Show Transcript
Markets are widely anticipating the U.S. Federal Reserve to deliver its first rate cut in four years when policy makers meet this week. Jing Roy, Vice President, Director and Portfolio Manager for Asset Allocation with TD Asset Management, speaks with MoneyTalk’s Greg Bonnell about the implications for markets and the economy.
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[MUSIC PLAYING]
This week, we get the event that the markets have been waiting for all summer. The US Federal Reserve widely expected to cut rates on Wednesday. What could it mean for the economy and the markets as we head into the fall? Joining us now to discuss is Jing Roy, VP, director, and portfolio manager for asset allocation at TD Asset Management. Jing, great to have you back on the show.
Thanks for having me.
So after all the talking all summer on this program out there in the financial press about the Fed, we finally arrived at the week. What are you expecting from the Fed?
We finally enter into a synchronized global rate cut cycle. So this week, the Fed is expected to join the Bank of Canada and the European Central Bank to start the rate cut cycle. By the end of this year, the Fed is expected to cut about 100 basis points and the Bank of Canada, another 70 basis points, and the ECB, another 40 basis point.
All right, so everyone's starting to move in concert with each other. When it comes to the Fed, you said 100 points before the end of the year. Do they have enough meetings to only do 25 basis point a meeting, or do we need to get a 50 in there somewhere?
Which is the question-- that's the major market debate right now, whether the Fed needs to have a jumbo rate cut at this point.
The jumbo rate cut, I mean, I've heard two different schools of thought here, the fact that rates are highly restrictive, inflation is coming back under control. You don't need to be this restrictive. At the same time, if you go for a jumbo rate cut, perhaps the markets say, wait, wait a minute, what's going on here? How should we be thinking about what we're coming into on Wednesday?
Exactly. So it really all ties back into the recession risk that we're looking at. So right now, the market consensus is pegging recession risk at 25% to 30% in the US and Canada. As a result of that, there's market speculation that the Fed wants to get ahead of that to stem a rapid deterioration in the economy.
Recession risks actually matter a lot for equity investors because in a plain vanilla, kind of garden variety recession, S&P 500 index typically would decline by 20% on average. In a more severe balance sheet recession, that number goes to over 40%.
So there are concerns out there. What are the guideposts, then, if we're trying to figure out, is this an economy south of the border, even here at home, that could fall into recession, what are we watching?
This cycle has been anything but typical. So we have to go back to the first principle. So right now, what I'm paying close attention to is really the consumer spending, the consumer health, especially in the top high-earning households. Because households in the top two income quintile, they actually account for over half of the total consumer spending in the US and Canada. And we know that consumer spending is a large part of the GDP growth in those two countries.
So if we have to assess the consumer health, we look at it through the lens of income effect and wealth effect. So take income effect. To start with that, if we see the emerging weakness in the unemployment situation, in the lower income cohort in the US to spread into higher income households, then that's a negative for the recession outlook.
Based on the sector job openings and unemployment data we have seen so far, we see very little sign of that in the US. However, the situation is a bit more precarious in Canada. And moving on to the wealth effect, the recession risk would be higher if we see equity market and housing market start to decline, because that will disproportionately hurt higher income households.
That's interesting in terms of when we think about the resilience of the US economy. When you put it in that terms, it starts to make sense to me that while we know that people at the lower end of the income spectrum were hurting, there was a lot of wealth to keep that consumer spending going.
Yes, it's kind of paradoxical in the US, especially for the housing price. As a mortgage rate comes down, it's supportive for Canadian household because it will relieve the debt pressure. But in the US, it might have the opposite effect because the homeowners in the US cannot port their low-cost fixed mortgage to new properties. As a result of that, 1.7 million homes have been taken off the market. And that supported price increase of 7% in the last two years. So if-- as the rate cut takes shape and mortgage rate come down and that increase the supply of housing stock in the market in the US, that can put some pressure on the housing price.
That's an interesting dynamic there. So if we do get the anticipated rate cut from the Fed this week and a 100 basis points somehow delivered before the end of the year, what could the impact be on the equity markets? I feel like the markets have been waiting for this one.
It's waiting. But finally, the wait is almost over. The shape and the profile of the equity return will be very different. Depends on the reason why the rate cuts are being done. So in a soft landing situation, and the rate cuts are just commensurate with the falling inflation, that will be very beneficial for the broader equity and fixed income markets and asset prices in general.
But if the rate cuts are trying to get ahead of-- to forestall a rapid deterioration in economic growth or a liquidity crunch, then the impact would be very different. In that scenario, the US will probably outperform Canada because growth, resilient growth companies in health care and technology probably would outperform.
In a soft landing scenario, there's a better shot for Canadian equity market to outperform the US because high interest rate sensitivity companies like banks, real estate, and utilities will benefit. And these sectors compose of a much bigger share of the Canadian index.
Yeah, I've been seeing obviously some impressive moves lately on the TSX Composite Index. And a lot of it has been those companies that are rate sensitive. It's interesting to know that we just can't take it through a simple lens. We can't say, well, you know, rates come down, the rate sensitives go up. It's like, well, they go up as long as the economy hangs together.
That's exactly the point. That's why we have to focus on the consumers.
How volatile could this market get? I mean, we were dealt a blow, a little bit of volatility there in August. And then the markets rallied again. We started September a little bit shaky. What's ahead?
We had a one-two punch in August. It's nothing short of being boring this summer. But the volatility outlook is pretty supportive, which means that the volatility will stay elevated for the rest of the year.
There are two reasons for that. First of all, the November presidential election in the US will potentially change the course of a lot of government policies and create winners and losers and change the outlooks on the growth and inflation. So that's one thing to be conscious of.
And secondly, the market investors are overwhelmingly positioning for kind of a soft landing. If incoming data challenges that consensus view, the resulting exodus will actually cause wild, pretty wild market gyrations. But there's a couple of ways to--
I was going to say, from an asset allocation point of view, a lot of unknowns. How do you actually deal with that as an investor?
Yes, there are several ways to help us ride out this choppy market. First of all, we can add more fixed income into our portfolio because it provides a very attractive falling yield, even though we're starting our base weaker cycle.
But at the same time, fixed income return actually is negatively correlated with equity returns when the growth outlook becomes a bit murkier. And secondly, it's time to look at the diversification within the equity portfolio itself. The Mag 7, the technology stock has been a big driver of FD returns. But as we shifting to a different regime, it will make sense to start looking at high dividend paying stocks, high-quality names with high interest rate sensitivities to increase the diversification of the portfolio, especially now.
They will actually benefit from the rate cut, but at the same time, reduce the portfolio's reliance on equity price return alone. So it's a plus. And lastly, instead of taking the cash and being sidelined and just hide under the bed and collecting falling yields because the rate cut cycle has started, investors can actually allocate to alternative strategies.
A top drawer alternative strategy most likely will have lower correlation with the broader equity and fixed income markets, and that will provide a nice source of diversification for investors.
[MUSIC PLAYING]
This week, we get the event that the markets have been waiting for all summer. The US Federal Reserve widely expected to cut rates on Wednesday. What could it mean for the economy and the markets as we head into the fall? Joining us now to discuss is Jing Roy, VP, director, and portfolio manager for asset allocation at TD Asset Management. Jing, great to have you back on the show.
Thanks for having me.
So after all the talking all summer on this program out there in the financial press about the Fed, we finally arrived at the week. What are you expecting from the Fed?
We finally enter into a synchronized global rate cut cycle. So this week, the Fed is expected to join the Bank of Canada and the European Central Bank to start the rate cut cycle. By the end of this year, the Fed is expected to cut about 100 basis points and the Bank of Canada, another 70 basis points, and the ECB, another 40 basis point.
All right, so everyone's starting to move in concert with each other. When it comes to the Fed, you said 100 points before the end of the year. Do they have enough meetings to only do 25 basis point a meeting, or do we need to get a 50 in there somewhere?
Which is the question-- that's the major market debate right now, whether the Fed needs to have a jumbo rate cut at this point.
The jumbo rate cut, I mean, I've heard two different schools of thought here, the fact that rates are highly restrictive, inflation is coming back under control. You don't need to be this restrictive. At the same time, if you go for a jumbo rate cut, perhaps the markets say, wait, wait a minute, what's going on here? How should we be thinking about what we're coming into on Wednesday?
Exactly. So it really all ties back into the recession risk that we're looking at. So right now, the market consensus is pegging recession risk at 25% to 30% in the US and Canada. As a result of that, there's market speculation that the Fed wants to get ahead of that to stem a rapid deterioration in the economy.
Recession risks actually matter a lot for equity investors because in a plain vanilla, kind of garden variety recession, S&P 500 index typically would decline by 20% on average. In a more severe balance sheet recession, that number goes to over 40%.
So there are concerns out there. What are the guideposts, then, if we're trying to figure out, is this an economy south of the border, even here at home, that could fall into recession, what are we watching?
This cycle has been anything but typical. So we have to go back to the first principle. So right now, what I'm paying close attention to is really the consumer spending, the consumer health, especially in the top high-earning households. Because households in the top two income quintile, they actually account for over half of the total consumer spending in the US and Canada. And we know that consumer spending is a large part of the GDP growth in those two countries.
So if we have to assess the consumer health, we look at it through the lens of income effect and wealth effect. So take income effect. To start with that, if we see the emerging weakness in the unemployment situation, in the lower income cohort in the US to spread into higher income households, then that's a negative for the recession outlook.
Based on the sector job openings and unemployment data we have seen so far, we see very little sign of that in the US. However, the situation is a bit more precarious in Canada. And moving on to the wealth effect, the recession risk would be higher if we see equity market and housing market start to decline, because that will disproportionately hurt higher income households.
That's interesting in terms of when we think about the resilience of the US economy. When you put it in that terms, it starts to make sense to me that while we know that people at the lower end of the income spectrum were hurting, there was a lot of wealth to keep that consumer spending going.
Yes, it's kind of paradoxical in the US, especially for the housing price. As a mortgage rate comes down, it's supportive for Canadian household because it will relieve the debt pressure. But in the US, it might have the opposite effect because the homeowners in the US cannot port their low-cost fixed mortgage to new properties. As a result of that, 1.7 million homes have been taken off the market. And that supported price increase of 7% in the last two years. So if-- as the rate cut takes shape and mortgage rate come down and that increase the supply of housing stock in the market in the US, that can put some pressure on the housing price.
That's an interesting dynamic there. So if we do get the anticipated rate cut from the Fed this week and a 100 basis points somehow delivered before the end of the year, what could the impact be on the equity markets? I feel like the markets have been waiting for this one.
It's waiting. But finally, the wait is almost over. The shape and the profile of the equity return will be very different. Depends on the reason why the rate cuts are being done. So in a soft landing situation, and the rate cuts are just commensurate with the falling inflation, that will be very beneficial for the broader equity and fixed income markets and asset prices in general.
But if the rate cuts are trying to get ahead of-- to forestall a rapid deterioration in economic growth or a liquidity crunch, then the impact would be very different. In that scenario, the US will probably outperform Canada because growth, resilient growth companies in health care and technology probably would outperform.
In a soft landing scenario, there's a better shot for Canadian equity market to outperform the US because high interest rate sensitivity companies like banks, real estate, and utilities will benefit. And these sectors compose of a much bigger share of the Canadian index.
Yeah, I've been seeing obviously some impressive moves lately on the TSX Composite Index. And a lot of it has been those companies that are rate sensitive. It's interesting to know that we just can't take it through a simple lens. We can't say, well, you know, rates come down, the rate sensitives go up. It's like, well, they go up as long as the economy hangs together.
That's exactly the point. That's why we have to focus on the consumers.
How volatile could this market get? I mean, we were dealt a blow, a little bit of volatility there in August. And then the markets rallied again. We started September a little bit shaky. What's ahead?
We had a one-two punch in August. It's nothing short of being boring this summer. But the volatility outlook is pretty supportive, which means that the volatility will stay elevated for the rest of the year.
There are two reasons for that. First of all, the November presidential election in the US will potentially change the course of a lot of government policies and create winners and losers and change the outlooks on the growth and inflation. So that's one thing to be conscious of.
And secondly, the market investors are overwhelmingly positioning for kind of a soft landing. If incoming data challenges that consensus view, the resulting exodus will actually cause wild, pretty wild market gyrations. But there's a couple of ways to--
I was going to say, from an asset allocation point of view, a lot of unknowns. How do you actually deal with that as an investor?
Yes, there are several ways to help us ride out this choppy market. First of all, we can add more fixed income into our portfolio because it provides a very attractive falling yield, even though we're starting our base weaker cycle.
But at the same time, fixed income return actually is negatively correlated with equity returns when the growth outlook becomes a bit murkier. And secondly, it's time to look at the diversification within the equity portfolio itself. The Mag 7, the technology stock has been a big driver of FD returns. But as we shifting to a different regime, it will make sense to start looking at high dividend paying stocks, high-quality names with high interest rate sensitivities to increase the diversification of the portfolio, especially now.
They will actually benefit from the rate cut, but at the same time, reduce the portfolio's reliance on equity price return alone. So it's a plus. And lastly, instead of taking the cash and being sidelined and just hide under the bed and collecting falling yields because the rate cut cycle has started, investors can actually allocate to alternative strategies.
A top drawer alternative strategy most likely will have lower correlation with the broader equity and fixed income markets, and that will provide a nice source of diversification for investors.
[MUSIC PLAYING]
