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The U.S. Federal Reserve is signaling it’s not done raising rates just yet, but it did suggest the pace of hikes could slow in the coming months. Kim Parlee speaks with Michael Craig, Head of Asset Allocation at TD Asset Management, about investment strategy in this rate environment.
[AUDIO LOGO] Let's start with that idea that there was a little bit of something for everybody in that statement, although it did seem decidedly bearish at the end of the statement. But what did you take? Well, the statement came out and said-- they nodded to the fact that interest rates take time, typically seven quarters or so, before they hit the real economy. So the market rallied on that. US dollar sold off. And then Powell came in and I think delivered a fairly hawkish message, not talking about pivot. Rates have to go higher. And the biggest thing, and I think the thing that is most important, is that they're going to get to a point, whether it's 4.5%, 5%, and then they're going to stay there. And they're going to stay there until they see material evidence that inflation has been cracked. And I think that is the part that-- that's where you're going to get a real dampening of economic activity, being in a restrictive period for a long time. It's something we haven't really seen for a long, long time. No. We've been in low rates for a really, really long time. It's the complete opposite. And it's interesting because it's a whole mindset in terms of how businesses operate and economies operate, right? Fairly well-- and households operate. I mean, we are leaving an era of ultra loose money, kind of tepid growth, but an asset price inflation, if you think about housing and whatnot, and a world where, if you're going to borrow money, it's going to cost you. And maybe think twice about consumption decisions. So I think economic growth is going to rely on investment more so than pure consumption, because I think people will pull back. I mean, look at lease rates on a new car. It was at 1% a year ago. Now it's 5.5%, 6%. And so that's going to really change the mindset of consumers, particularly if this is here for an extended period of time, which I don't think we're going to sit at these high levels of rates for a few years. But I don't think that as rates start to come off long term, I don't think we're sitting on a 1% or 2% rate handle anymore. And that will require an adjustment by both businesses and households, and governments, in how they operate. Yeah. I mean, the interest expense alone for governments at this point is going to be through the roof. Let's flip on some opportunities in here, because not great for equities but the fixed market is starting to look a lot-- I've heard from you and many other team members, it's starting to look a lot more interesting now. Yeah. Well, first off, fixed income returns, when you look at it in a pyramid of annual returns for the last 100 years, I'm pretty certain we're in the worst year in the last 100 in terms of fixed income returns. So that's a little bit unnerving. But ultimately, it's the opportunity set, in a sense that there's actually income now in fixed income. I mean, if you had a portfolio of investment grade bonds, government, provincials, corporates, you're looking at 5%. And that was 2%, 1.5%, 2% not so long ago. So there's actual true income stream from fixed income. So there still might be some volatility next little while, sure. But if you buy a typical portfolio of bonds today, most are trading below par. So the actual return stream is probably half capital gain, so tax efficient. And the coupon or income as bonds mature and are refinanced are at much higher rates. And so it's quite an opportunity, I think, for income investors to look at this and start acquiring. Again, we're still not out of the woods. Still going to be volatility for a quarter or two. But ultimately, when we're sitting here 12 months from now, I think fixed will have done OK. Yeah. It's hard. I mean, we all have our own recency bias, what we've been through to say-- MICHAEL CRAIG: Terrible. Yeah, it's not a great time. But let me ask you-- take me through the next year, if you would, in terms of, do you still see volatility? I'm assuming as the earnings come out from companies, we're still-- as comparing to last year, it's going to be hard. The bar is high still, compared. You've got midterms. You've still got the world doing what the world is doing. So what should we be buckling up for and getting ready for over the next year? Well, I think just to draw on Jerome Powell from earlier, he did mention a number of times how there is a tremendous degree of uncertainty about everything they're saying. That's another way of saying nobody knows anything. It's really tough right now. I would say a few things. One, would expect to see a continued bear market in equities for a couple of quarters. We haven't seen a trough in economic activity. And I think you need to see a real bottoming out of the market. I would expect that to come around mid-year, plus or minus a quarter. On fixed income, certainly, we are near the end of this hiking cycle. Whether it comes in February, March, it's within sight. And then what could happen? So a few things. One, US midterms next week-- likely to see divided government. KIM PARLEE: Yeah. Which is generally good. Ironically, yeah, not to be too cynical, but ironically good for government. KIM PARLEE: Not for society but for the markets. Within the Ukraine situation, I think it's entering a period of status where you could see a stalemate. There will be pressures. Neither side-- it's going to be hard for either side to get a material advantage here, and so a stalemate there, and where we'll be at the end of this hiking cycle. So those are three actually pretty bullish things. And so I would expect the first half of the year to still be a bit of a struggle for risk assets. But I think in the second half of the year, things look good. We're working on our capital market assumptions right now, so our longer term predictions for stocks. And not surprising, they're higher than they were last year because of the weakness in markets this year and where we are in the growth cycle. So I think it's going to be still a period of choppiness. But as we start to reset the economy back half of next year, it might not look so bad. Hm, interesting. But volatility, again, you expect that to continue. And I want to ask as well, with the inflation story, a lot of people have been pivoting and looking towards commodities. Seeing that story, it looks pretty compelling, with more just the structure of energy changing and those types of things. Is that something that's an interesting area as well? Yeah, and from a longer term view. I'm pretty simple. I like to keep things very understandable. With commodities, there's two things. One is that we haven't really invested in new supply for a long time. And today, with environmental concerns and governance concerns and just trying to-- safety concerns-- very, very hard to build a new mine. There's not a lot of support to exploit new sources of fossil fuels. And we're not really at a point in time where renewables can take the handoff from fossil fuels. So there is a deficit on the commodity side. On the flip side, we are going to need to reinvest in infrastructure in cities. I think climate change is real. And ensuring cities are built to withstand hotter periods or colder periods is real. And so there's going to be a lot of demand for commodities as well. And so you have a bit of a perfect storm in the commodity markets. Years like this year, where you have a real struggle in fixed income and equities, commodities have been positive. So they do also provide material improvements in multi-asset portfolios. So we like commodities. We're obviously building out a group there. But see this as not so much a next year thing. It's more of kind of a 10-year idea, quite frankly, plus that. And that's typically how long commodity cycles go, 10 years. And this one likely longer because of the lack of a supply response to tight markets because of the challenge of bringing new sources of commodities online. [AUDIO LOGO]