Whether it be slowing growth, upcoming U.S. elections or numerous geopolitical concerns, there is no shortage of potentially market moving events that could impact investor sentiment. Kim Parlee discusses how to approach the year ahead with David Sykes, Chief Investment Officer at TD Asset Management, and Michael Craig, Head of Asset Allocation and Derivatives, at TD Asset Management.
* David Sykes, Chief Investment Officer at TD Asset Management, and Michael Craig, Head of Asset Allocation and Derivatives also at TD Asset Management. Nice to have you both here.
* Thanks, Kim.
* Thanks for having us.
* So let's start-- I'd like to break up the conversation, if I could, to think about what happened and then, perhaps, what you see at a high level 2024 shaping up-- risks and then what the actual opportunities are. So let's start with 2023. What did you take away from the year? What did we learn going through 2023?
* So, look, just to kick this off, it was an extraordinary year in so many ways-- a volatile year across so many markets. But I think the real conclusion was a lot of the returns and a lot of the asset classes came at the very end of the year. Basically, at the end of October to the end of December, you saw a significant rally in equities. You saw a significant rally in fixed income with the so-called pivot that you saw from the Fed really helped the alternatives business.
* So it was, really, a two to three-month phenomenon where those returns came in. And I think it was all about getting to understand that rates are somewhere close to the top, and they're going to start to come down at some point in '24. I think that was the big, big takeaway.
* It's frustrating probably for some people, because it sounds like motherhood to say, it matters to be in the markets. But that's the example-- that it is.
* Yeah. It's true. The path to kind of financial success is compounding positive gains. And it doesn't happen overnight, unfortunately. But that's essentially the secret. And I think we step back, there was a pretty powerful rally end of the year, but we are now kind of flat on two-year.
* So it's not like we're overdone or it's all over. It's just we've just kind of made it back after the struggle of 2022. So I think markets are tough. They're forward discounting.
* So it's not about what's happening today. It's what markets expect in the future. And I think clients always need to think about that longer term compounding of positive gains where you can really see increases in your wealth quite rapidly.
* Let's just start, Michael, with you if I could. In terms of when you look at 2024 and how things are shaping up, at a high level, what are the drivers or the things you're going to be watching to see how this year plays out?
* I'll pick up from where Dave left off-- a continued process of inflation coming down. Many goods now are actually deflating. So on the goods side, we're there. On the services, they tend to be a bit slower. And then a lot of the focus is on rents, and that still hasn't really rolled over yet. But we are in this process of deflating.
* That will ultimately, likely, lead to cuts in monetary policy. So I think the market's probably a little bit ahead of itself in terms of expectations. Market's actually looking for seven cuts right now over the next 12 months. That's probably a little bit much. But we should see easier policy going into the year.
* And then, really, the question that will define, I think, the year is, are we going to see recessions or not? The US is probably best positioned not to see one. I think slower growth is certainly on the table. But I think, in many ways, when we finish off this year, probabilities are it's probably not going to see it.
* Europe is on the other situation where things are earlier on in the disinflationary process, probably a bit more challenges there. And then Canada, we've kind of got our own unique challenges right now in terms of really tepid productivity growth and somewhat of a population trap in terms of the economy is just having a hard time absorbing seven figure levels of immigration that we've seen in the last year.
* So Canada is kind of stuck somewhere in between. And again, starting from this point, though, right now, if the surprise is no recession, probably see a pretty decent year in markets.
* Dave, just to build on that from the last time we talked, people can kind of get overwhelmed with, if you watch the news, there's not a lot of good news out there in terms of what's happening in the world from a military, geopolitical, you name it-- all the stuff. But I remember you were saying to me, too, in addition to, perhaps, some good news if things get the soft landing or no recession-- and there's a lot of really, I'll say, humanity-changing technology things going on right now. And that's got to translate into something in the markets.
* Yeah. So, look, there are always risks, but there's also always opportunities. And I do think we're at a point in history where last year in the market, it was really about seven big stocks. And I'm going to call those the innovators. It was all about chips, and how do we get the computing power to drive AI?
* I think now it's all about what companies are going to adopt those strategies and adopt that technology to make themselves more efficient. And it's not just in sort of AI that we talk about. It's also going to impact robotics and digital and cloud. There's so many different areas we're going to see growth and see potential.
* And that's what we're really trying to focus on and where we can capture that upside. But for sure, lots of risk. And I think it's easy to get doom and gloom, but you have to remember that we're going to continue to grow, we're going to continue to see progress and innovation. And that's going to drive markets ultimately forward, and how we get those compounding effects over time.
* It's interesting. Again, we'll talk about the risks coming very soon to all of this, but we see the flash of innovation, I guess, last year. I think I saw something about GPT5 is going to be coming out. And I think AI is moving three times faster than Moore's Law, which is just staggering.
* But the idea that it's actually going to get embedded you start to see, is it through cost savings from companies? Is that where we're going to start seeing the productivity side?
* I think there are arguments on both sides. I think a lot of folks figure that with AI, companies will be able to mine customer bases and databases and drive revenue synergies. I think there's some truth to that. But I think for us, it's more about companies getting more productive internally. It's getting rid of processes that are time-delayed, that are inaccurate.
* It's thinking about how you run an office business, which is really based on emails and information and meetings, or if you're setting up a factory and production lines, how can you do things more efficiently? It's really, to me, about cost reduction, getting rid of the waste, and making firms more productive.
* What are the risks if you look ahead? If you were to list them off for me, what are the risks to the upside?
* Well, first off, I'd say that no year starts without noise and risks. Not so long ago, we saw banks failing in the US and were worried about a financial crisis. And that completely has passed over. So these things tend to be sometimes-- they're not here forever.
* I would say the largest, and it kind of goes both ways from a market perspective, but certainly the US election this year carries more weight than in past years just because of policy, directions of which policy will go depending on which candidate and which party takes power. Policy tends to, on a longer term basis, be very important in terms of market returns. And I think in the past where we've had elections, there's been a lot of angst before it, and then the election happens, and we drive on.
* This time around, I think there will be some lagged effects from the election. We all know what's happening in the Middle East and in Ukraine. I would say in Ukraine, I don't know if it's going to get a whole lot worse. If anything, it's a stalemate, if not-- And that is kind of neither here nor there from an investment perspective-- obviously, a horrible humanitarian perspective.
* So I think those are the big things right now that are on top of mind. But certainly, as we go into the spring, the election will take center stage for market participants.
* We talked about just the shape of 2024, some of the things that are happening. I want to talk about risk. And Michael just said number one on his list is the US election.
* So I don't think there's any way of getting around this. We've seen a significant lead by President Trump in the early polls. It looks like it's going to be a Biden-Trump runoff. It looks close. But I think we have to think about if we do see a new Trump presidency.
* In my mind, there's sort of three big geopolitical issues. And that's, obviously, China Taiwan, it's Ukraine Russia, and then, of course, it's what's happening in the Middle East. If you think about Trump and a re-election, there are pretty significant impacts.
* How will he approach that Ukrainian situation? Perhaps a withdrawal from NATO. That's going to have a whole bunch of risks embedded with it. What will they do to probably increase tension with China over Taiwan? And certainly in the Middle East-- boy, oh, boy, as that conflict tends to escalate and broaden out into Yemen and other places, you worry about an Iranian reaction and how Trump would handle that.
* That's a very different set of probabilities and outcomes than if it's a Biden administration. And so I think there's huge implications there. We're not going to know the answers for several months. But I think also, it's really going to come down to his policies, whether it's on tax and tariffs, his stance versus Mexico and the border, immigration. There's a lot of things there that are really big unknowns.
* I'm just going to turn and look to you on this, maybe tease it out a bit. What do you--
* Well, first off, I think, bigger picture, Biden or Trump-- I don't think we should assume that the Americans underwrite global security in the decades to come. They just don't have the resources, wealth, or what have you. And so the world continues to go into this more multipolar state.
* It certainly feels like he'll look at these things in isolation as transactions and not think about the collateral-- pulling out of NATO, what does it mean for Taiwan Chinese relations, et cetera. I think from an investment standpoint, we got to be really mindful about an across the board tariff. That will be very bad for Canada.
* And I wonder, just to interject, though, because I remember when Trump and his team were one of the architects-- of I think it was Lighthizer came in with USMCA-- or whatever it is, the replacement for NAFTA.
* NATO. Or NAFTA.
* All our acronyms-- UNC-- anyway, we'll keep going. The point is, though, is because he helped architect that, do you think we might be a bit safer? I guess you can't predict it, but I just would think that that might be--
* Oh, no, I think he's just looking at across the board-- tariffs, both including allies and foes. Other areas you'll think about is areas that are highly regulated, I think you peel back regulations. That actually could be quite bullish for financials-- energy, whatnot. And areas that have had government subsidy are probably at risk-- so alternative energy, for one, would be areas that have been supported by government subsidy.
* I think they are at risk. So there will be, when we think about from a purely investment perspective, some degree of rotation in the market, if you will. And if you think about last year, Dave mentioned the stock market was driven by a handful of companies. There were companies that were lagging.
* This could be the catalyst to see them actually start to lead the market in terms of performance. So something to think about right now. Again, we start off with if we don't have a recession, you usually want early cyclicals in that market. And that gets into energy, financials, industrials, materials, et cetera. Also, in theory, should be good for the TSX. But we'll see if that kind of flows over into our markets.
* I want to come back to the Middle East in a second, but as you're talking, it makes me think-- when you've got a couple of variables, you manage that. In the old days, you worried about rates and inflation. And I'm sure there's a lot more. But now, there's just so much. There's so much that can move. So how do you navigate?
* The only free lunch in the investment management world is diversification. And so we sit here and we talk about probable outcomes and possibilities, but there's no compass that's going to land you exactly on the right outcome here. And so it's to make sure that you've got diversification across asset classes, within asset classes, that you're not being very shortsighted and thinking about the next three months or the election in November.
* It really has to be a 3, 5, 10-year view. Because if you do that, you end up making emotional decisions. And as we started off talking about, we had a 15% move in the final nine weeks of the year.
* If you miss that 15%, that's a material impact to your livelihood. And so I think that's the real key here. You've got to be diversified.
* Can I just also build-- we talked at a high level about the Middle East and the conflict. And, actually, even all the other things you mentioned, like peeling back of regulation-- I'm trying to figure out what's deflationary and what's inflationary. I would think Middle East conflict would be inflationary. I think AI, maybe it might be deflationary. I don't know. But how do you kind of see this netting out?
* Right. So to step back, kind of the framework that we're thinking about in the years to come is that the volatility of inflation is higher. And much of our career has been in very much a disinflationary environment, and I think we're going back to a world where inflation, I think we deflate this year, but it doesn't mean that in 2025, 2026, particularly with the amount of what people want these days, which is typically they want change rapidly.
* And when governments start getting involved in the economy, that can be quite inflationary. So you really need to think about an asset mix that you can tilt that works in both those worlds. And that gets you to a broader set of tools. In our world, we have real assets-- infrastructure, real estate, commercial mortgages, commodities, and as well as all kinds of derivative strategies to augment what we do in both fixed income and equities.
* By creating a more kind of diverse portfolio, first of all, it's easier on our clients, which is very important. And also, you're able to work from a position of strength, because when you have an asset class outperform and one that struggles, you can reallocate out of that winner into one that's lagged a bit and be able to earn more return for your clients.
* So Dave and I talk about the world ahead, and it's tricky. And when we look back, we'll probably say, I missed that. But starting off with a very, very broad set of assets to draw from allows us to work from a position of strength.
* We've been talking about the outlook for 2024, the risks for 2024, and now it boils down to what your thoughts are from an asset allocation standpoint. So want to run through equities, bonds, alts, and commodities. David, let's start with equities. What are you seeing for this year?
* Yeah. So we look into '24, I think it's fair to say we've talked about the magnificent run we had at the end of last year. But I think if you look forward, at the end of the day what drives equities higher is earnings.
* And if we don't have a hard landing, if we have a soft landing, I think it's fair to say, you can get modest earnings growth this year-- something in the 4%, 5%, 6%. That would be in Canada. That would be in the United States-- maybe a little bit weaker probably in Europe, maybe a little bit weaker in China.
* But I think, broadly speaking, if we do start to see rate cuts in the back half of the year, you can expect I think modest decent returns, high single digits from equities. And it really does come down to which equities you want to buy. All equities are not created equal.
* But I think the big misnomer is that, oh, wow, in times of uncertainties, equities can't perform. And I think quality equities always can perform.
* Yeah. And how do we define "quality?" Just to remind people.
* Yeah. For us, it's really starting with one simple thing, which is the balance sheet. Does the company have a lot of debt? If you have a lot of debt, you may not want to make that investment. But if you don't have a lot of debt and you have a business model that has a moat or some type of competitive advantage around it that allows you to have recurring revenues, recurring cash flows, that, to us, is a quality business that you really want to take a good hard look at to see if you should own it.
* It's funny-- just when you think about AI, deregulation, all the things, a lot of that might be changing this year too.
* Absolutely. And that's one of the keys to equity investing is to really understand, what is that competitive advantage? And is it sustainable? Can it last? Can it endure the test of time?
* OK. Bonds, Michael-- we had a nice rally at the end of last year. But--
* We had a nice rally after the bond market was really hurt. By mid-October, bonds were down 4% or 5% on the year. End of the year, up 6%. So tremendous rally, but it was coming off grossly high yields.
* I would say as we go into this year, real interest rates are, when we think about expectations longer term, are sitting around 2%. I think longer term, more realistic to see that around 1%. So I think there's still capital gains that are there to be made in fixed income.
* Let's just be modest and say 50 basis points. If you get 50 basis points of yield compression plus the 5% that you're earning just from yields right now, you're getting into high single digit return on the bond market for 2024. Certainly, if we have another unexpected bout of inflation, all bets are off. But that would be a very low probability outcome. And if we do have more of a harsher economic downturn, then those returns should be even higher.
* What will give you, just if I could in 30 seconds, indications that big inflation or a worse economic outcome-- what are you going to be watching to know if that happens?
* I would say that if you see the consumer really start to ratchet up purchases again, I'd be a little concerned about that. Also, if we don't really see some follow through on the job market, it is still quite tight-- there are indicators that it started to loosen. But if that doesn't really follow through, I think you're going to still see sticky inflation, if you will.
* And that will start to pull off rate cuts off the table. So that pulls you back to more single digit returns for fixed income. And then if you do have a situation where you get expectations, go from cuts to hikes, then we're going to see a challenged market.
* OK. What about alternatives and all the good stuff that's in there? Because there's a lot of investor appetite, I would say, for understanding it.
* Yeah. And I would say part of the issue in the industry is people talk about alternatives. And it's sort of taken as this esoteric, complicated term. And it's not. If you think about, what is an alternative, for us, that's things like real estate.
* Now, that can be office, industrial, it can be multi-unit residential. It's things like infrastructure, which are, very simply, transportation, roads, shipping ports, if you think about alternative energy with solar panels or with wind turbines. And the beautiful thing about alts from our perspective, if you think about a total portfolio, they don't necessarily have that high correlation.
* And they tend to have very sticky competitive advantage in business models that generally, over time, show rising levels of income and distribution. So we really are positive on the alternative space. I think, in particular, something that we have is commercial mortgages.
* The yields there are very, very high and very attractive in a short duration. And then I think on the other side of the spectrum is infrastructure. There's no doubt we have underinvested in infrastructure for decades-- not just in Canada, I think globally. And we need a lot more.
* And it's interesting, because at a time when governments around the world have a lot of debt on their books, they're looking to partner with private industry and use private capital to create those infrastructure assets. And we're really excited about the opportunities there.
* That quite nicely leads into commodities, quite frankly, because I feel like there's your demand for it.
* So similar story in commodities-- lack of investment for a variety of reasons. Commodities go through these long cycles where we go into a deficit, we overbuild, we have too much, and so you have these 10-year periods when they're either very strong and very weak. We're coming out of a period where they've been quite soft for some time now.
* 2023 was not a great year for commodities. 2022 was a good one. So we think structurally, a very good story there. The way we invest, there's also a yield element, which is interesting. And it's also kind of protecting from the tail-- so we do get that on an uninvited guest of inflation at the party.
* Commodities round out a portfolio there, the defensive anchor. So we don't use a massive allocation-- typically no more than 3%, 5%. But it is there to provide that diversification. And there is a structural story behind them that dovetails into what David was mentioning on infrastructure.
* Just on the commodities front, though, just so people understand, because you talked a little bit about what's in alts-- commodities is a big, broad box of all sorts of things.
* Yeah. So it's a basket. And primarily, you've got energy, which would be, obviously, oil, natural gas, heating oil. Base metals-- copper, nickel, et cetera. Precious metals-- gold, silver. As well as softs-- so agricultural goods-- soy, lean hogs, et cetera.
* So different drivers for each one. But, really, that energy and base metals aspect really ties into what David was mentioning on infra.
* I'm ending this conversation much more optimistic than when I started this conversation. So that's good. Maybe any final words for people as they think about what to think about?
* Yeah. I think from our perspective, there are always risks. And this is people's finances, this is money, this is pension plans and endowments. This is serious stuff.
* And you can always look and find issues that you're not exactly how sure they can resolve. But if you're willing to understand what you're buying-- to whom are you lending your money? What are the probabilities of getting your money back and your coupon?
* What business are you investing in? What alternative strategy are you analyzing? I think if you look at it that way, try and take the emotion out. But, most importantly, take a longer term view.
* There's a lot of issues in the world. We've come through the pandemic. There's been inflation. There's geopolitical issues that we've talked about. But all through that, if you've gone through that with a diversified portfolio with quality assets, you've actually had a very, very nice rate of return.
* And I think we need to remember that for the next 3, 5, 10, 15 years. You will do just fine. But make sure you stick to that plan.
* David, Michael, always a pleasure.
* Thanks for having us.
* Thanks, Kim.