I have with crypto is just how much of that is actually now part of a true financial system. How many people have used crypto as an asset to pledge to make a purchase? I don't know the answer to that. It'd be something I'd be quite watchful over the next little while. But it's pretty messy right now in the crypto land. Not just Bitcoin, but just whether you look at some of the stablecoins or even some of the companies involved-- a lot of carnage. 

- I'd like to dive in a little bit into each asset class and just tell me what you're seeing. And let's start with bonds. Because you were saying even today there's some interesting things happening in that space. 

- So bonds have just gone through the worst bear market in 50 years-- 1973, worst time, but last time it was this bad. My sense is-- our sense is that it's starting to ebb and that we're probably priced now. The extent of the Fed hawkishness is fairly priced into the bond market. It's fairly out of consensus view. The market's still very bearish. 

My sense is this is actually going to be a pretty safe place to hide over the next six months or so as yields start to react to that growth concern I mentioned. And so could be an interesting spot. We are continuing to like the asset class and use it as a diversifier but also a place to make some money if yields do start to rally, which would mean prices would go higher. 

KIM PARLEE: OK. So that's what we're seeing with bonds. Equities, and maybe give us a sense too of just Canada, US, Europe, what you're seeing. 

- Yeah, maybe we'll start from worst to best. So in terms of-- equity is very sensitive to recessions. I would say, the likelihood of recession in Europe is high. The likelihood of recession in Japan-- or in Asia is not as bad, but still there. 

KIM PARLEE: Yeah. 

- And then North America would be probably the best of the three. For stocks, they've priced out a lot already. There hasn't really been a huge capitulation though. So I would be concerned that there are still some headwinds for equities. 

Trough valuations in previous currencies would get here in the S&P. Let's say 3,600, 3,700 would be kind of a downside target. The S&P-- or sorry, the TSX has done quite well this year. I know it's down a bit, but it's been a champ. That commodity allocation probably going to be an OK place to be over the next 10 years. 

But a little leery about the TSX right now too. If we do go into that growth slowdown, it's going to hit commodities. So would be an area too where this-- I mean, I don't think it's time yet to add back into the stock market. Way more attractive-- again, for long-term investors, this doesn't really matter. You're going to be just fine. But over the next little while, still some pretty big headwinds for equities. I don't think they've fully digested the amount of financial tightening and growth slowdown that's coming over into the fall. 

- Let's talk about commodities. I mean, you mentioned obviously equities that are exposed to commodities. TSX obviously is something. But maybe just take us through what you're seeing. We're seeing a bit of a pullback. I mean, oil had this incredible move. And now it seems the concern about growth is starting to get priced into the price of oil. 

MICHAEL CRAIG: It was actually a good day today for commodities. It has been the standout this year. It's been the one asset class that's just rocked it. 

KIM PARLEE: Yeah. 

- Going into-- on this concept of a slowdown, it is going to be a headwind for commodities. We like commodities on a longer-term basis, in terms of we just have massively underinvested in supply. And there is going to become real demand for certain commodities, particularly as we transition out of a more-- into a more electrical and less carbon-intensive economy, a huge demand for certain base metals that just aren't really around. And that gas, we know what's happening in Europe with Russia. Natural gas also becomes a very interesting kind of transition fuel. 

So look, the near-term is quite uncertain for commodities. The futures curves in the market is actually give you positive yield. You could buy a basket of commodities now in the futures market and earn about 5% or 6%, which is kind of interesting. So we like it as a portfolio diversifier and also a place to just make money. But it's more of a longer-term call as we deal with the lack of supply and demand imbalance. 

KIM PARLEE: It's always been interesting. I think I've been talking to lots of people about just ESG and just the infrastructure pivots, and more on the eFront, I will say, in terms of just the copious amount of infrastructure that needs to be built to change how we do things. And that has to be a huge boom for commodities. 

MICHAEL CRAIG: Huge boom. And China trying to build a mine today, I wouldn't want to wish that on anybody. The environmental permitting to set up a mine now is brutal. 

KIM PARLEE: Yeah. 

- It takes years. 

KIM PARLEE: So demand is skyrocketing, supply is constrained. 

- Yes. Very, very constrained. Yeah. No one wants a copper mine in their backyard. 

- Yeah. 

- So that's the challenge. We're not really-- energy companies have been punished for increasing exploration. Shareholders want that cash back, so there hasn't been a lot of new supply. Crazy thing-- last time we saw oil at this level, you see the rig counts also go. Rig counts really haven't moved this time around. There's been a tremendous amount of conservatism amongst oil companies in terms of production. So that sets up an environment for higher prices. 

KIM PARLEE: Yeah. Last one I want to touch on is the US dollar. It seems like one of the-- only places you could hide in the past little while. 

MICHAEL CRAIG: It's been flying. So it's going to be a little bit murkier, I think, going forward. Euro is getting to levels that are pretty bombed out now. There's a lot of bad news in Europe. And going to parity, I think, is probably in the cards in the short-term. But longer term, Euro doesn't really make sense down here. We expect it to be stronger. 

Canadian dollar is an interesting one. We're in this weird-- Canada has seen tremendous population growth. We need an infrastructure investment, so that's going to be supportive of growth. We do have a housing issue. I think that's fair. But in terms of demographics, access to commodities, fairly well-priced and highly skilled workforce-- very, very interesting country to invest in. 

I would think the Canadian dollar is materially stronger over the next five years. I don't see-- certainly, if you go into recession, it's going to sell off a little, whatever. But my sense is that the shock that investors might not be thinking about is, what if the Canadian dollar goes to $0.90 US or $0.95? That's something I think we need to start thinking about in terms of what could play out over the next five years. 

I've had this conversation with a handful of my peers and kind of get to that same conclusion that there is material upside in the CAD. It's very cheap. There's a lot of things about our country that's great. It's starting to trade much more-- not like a petro currency, but like a proper fully developed economy type of currency. 

And if we get policy right, the worst risk for Canadians is ourselves. If we get our policy right, we have every reason to be hugely successful. So that gives me hope then. And ultimately, I think the Canadian dollar strengthens over time. 

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