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Michael Craig, Head of Asset Allocation at TD Asset Management, discusses the outlook for fixed income and other asset classes this year and where he sees opportunities, especially amid concerns about slowing economic growth.
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It has been a positive start to the year for markets. But as economic conditions deteriorate, what's that going to mean for the markets going forward, especially when it comes to asset allocation? Michael Craig, head of asset allocation at TD Asset Management is with us now.
Great to have you here, Michael. Let's talk about it. I mean, in January, people thought, maybe we don't have a great year, and maybe it takes a while. And suddenly in January, the returns looked half decent. Where do we go from here?
So first off, with January, it has been somewhat of a marginal rally in terms of the companies that led. Look at some of the charts. There are companies this year up 67%, and when you look at their longer-term chart, it's a little bit of uptick after a pretty prolonged decline.
So there has been a tremendous amount of short covering. Some quantitative strategies have struggled. And it has been one of those years where I think it's been a painful rally higher because I don't think many investors were positioned for it. Wall Street was very much pretty bearish going into the year, and it's been a bit of a counter-trend rally, if you will, against the bear case.
Where we are right now, the S&P is at 4,100. If you look at forward earnings, they are coming down. We're trading at almost 20 times PE, which is rich. We kind of traded there when bond yields were at 1%, 2%. With bond yields now at 3%, 3 and 1/2%, 4%, you would expect a lower equity valuation.
So we would say that this last rally has got a little bit ahead of itself, and I would expect to see some degree of volatility as we get more and more deteriorating economic data coming towards us next couple of quarters.
If it's gotten ahead of itself, is this too much to call it a head fake? You and I have talked about this several times over the past year or so, when you see these rallies. And last summer, I think it was August we saw the rally. And you're trying to figure out, do we got the real deal on our hands?
Full disclosure, you almost need to study bear markets very, very-- and remind yourself, you got to go back for a remedial class because what you find a bear markets is you do have these very, very powerful rallies. 10%, 20%, 30% counter-trend rallies. And it happens quick.
And that's typically the hallmark of a bear market environment. So I'm not saying the markets-- it's not the end of the world. We're not going to have, I don't think, some epic kind of sell-off. But it is a testament to the kind of volatility in the marketplace today.
And you've got to be really cautious. I think you've got to stick with your strategy. We still hold equities, but you don't chase. The worst thing investors do is they panic, and everyone's selling in September of last year when everything was falling apart. And they got pulled back in when you get these kind of euphoric rallies off the lows. You really kind of have to pick your spots and be tremendously disciplined in these environments. Otherwise, you do tend to get chopped up.
Now, if we are talking-- in Canada, we're already talking about a pause. We've got that clearly signalled from our central bank. We're talking nearing the end of the rate hiking cycle for the US Federal Reserve. I've heard it a few times, that fixed income, after everything was pretty tough last year, becomes very interesting this year. What's the idea behind this?
A few things. First, if you just take outright yield, we're back to levels we haven't seen in a couple of decades. So pretty attractive on an all in yield basis. So investors have been really punished in fixed income for years, earning 1%, 2% all in yield. Today it's 4 and 1/2%, 5%, and that's not even looking at speculative-grade credit.
Second thing, when you look at the bond market-- and this might be right. It might be wrong. But it's what the market's telling you. The market's telling you that kind of longer-term expectations for inflation are kind of low, 2.2%.
And so for the first time in a long time, we're actually earning tremendous premium over inflation expectations. So you're earning 1 and 1/2% in addition to inflation. So anytime bonds give you more than inflation, it's attractive, certainly in the last 30 years. And so that's also quite interesting.
So it's also very restrictive policy, but it does provide a pretty interesting tailwind. We do like governments here, in terms of maybe we know nothing. But we do know that the likelihood of some type of slowdown is high. It's possible we have a soft landing. But in all those scenarios, bonds should do fairly well.
And the one scenario that I would be cautious of within fixed income is if we do have a re-acceleration of inflation. Right now, the three components of inflation-- goods rolling over, rents about to roll over, and labor, which has been quite sticky. So you get two-- 1 and 1/2 of the three kind of pieces rolling over, in terms of inflation. That should provide a solid tailwind to fixed income. In the sense that the market is beginning to believe in fixed income again? Because last year everything was just so tough. Because of what was happening with the central banks, it's a real conviction now that, hey, this might be interesting?
It's turning. See, I mean, you can see it in investor behavior. You can see it in hedge fund positioning, and all the biggest overweight right now within the hedge fund community is utilities, which is a proxy for fixed income. So you are starting to see people move there.
And this is after coming off very, very bearish positioning in 2022 because it was an awful fixed income market. So I think it's early innings for that, but still plenty of-- at least a year or two of good fixed income returns.
We've talked stocks. We've talked bonds. Let's talk alternatives because obviously, some people get interested in this space. What's the sort of landscape?
So with alternatives, it's a bit of a catchall phrase, right? I mean, we could talk about infrastructure, private credit, private equity, et cetera. With this, we have groups at our firm that have been doing this for a long time, been very successful, have seen a few cycles.
You do need to caution when you do go into the alternative space, it's not like a one size fits all. There's been no shortage of articles in the national newspapers about alternative funds running into trouble. So you do need to understand the governance structure, what they're trying to achieve, and ensuring that they stick to their policy.
We spend a lot of energy at ensuring we understand the process of what's happening and have a good sense of what we should expect. Ultimately, alternatives is there to improve upon a traditional 60/40 portfolio by giving various different types of return streams to that investor. That's the way you think about alternatives, versus chasing what is kind of the flavor of the day, if you will.
So it's really important to do your due diligence here, understand they are more complicated, and understand how they fit into your overall portfolio.
[MELLOW MUSIC]
It has been a positive start to the year for markets. But as economic conditions deteriorate, what's that going to mean for the markets going forward, especially when it comes to asset allocation? Michael Craig, head of asset allocation at TD Asset Management is with us now.
Great to have you here, Michael. Let's talk about it. I mean, in January, people thought, maybe we don't have a great year, and maybe it takes a while. And suddenly in January, the returns looked half decent. Where do we go from here?
So first off, with January, it has been somewhat of a marginal rally in terms of the companies that led. Look at some of the charts. There are companies this year up 67%, and when you look at their longer-term chart, it's a little bit of uptick after a pretty prolonged decline.
So there has been a tremendous amount of short covering. Some quantitative strategies have struggled. And it has been one of those years where I think it's been a painful rally higher because I don't think many investors were positioned for it. Wall Street was very much pretty bearish going into the year, and it's been a bit of a counter-trend rally, if you will, against the bear case.
Where we are right now, the S&P is at 4,100. If you look at forward earnings, they are coming down. We're trading at almost 20 times PE, which is rich. We kind of traded there when bond yields were at 1%, 2%. With bond yields now at 3%, 3 and 1/2%, 4%, you would expect a lower equity valuation.
So we would say that this last rally has got a little bit ahead of itself, and I would expect to see some degree of volatility as we get more and more deteriorating economic data coming towards us next couple of quarters.
If it's gotten ahead of itself, is this too much to call it a head fake? You and I have talked about this several times over the past year or so, when you see these rallies. And last summer, I think it was August we saw the rally. And you're trying to figure out, do we got the real deal on our hands?
Full disclosure, you almost need to study bear markets very, very-- and remind yourself, you got to go back for a remedial class because what you find a bear markets is you do have these very, very powerful rallies. 10%, 20%, 30% counter-trend rallies. And it happens quick.
And that's typically the hallmark of a bear market environment. So I'm not saying the markets-- it's not the end of the world. We're not going to have, I don't think, some epic kind of sell-off. But it is a testament to the kind of volatility in the marketplace today.
And you've got to be really cautious. I think you've got to stick with your strategy. We still hold equities, but you don't chase. The worst thing investors do is they panic, and everyone's selling in September of last year when everything was falling apart. And they got pulled back in when you get these kind of euphoric rallies off the lows. You really kind of have to pick your spots and be tremendously disciplined in these environments. Otherwise, you do tend to get chopped up.
Now, if we are talking-- in Canada, we're already talking about a pause. We've got that clearly signalled from our central bank. We're talking nearing the end of the rate hiking cycle for the US Federal Reserve. I've heard it a few times, that fixed income, after everything was pretty tough last year, becomes very interesting this year. What's the idea behind this?
A few things. First, if you just take outright yield, we're back to levels we haven't seen in a couple of decades. So pretty attractive on an all in yield basis. So investors have been really punished in fixed income for years, earning 1%, 2% all in yield. Today it's 4 and 1/2%, 5%, and that's not even looking at speculative-grade credit.
Second thing, when you look at the bond market-- and this might be right. It might be wrong. But it's what the market's telling you. The market's telling you that kind of longer-term expectations for inflation are kind of low, 2.2%.
And so for the first time in a long time, we're actually earning tremendous premium over inflation expectations. So you're earning 1 and 1/2% in addition to inflation. So anytime bonds give you more than inflation, it's attractive, certainly in the last 30 years. And so that's also quite interesting.
So it's also very restrictive policy, but it does provide a pretty interesting tailwind. We do like governments here, in terms of maybe we know nothing. But we do know that the likelihood of some type of slowdown is high. It's possible we have a soft landing. But in all those scenarios, bonds should do fairly well.
And the one scenario that I would be cautious of within fixed income is if we do have a re-acceleration of inflation. Right now, the three components of inflation-- goods rolling over, rents about to roll over, and labor, which has been quite sticky. So you get two-- 1 and 1/2 of the three kind of pieces rolling over, in terms of inflation. That should provide a solid tailwind to fixed income. In the sense that the market is beginning to believe in fixed income again? Because last year everything was just so tough. Because of what was happening with the central banks, it's a real conviction now that, hey, this might be interesting?
It's turning. See, I mean, you can see it in investor behavior. You can see it in hedge fund positioning, and all the biggest overweight right now within the hedge fund community is utilities, which is a proxy for fixed income. So you are starting to see people move there.
And this is after coming off very, very bearish positioning in 2022 because it was an awful fixed income market. So I think it's early innings for that, but still plenty of-- at least a year or two of good fixed income returns.
We've talked stocks. We've talked bonds. Let's talk alternatives because obviously, some people get interested in this space. What's the sort of landscape?
So with alternatives, it's a bit of a catchall phrase, right? I mean, we could talk about infrastructure, private credit, private equity, et cetera. With this, we have groups at our firm that have been doing this for a long time, been very successful, have seen a few cycles.
You do need to caution when you do go into the alternative space, it's not like a one size fits all. There's been no shortage of articles in the national newspapers about alternative funds running into trouble. So you do need to understand the governance structure, what they're trying to achieve, and ensuring that they stick to their policy.
We spend a lot of energy at ensuring we understand the process of what's happening and have a good sense of what we should expect. Ultimately, alternatives is there to improve upon a traditional 60/40 portfolio by giving various different types of return streams to that investor. That's the way you think about alternatives, versus chasing what is kind of the flavor of the day, if you will.
So it's really important to do your due diligence here, understand they are more complicated, and understand how they fit into your overall portfolio.
[MELLOW MUSIC]
