Show Transcript
With the first half of 2020 behind us, equity markets have been resilient despite the uncertainty caused by COVID-19. Equity markets recovered quickly after falling into the fastest bear market in history. Kim Parlee speaks with Michael Craig, Head of Asset Allocation, TD Asset Management.
Print Transcript
[MUSIC PLAYING]
- Well, we all have been watching the markets, and they've been quite a roller coaster over the past little while, which makes active management of a portfolio that much more important.
Michael Craig is Head of Asset Allocation at TD Asset Management, and he joins me now. Michael, you've got a great quote in a note that just recently went out that said, the world went from the winter of despair to the spring of hope in the second quarter. That's not a lot of time between two extreme emotions. There's a lot going on.
- There is. There's a lot going on in the financial markets and the central-banking community. Obviously there's tremendous social unrest. There's a lot of policy that's happening quickly that we thought would take years to emerge.
So lots going on. And sometimes, in this business, it's important just to focus, from an investment standpoint, what really drives things. And right now in Q2, it was all about central-bank actions, as well as the pledge by governments around the world to spend basically unlimited amounts of money to fight this economic recession.
- I want to focus, if I can, on some of the changes that you've been making in your portfolios that you run. And there's been a lot. I talk about active management. Lots of changes going on. But we'll start of the first one. You've been increasing your equity exposure.
- Yeah, and we're not in an easy environment right now. Certainly, with bond yields where they are, it's hard to make money in fixed income. We had increased kind of our growth exposure in April and March, which has been fortunate for us. It's worked out well. And really gearing the portfolios towards more of a growth tilt, if you will.
Because we see that this is not like typical recessions when you have a big shock and then we kind of come out with cyclicals running. This is a much more longer-lasting hit, and I think growth is going to be quite weak for some time. I don't think we're going to see the recessionary numbers in Q3 that we saw in Q2, but we're not bouncing back to status quo anytime soon.
- You mentioned fixed income, and it's a tough time right now. But is there anything that's attractive within fixed income, or is it just it's tough right now because of what's been happening with yields?
- Yeah, there are parts of the fixed-income market that are interesting. Inflation-linked debt as a long-term kind of back of your pocket thing to have I think makes sense here. I don't think inflation is an issue anytime soon. But certainly, when you look longer out with certain forces at play, you could certainly paint a picture of the world that sees higher levels of inflation in years to come.
And for us, we still continue to favor corporate bonds. So lots of support. They have rallied a lot, so there is certainly not-- these aren't early days.
And I guess the last area for us has been really moving our focus to other sources of income-producing securities, and that gets you into the alternative space, whether it be in real estate or infrastructure as kind of new places to invest that are going to give us income streams for years to come.
Let me ask you-- just an overlay in all that, of course, is geography and where you're looking within all of these. But overall, I understand you're overweight in the States and you're underweight in Canada. Tell me about just why-- is that, again, linked to the growth story in terms of equities, and do you see more growth stories in US equities than you see here in Canada?
- It's about the composition of the two stock markets. So in Canada, when you buy the TSX, you're getting financials and materials generally-- and energy, generally speaking. That makes up the bulk of our market, and they're not areas that we see as tremendously interesting right now. Financials are certainly going to face a headwind with lower interest rates. Net interest margins are under pressure because of those low interest rates.
Energy has certainly come back from the dead. But if you think about, whether it be ESG, less use of energy in the years to come, people going into electrification of cars, there are long-term structural headwinds for oil, so that makes oil as a long-term investment not ideal.
And then therefore, as you think about where the most productive firms in the world that are creating the most economic value added, you get into the US market as the primary place. It is the home of kind of the behemoths that really perversely have benefited from this virus, as I think long-term trends that were taking time to emerge have happened over a few months. We really adopted to using technology much more in our lives, whether it be business or personal, and that's really going to benefit that part of the market.
- How do you navigate valuations, though? Because so much-- I mean, those are the opportunities, but it feels as though all that long-term value has been compressed and is now baked in to a lot of stock prices we're seeing, especially south of the market.
- And so I have to admit I'm an old-time bond guy. I was trained as a fixed-income investor. So when I think about equity and valuations, I always relate it back to the cost of money, and then we get that through the fixed-income market. So you can't take equity valuations of the '80s or '90s or 2000s and compare them to today because you're not taking into account where yields were in the bond market.
So when we think about equity valuations, we look at them relative to fixed income, and we look at where the earnings yield or free-cash-flow yield of markets return. We basically turn our earnings valuation into a yield and then compare it to the equivalent risk-free rate. And doing that, while equities on their own look expensive, the world's full of expensive assets.
And therefore, relatively speaking, equities aren't too bad. There's certainly some parts of the equity market that have moved along and probably a little bit rich, but overall, relative to fixed income, equities provide a lot more value at this point in time. And you've really got to pick a sector to invest in. We can't sit in cash forever. Equities I think look a lot better at this point in time.
- You talked about right now how your portfolios are overweight equities, underweight fixed income, and overweight cash right now. Tell me a bit about the overweight cash. Why does that make sense in this environment?
- So we have tactical pools of capital to bid more shorter term. And so what we've been doing there is we've held cash, and then we've sold options, put options on the market, which if the market sells off will be assigned and will add to our equity positions.
There's a couple of reasons for that. One, we'd like to buy the market a little bit cheaper. But two, the amount that we pay for insurance in the market is still quite elevated. The VIX is trading at around 27, 28 today. You know, pre-COVID it was trading around 12. So we're paying a lot more for protection, and we're kind of happy to sell insurance here. We're able to earn a lot more income than we would from a fixed-income security, if you will. This opportunity won't be there forever, but right now we're taking advantage of it. Much more of a short-term play, but that's how we're using that cash.
- Let me ask you, if we just shift to kind of outlook in terms of politics and maybe the broader picture of what we're seeing right now, which I know feeds your investment thesis, what do you see happening right now with the US election? And I'd even throw out there the US currency. There's a lot of people right now with all the printing of money en route, plus just the instability of the US election cycle has people asking a lot of questions.
- Yeah, I guess in summary, it's messy. The US election, obviously, is going to be one of the more hotly contested elections in recent years. You've heard the Republican incumbent talk about not accepting the results, which is terrifying.
And I think that's certainly leading to some lack of faith in the US dollar. I think this is somewhat transitory. I don't think it's going to be an issue come January, but it certainly is leading to a little bit less faith in the US economy or US currency going into it.
Certainly a lot of social unrest right now, and the irony is that COVID has really been the fuse that's lit long-term simmering tensions within societies. You can count to a number of things-- various types of inequality, wealth inequality, income inequality. And so it's a messy time in the US. It's not good.
And from an investment standpoint, so far the market's been fairly immune to it, but we are very sensitive right now as to how this plays out. And right now from a macro sense, the one area that is feeling it is the US dollar. It sold off about 8% from the highs and continues to sell off as we speak right now.
- And we see, of course, an inverse correlation with gold on that very note, and there's a lot more people talking a lot more about gold, including myself. It's something we've been talking about on the show lately. So what are your thoughts on that?
- Yeah, so we've had a position in gold for some time, not for the reasons it's rallying today. We look at gold as kind of the proxy for interest rates, particularly real interest rates, which is a bit of a wonky topic. But in summary, it's you take the government bond yield. You minus expected inflation, and you get a real rate. And right now, real rates are at the lowest they've ever been, at about negative 92 basis points.
Gold tends to trade inversely off this. So with real rates going lower, gold's gone higher. And my sense is real rates will continue to fall, being very supportive for gold.
However, gold is a very-- it's not a big asset class. And so when kind of the broad market starts to get engaged, it moves quite rapidly. As once was explained to me, it's like trying to pour water out of a pitcher into a bunch of shot glasses. It just kind of spills over because there's just not enough of the assets to sup it up. And that's what's happened, and now we're at all-time highs.
My sense is that, while the negative-real-rate story I think is important, there is another sinister narrative playing to the market. You see it recently at art auctions, auctions for fine wines, and that is people are just buying anything that's not nailed down right now. And that, to me, is telling you that there's a little bit less faith in fiat currency. And as a result, not only is gold rallying, but the price of art's rallying, vintage baseball cards, fine wines.
Again, the irony of what COVID's created is all these other kind of mini bubbles elsewhere, and so it bears watching to see where this goes. Gold's going to move really quick one way or another. It's going to go a lot higher or, quite frankly, if the growth story turns around and starts to be more positive, gold could easily fall a few hundred dollars.
And so it's quite a volatile asset. We're still bulls, but we are mindful that this is not a terribly stable investment, and we're very mindful about the sizing of it.
- Yeah, going back to that active-management conversation, the importance there. Let me ask you, though, about-- you talk about simmering tensions. There's simmering domestic tensions happening, of course, within the States and everything that's happening there, but also with China and the States. How do you see this playing out?
- It really depends on who's in the White House in January. And the irony is I think a Joe Biden presidency is actually much more of a negative for the Chinese leadership than a Trump presidency.
- Why is that?
- I believe Biden will still toe a pretty hard line with China. In his recent campaign rhetoric, he has talked about US-only supply chains, et cetera. But I think what Biden will do that Trump has failed to do is garner support of like-minded countries and really gang up on China.
It's one thing for China to kind of pick off country by country because there's really no unified front right now. But if there is much better coordination across kind of like-minded liberal democracies, that's going to be a far more challenging situation for the Chinese leadership than dealing with the kind of Twitter wars with Donald Trump.
So my sense is they're, ironically, probably rooting for Trump. Trump wants to go it alone and do his own deals, et cetera. But with a Biden leadership, you're not going to get any letup. The only issue I think in Washington that's bipartisan that everyone agrees on, whether you're Republican or Democrat, is a distaste for China right now, and that should continue well into 2021.
- Michael, always a pleasure. Such a great conversation. Thanks so much.
- Thank you for having me, Kim. Take care.
[MUSIC PLAYING]
- Well, we all have been watching the markets, and they've been quite a roller coaster over the past little while, which makes active management of a portfolio that much more important.
Michael Craig is Head of Asset Allocation at TD Asset Management, and he joins me now. Michael, you've got a great quote in a note that just recently went out that said, the world went from the winter of despair to the spring of hope in the second quarter. That's not a lot of time between two extreme emotions. There's a lot going on.
- There is. There's a lot going on in the financial markets and the central-banking community. Obviously there's tremendous social unrest. There's a lot of policy that's happening quickly that we thought would take years to emerge.
So lots going on. And sometimes, in this business, it's important just to focus, from an investment standpoint, what really drives things. And right now in Q2, it was all about central-bank actions, as well as the pledge by governments around the world to spend basically unlimited amounts of money to fight this economic recession.
- I want to focus, if I can, on some of the changes that you've been making in your portfolios that you run. And there's been a lot. I talk about active management. Lots of changes going on. But we'll start of the first one. You've been increasing your equity exposure.
- Yeah, and we're not in an easy environment right now. Certainly, with bond yields where they are, it's hard to make money in fixed income. We had increased kind of our growth exposure in April and March, which has been fortunate for us. It's worked out well. And really gearing the portfolios towards more of a growth tilt, if you will.
Because we see that this is not like typical recessions when you have a big shock and then we kind of come out with cyclicals running. This is a much more longer-lasting hit, and I think growth is going to be quite weak for some time. I don't think we're going to see the recessionary numbers in Q3 that we saw in Q2, but we're not bouncing back to status quo anytime soon.
- You mentioned fixed income, and it's a tough time right now. But is there anything that's attractive within fixed income, or is it just it's tough right now because of what's been happening with yields?
- Yeah, there are parts of the fixed-income market that are interesting. Inflation-linked debt as a long-term kind of back of your pocket thing to have I think makes sense here. I don't think inflation is an issue anytime soon. But certainly, when you look longer out with certain forces at play, you could certainly paint a picture of the world that sees higher levels of inflation in years to come.
And for us, we still continue to favor corporate bonds. So lots of support. They have rallied a lot, so there is certainly not-- these aren't early days.
And I guess the last area for us has been really moving our focus to other sources of income-producing securities, and that gets you into the alternative space, whether it be in real estate or infrastructure as kind of new places to invest that are going to give us income streams for years to come.
Let me ask you-- just an overlay in all that, of course, is geography and where you're looking within all of these. But overall, I understand you're overweight in the States and you're underweight in Canada. Tell me about just why-- is that, again, linked to the growth story in terms of equities, and do you see more growth stories in US equities than you see here in Canada?
- It's about the composition of the two stock markets. So in Canada, when you buy the TSX, you're getting financials and materials generally-- and energy, generally speaking. That makes up the bulk of our market, and they're not areas that we see as tremendously interesting right now. Financials are certainly going to face a headwind with lower interest rates. Net interest margins are under pressure because of those low interest rates.
Energy has certainly come back from the dead. But if you think about, whether it be ESG, less use of energy in the years to come, people going into electrification of cars, there are long-term structural headwinds for oil, so that makes oil as a long-term investment not ideal.
And then therefore, as you think about where the most productive firms in the world that are creating the most economic value added, you get into the US market as the primary place. It is the home of kind of the behemoths that really perversely have benefited from this virus, as I think long-term trends that were taking time to emerge have happened over a few months. We really adopted to using technology much more in our lives, whether it be business or personal, and that's really going to benefit that part of the market.
- How do you navigate valuations, though? Because so much-- I mean, those are the opportunities, but it feels as though all that long-term value has been compressed and is now baked in to a lot of stock prices we're seeing, especially south of the market.
- And so I have to admit I'm an old-time bond guy. I was trained as a fixed-income investor. So when I think about equity and valuations, I always relate it back to the cost of money, and then we get that through the fixed-income market. So you can't take equity valuations of the '80s or '90s or 2000s and compare them to today because you're not taking into account where yields were in the bond market.
So when we think about equity valuations, we look at them relative to fixed income, and we look at where the earnings yield or free-cash-flow yield of markets return. We basically turn our earnings valuation into a yield and then compare it to the equivalent risk-free rate. And doing that, while equities on their own look expensive, the world's full of expensive assets.
And therefore, relatively speaking, equities aren't too bad. There's certainly some parts of the equity market that have moved along and probably a little bit rich, but overall, relative to fixed income, equities provide a lot more value at this point in time. And you've really got to pick a sector to invest in. We can't sit in cash forever. Equities I think look a lot better at this point in time.
- You talked about right now how your portfolios are overweight equities, underweight fixed income, and overweight cash right now. Tell me a bit about the overweight cash. Why does that make sense in this environment?
- So we have tactical pools of capital to bid more shorter term. And so what we've been doing there is we've held cash, and then we've sold options, put options on the market, which if the market sells off will be assigned and will add to our equity positions.
There's a couple of reasons for that. One, we'd like to buy the market a little bit cheaper. But two, the amount that we pay for insurance in the market is still quite elevated. The VIX is trading at around 27, 28 today. You know, pre-COVID it was trading around 12. So we're paying a lot more for protection, and we're kind of happy to sell insurance here. We're able to earn a lot more income than we would from a fixed-income security, if you will. This opportunity won't be there forever, but right now we're taking advantage of it. Much more of a short-term play, but that's how we're using that cash.
- Let me ask you, if we just shift to kind of outlook in terms of politics and maybe the broader picture of what we're seeing right now, which I know feeds your investment thesis, what do you see happening right now with the US election? And I'd even throw out there the US currency. There's a lot of people right now with all the printing of money en route, plus just the instability of the US election cycle has people asking a lot of questions.
- Yeah, I guess in summary, it's messy. The US election, obviously, is going to be one of the more hotly contested elections in recent years. You've heard the Republican incumbent talk about not accepting the results, which is terrifying.
And I think that's certainly leading to some lack of faith in the US dollar. I think this is somewhat transitory. I don't think it's going to be an issue come January, but it certainly is leading to a little bit less faith in the US economy or US currency going into it.
Certainly a lot of social unrest right now, and the irony is that COVID has really been the fuse that's lit long-term simmering tensions within societies. You can count to a number of things-- various types of inequality, wealth inequality, income inequality. And so it's a messy time in the US. It's not good.
And from an investment standpoint, so far the market's been fairly immune to it, but we are very sensitive right now as to how this plays out. And right now from a macro sense, the one area that is feeling it is the US dollar. It sold off about 8% from the highs and continues to sell off as we speak right now.
- And we see, of course, an inverse correlation with gold on that very note, and there's a lot more people talking a lot more about gold, including myself. It's something we've been talking about on the show lately. So what are your thoughts on that?
- Yeah, so we've had a position in gold for some time, not for the reasons it's rallying today. We look at gold as kind of the proxy for interest rates, particularly real interest rates, which is a bit of a wonky topic. But in summary, it's you take the government bond yield. You minus expected inflation, and you get a real rate. And right now, real rates are at the lowest they've ever been, at about negative 92 basis points.
Gold tends to trade inversely off this. So with real rates going lower, gold's gone higher. And my sense is real rates will continue to fall, being very supportive for gold.
However, gold is a very-- it's not a big asset class. And so when kind of the broad market starts to get engaged, it moves quite rapidly. As once was explained to me, it's like trying to pour water out of a pitcher into a bunch of shot glasses. It just kind of spills over because there's just not enough of the assets to sup it up. And that's what's happened, and now we're at all-time highs.
My sense is that, while the negative-real-rate story I think is important, there is another sinister narrative playing to the market. You see it recently at art auctions, auctions for fine wines, and that is people are just buying anything that's not nailed down right now. And that, to me, is telling you that there's a little bit less faith in fiat currency. And as a result, not only is gold rallying, but the price of art's rallying, vintage baseball cards, fine wines.
Again, the irony of what COVID's created is all these other kind of mini bubbles elsewhere, and so it bears watching to see where this goes. Gold's going to move really quick one way or another. It's going to go a lot higher or, quite frankly, if the growth story turns around and starts to be more positive, gold could easily fall a few hundred dollars.
And so it's quite a volatile asset. We're still bulls, but we are mindful that this is not a terribly stable investment, and we're very mindful about the sizing of it.
- Yeah, going back to that active-management conversation, the importance there. Let me ask you, though, about-- you talk about simmering tensions. There's simmering domestic tensions happening, of course, within the States and everything that's happening there, but also with China and the States. How do you see this playing out?
- It really depends on who's in the White House in January. And the irony is I think a Joe Biden presidency is actually much more of a negative for the Chinese leadership than a Trump presidency.
- Why is that?
- I believe Biden will still toe a pretty hard line with China. In his recent campaign rhetoric, he has talked about US-only supply chains, et cetera. But I think what Biden will do that Trump has failed to do is garner support of like-minded countries and really gang up on China.
It's one thing for China to kind of pick off country by country because there's really no unified front right now. But if there is much better coordination across kind of like-minded liberal democracies, that's going to be a far more challenging situation for the Chinese leadership than dealing with the kind of Twitter wars with Donald Trump.
So my sense is they're, ironically, probably rooting for Trump. Trump wants to go it alone and do his own deals, et cetera. But with a Biden leadership, you're not going to get any letup. The only issue I think in Washington that's bipartisan that everyone agrees on, whether you're Republican or Democrat, is a distaste for China right now, and that should continue well into 2021.
- Michael, always a pleasure. Such a great conversation. Thanks so much.
- Thank you for having me, Kim. Take care.
[MUSIC PLAYING]
