Good morning, everyone. Welcome to the final market update webcast of the year. This is our 2023 outlook edition. Joining me is Kevin McCreadie, AGF CEO and Chief Investment Officer, Bill DeRoche, Head of Quantitative Investing, Tom Nakamura, Vice President, Currency Strategy and Co-Head of Fixed Income, and Steve Bonnyman, Director of Equity Research and Portfolio Manager. Before we begin, I need to cover off a few administrative items, as always, related to our virtual event platform. Today's presentation will last no longer than 60 minutes. Those joining us live can submit questions any time during the presentation by opening the Q&A icon found along the side of the presentation screen today, and questions will be addressed near the end of the webcast. Additional resources for this session can be accessed in your attendee hub at the top of the page under the Resources tab.
Finally, please note, CE credits may be available for members of our Canadian audience. Okay, Kevin, we wanna talk a little bit about 2023 today. Maybe you can get us started with your take on the investment climate heading into the new year, including some of the major issues facing investors.
Thanks, David, thanks everybody for joining us this morning. I mean, I guess I'd start where we're going is a quick look at where we just came from, right? A year ago at this time, we had just started to talk about raising rates, right, using the Fed speak from the fall of 2021. You know, here we are, approaching numbers in the U.S., which will be north of 4, Canada closing there, the U.K. at 3.5 probably by tomorrow in terms of short rates. We've had a massive move in rates to fight a massive spike in inflation. What was once transitory got sticky. As we move into 2023, I'd say it's a bit of the same story, but with a different pace of things.
We're no longer looking at, I think the inflation peaking story is what's the concern for the markets. Is it? If it does, what does that suggest for central bank policies? Certainly it's gonna be different from where you're sitting. The theme of the market, I think, for now is downshifting, meaning, you know, the hiking cycle. We're still hiking, but at a lower pace. Starts to get replaced with when do we stop, and that will be the theme. Probably create some volatility as we move into that place where quote-unquote, we stop hiking. I think probably the second piece for the markets to digest is that doesn't mean we're gonna immediately start to cut rates.
I think that's part two of as the market starts to look at where the central banks are, and they're all gonna be doing different things based upon a very similar but different backdrop, whether it be Europe, Canada or the U.S.
Again, I think the narrative is similar. It's inflation and interest rates, and now I think we throw in one third new equation this year, which would be, and where, if any, does a recession show up? I think that's where the markets are gonna grapple with both equities and fixed income.
Okay. Guys, maybe we can let's pick up on this idea of central banks. We've got the Fed meeting later today, their next rate decision. Maybe that's a good place for us to get into this a little bit. Maybe Bill, I'll start with you, but then we'll go around the horn a little bit. What's your expectation for the Fed today at 2:00 P.M. when it comes out with this announcement?
Yeah. The Fed doesn't wanna surprise everybody. I think it's pretty much known that they're gonna go at 50 basis points. They've been very clear in their communications. I don't think at this point they're ready to surprise anybody. There really isn't any need to. Inflation, like we said, is most likely peaked. I think they're gonna continue to stay the course.
Steve and Tom, any thoughts on that?
Yeah, I think, you know, they've put it well. The team has put it well so far. You know, knowing there's a serious lag in the implication between rate rises and actual impact on the economy, the Fed's done a lot of heavy lifting very quickly and very early on, and they're probably sitting back at this point determining at what point you slow the process and wait for the flow-through to see it really coming into the economy. The first glimpses of that are starting. I don't think they wanna get too far ahead of themselves.
Yeah. The other thing, in terms of expectations, is we do get an update to the Fed's summary of economic projections today. A lot of eyes will be on their so-called dot plot, where they expect things to be over the next several years. In particular interest will be where committee members think the federal funds rate will be at the end of next year and at the end of 2024. Looking for an uptick in those dots from the previous meetings. How much and how diverse those opinions are gonna be pored over by the market. You know, I think the market's priced in some the potential for a rate cut towards the end of next year.
I think that's gonna be something that we'll have to see how the Fed addresses that. There might be some discomfort around expectations of loosening a policy too soon. Whether that shows up in the dots or whether that's in the press conference, that's gonna be kind of a key moment for us.
Again, open to anybody here, but, go ahead.
Yeah. Can I just follow on that? I mean, I think one thing, I think I agree with what everything has been said by these guys. I would add one other thing. I think it's also gonna be the tone today, which is, you know, I think you've seen a fair amount of several times this year, where the market's gotten ahead of the Fed in terms of saying. You know, what policy is and where inflation is, right? You've seen equity markets move ahead, you've seen interest rates drop in terms of the bond market. There's been a fair bit of financial conditions easing over the last 6-8 weeks, whether it be the wealth effect from equities higher or, again, this drop in 10 years, which has dropped mortgage rates.
If you're the Fed, you may wanna stay a little hawkish in your tone today to keep people from pricing ahead of them in terms of what they're gonna do. I'd say that would be something I would add to Tom's comment about Powell last time basically said, "Hey, we're gonna slow down the pace of this, but we may have to be here longer." That's gonna be the question, how much longer, and where will you end the terminal rate? I think it's tone and this idea of the terminal rate probably get a lot of, a lot of airplay today.
Adding on to that about tone and the signal about the moderation, is it possible that they do come out and actually say, you know, "We went 50 today, but, you know, expect 25 the next time and maybe the next time?" Will they get that granular, or will they try and keep that type of communication a little bit more general going forward?
I don't think in the statement you're gonna see that kind of granularity. I think the key will be whether they kind of indicate that they're more data dependent. In the press conference, it's likely to be asked, right? I think that's where, you know, is this the first of the next step down? I think there are some strategists out there that do think that after this 50, that we'll step down to 25, and potentially that's it. That's more on the dovish side. I think Powell will be asked that question in the Q&A around, you know, what would the next step look like. I would imagine he's gonna try to keep the door open to anything in that scenario.
It could go back to, you know, they could come back with another 50. You know, ultimately, if the data, inflation data gets worse, they could go back up to 75. I think he's gonna try to keep the doors open in terms of what the next steps are and really be watchful for the data.
Yeah. You're gonna see a similar tone to what you heard from the Bank of Canada, which is, you know, we need to be vigilant around inflation and while we're cognizant we may have to back off here, but the greater danger is removing the hiking too soon and letting inflation get embedded. I think there's some of that that seeps into this language as well.
Is that a message that the market's comfortable with at this stage, though? That this sort of caution. Or do they get a little bit spooked by that? Or does it make them rethink, you know, where they're at in terms of all of this?
Yeah. I mean, from my perspective, I've said we rallied this market a couple of times this year, starting in the summer, on the hope that there would be this tone change, right? When it didn't come or didn't come to the extent that the market wanted it to, it faded this rally. We've done that two to three times here. You know, I think the market has gotten ahead of itself. If to your question, if you're actually asking them to say that the next move is 25, you're gonna be disappointed. I don't think that that's in the market. The market will start to say, "All right, the next one will be 25," and that's where the potential disappointment comes in as we move into January and that January meeting.
One last question on the Fed in particular, and the inflation rate. Are you surprised at all or any of you surprised that it's coming down-- that it's come down to the level that it has to this stage? I'm just wondering if there's, you know, is the Fed doing a good job or-
Inflation is a rate of change, right? Whatever. If this month, it could be a ridiculously high number on a single month, as long as it's lower than last year's month at the same time, and you drop that higher one-off, inflation is mathematically coming down. We've always thought, I think, going from eight to four was not gonna be difficult. It's going from four to two is gonna be the challenge. I think Just looking at what the numbers that were in the mix last year, that drop off, right? You could see a four-ish number by late spring on headline U.S. You know, Canada's probably in the same place as you move to that. Europe is gonna be really very different.
You're dealing with rates are still up near north of 10%, and that's just driven on the headline by a lot of the energy issues coming out of Ukraine, etc. Where you say it's gonna be different, I think that we're not surprised by the drop. It's just, I think, as I've said, 8%-4% isn't hard. 4%-2% is gonna be really challenging.
I think it lends itself to the duration question as to how long we're gonna stay at it. I think, you know, using the war, you know, a war analogy in terms of the war on inflation, we may have had, you know, won a nice battle in terms of we've reached peak inflation, but there's still a long way to go before it's over. Unfortunately, I think when we see these quick rallies, when people think the turning points are, you know, pointing to a quick end, you know, I can see this extending out for quite some time, to Kevin's point, to get down to the levels of inflation that they're all interested in getting to. You know, it wouldn't surprise me if next year there weren't any rate cuts. I think that's the big question.
It's somewhat bimodal. When do we turn the focus away from inflation and turn the focus on engineering, call it the soft landing that everybody hopes? Can occur. You know, given the strength of the economy, the fact that things happen on the margin, I can just see it taking longer than people would like to see, you know, that whole hope thing.
That's certainly part of the risk in this idea of the head fake that Kevin's talking about, right? Maybe we're getting ahead of ourselves. Last question on central banks, and I'm gonna ask you to put your forecast hats on a little bit here. If you were to rank the major central banks, so ECB, Canada, the US, who pauses first, and then who maybe cuts first going forward?
Canada.
Canada pauses first and probably cuts first too, right?
Yeah. I wouldn't disagree with that because Canada was the first one in. There's a timeframe lag. I'd say second, interestingly, could be the ECB because they're already tightening into an economy that's in a recession, it feels like. They can keep doing that, I think that they too will start to downshift here. Very different problem. Headline inflation is much higher there. I would agree with Tom on Canada.
Yeah. Again, Canada, remember, was also very aggressive in front-loading their rate increases and has been steadily ramping those down. It does feel like we're close to at least a pause for the Bank of Canada. I think we've seen in some of the economic data a little bit more softness in the domestic sector. That should be of concern for the Bank of Canada as we kind of look into, you know, the middle part or latter part of next year. I think the ECB, to Kevin's point, like, I think they've been. They've, it's a real tough choice for them, right? In terms of fighting inflation or safeguarding the economy.
One thing that I think the ECB might be able to do is to move down to smaller steps and keep, you know, dripping those rate increases into the market to maintain some credibility. I think some of the data has started to show some life, signs of life in Europe as well. I think they're hoping for a milder winter and hopefully they can get through this into next year. I probably agree. It seems like there is a chance that the Fed could surprise the markets in terms of keeping the rate hikes going a little further than what markets have priced in.
Central banks are a huge focus for next year, there's other stuff going on in the world that may impact markets. Again, around the horn, just a thought on what other things, your events, you're looking at as we head into the new year as potentially, you know, a tailwind or a headwind for markets. Steve, maybe I'll start with you on this one.
Sure. I'm gonna dive a little deeper 'cause most of the world that I live in has a high physical component. One of the things that we've noted over the last quarter has been a massive rebuild in finished goods inventories. We had demand effectively pulled forward to restock all of those, be it consumer, metals, producer, inventory stockpiles that got drawn down through the pandemic and the supply chain challenges. That's gonna be demand that's going to ebb and will probably show up through the first half of next year. May not be fully reflected in the market right now. I think a lot of people are looking to China reopening to solve for some of that.
You know, as you look into some of the granularity of some of the pieces, it makes us a little more cautious on how things will play out in some of the more physical markets.
Okay. Bill, maybe I'll turn to you next. What are some thoughts in terms of some other issues beyond central banks?
Well, I still think the biggest issues you have to focus on is, you know, in terms of if we're gonna end up in a recession, how deep is it going to be? From my perspective, that's gonna be the focus of next year. I know some folks were hoping that we can avoid, you know, a recession, but I think it's somewhat inevitable. From my perspective, we just need to figure out the depth and duration of that as we look forward.
Maybe we'll get back to that. Bill, there's lots of questions about this idea of recession, so from the audience. We'll dive into that a little bit later on. First, Tom and Kevin, just some thoughts on some other issues that you're watching for over the next 12 months.
Maybe I can just quickly start. I'm FX and fixed income, central banks are pretty central to everything. You know, I think what we probably shouldn't lose sight of here is that we've had a tremendous amount of normalization in rates markets. You know, I think, you know, the average high yield, the high yield index is yielding over 8%. If you take high yield EM issuers in dollars, that's yielding over 10%. It feels like this is kind of it's not just a spike up and that we're gonna immediately rally back. It feels like these are kind of more sustainable yield levels. Really, I mean, I've been in this market for over 20 years, I don't think I've seen an environment like this.
These are fantastic opportunities, and whether the entry point is today or three months from now or six months from now, I think in the long term, from a long-term perspective, I think there's an incredible opportunity brewing in rates markets and credit markets. I think it really kind of sets up for a different tone in investment, because you do have things that offer you actual yield. You do have cash that provides you with yield, and I think that really changes some of the calculus that goes into thinking about investments and thinking about portfolio construction.
Kevin, maybe a quick comment from you. I'm just wondering from a geopolitical standpoint, if there's anything out there that you're worried about?
Yeah. Two major things, obviously, the China reopening and dealing with this burn through of COVID. I'll use that word burn through. I mean, obviously, as you've seen, caseloads are now so frequent and large in terms of the number of places that it's impacting, that lockdowns won't really be effective any longer. You're now at this place where you're gonna have to let it burn through, which we think is something that runs through the spring. The question would be, so far, we've managed the supply chain issues around that differently, in a good way. If, in fact, you had to have issues with supply chains, again, you may have, again, an issue with some of the inflation related to that that we saw. That's one.
I'd say obviously Ukraine, Russia comes back to the fore. You know, getting through this winter, we might get lucky in Europe with that. When it comes time to having to refill natural gas for next year, it could present some of the same issues. The question really comes is when does the West get tired of this? You know, if it's in fact a cold winter and people have to turn their heat down and they have to make choices about, you know, these higher prices because of the Ukraine, et cetera. I think that comes back into play as we move through the early part of January, February.
Okay. Let's get into some commentary on specific asset classes. We'll start with equities. Kevin, I'll ask you to weigh in on this one for us. Really the question, you know, where do you see the best opportunities in the new year and perhaps from a geographic standpoint, heading into the year? You know, where are we positioned or how should investors maybe think about positioning from here?
Yeah. On a broad basis, we're overweight equities by a little bit now. Recognizing it's gonna be a choppy ride, and we've compensated by holding a little bit of cash. Cash is coming from being underweight fixed income, which is a position we've been significantly underweight over the last 18 months, which closed that gap dramatically. A little bit of cash, and we're using alternatives such as real assets. We have an anti-beta hedge, and that we use in the portfolio. As we keep that overweight to equities, we have some offsets there. Within the equity buckets, we favor Japan. Right now in the U.S., Japan, it's handled COVID very well. It is a reopening story. With the currency this week, it's an export story.
If global growth, if China comes back on and global growth can actually hang through this and it's a mild recession, there's pretty good valuation support when you look at Japan and put all that in that context. I'd say the next is the US. We think the recession there could be shallower. They're less sensitive from a housing standpoint today than they were in 2008 to these higher rates. Housing market doesn't have some of the toxic stuff it did in 2008. If you don't like where rates are going and you have a 30-year mortgage, it amortizes over 30 years, you can stay in your house for 30 years. It's a very different sensitivity to these higher rates around that versus, for instance, Canada, which everyone's got to refi after 5 years.
I think the sensitivity for Canada is probably much greater. Underweight Canada, and we've talked about Europe. We clearly believe that Europe is already in recession. Overweights Japan and U.S., underweights Canada and Europe.
Quickly on emerging markets, in China in particular, I feel like there's a little bit more optimism about that area heading into the new year as well.
I'll start, maybe Tom can follow on that. I mean, yeah, I think the China story is actually, well, there's gonna be a lot of pain and suffering as they go through this phase of COVID. It's what you probably need to see to get this behind them for once and for all. You know, they too are struggling with some other internally inflicted wounds. If you think about some of the regulatory hand that they've used on certain sectors, they've got a large real estate problem. All of that means that they're gonna stimulate that economy a fair bit, which should be good for EM. I think EM really becomes a story about where the dollar goes.
I think, Tom, you know, if you believe that the dollar starts to flatten out here, and EM starts to look pretty attractive, both from not just the fixed income side but maybe the equity side as well.
Okay. Tom, I'm gonna get your views on the currency and fixed income a second. I just wanna go to Steve first. You know, a lot of the stocks that we're talking about, they fall under the category of real assets in terms of what you do. I'm just wondering, what's your viewpoint in terms of how real assets will perform in the new year?
Yeah, we're taking each of the different pieces of the real asset universe and analyzing them separately because there's different dynamics playing out. Our largest exposure at this point remains energy. We think we're actually in the mid-game, if you will, for the energy cycle. This will not be a cyclic spike and collapse. We think we're into a much more secular change here. You know, I think Brent is trading at $82 today. I think that's probably $18-$20 too low on a sustainable basis. A rerating in place. I think the market continues to view these companies through the same lens that they did through the last decade, which is incorrect.
You know, moving to other spaces, we see some neat opportunities in real estate, staying with what we consider shorter duration names, getting some interesting recovery trades through on things that are transportation-linked or hotel-linked. The specialties and the industrials are doing well. We think that this group has not been fully valued yet. We think there's great opportunities. Remembering too, that notwithstanding inflation slowing, we're gonna be in a positive real rate environment here, which is going to be different than the last few years.
Okay, Bill, I wanna maybe ask, let's talk a little bit about factors and styles of investing. Where do you see that kinda going? We've talked a lot about the growth versus value dynamic over the last couple of years. Just curious from that lens, where you see some opportunities going forward.
Yeah. If you look at low volatility , low beta, that particular trade has done exceptionally well for the last 12 to 13 months. High quality has also done very well. Those are areas that do well in a rising rate environment. What's interesting is they also do well when the economy is slowing, as if we're moving to a recession. I think the bigger concern is because that trade has worked now for over a year, you're seeing a fair amount of correlation with that high quality, low beta, low volatility securities with momentum. The reality is you're getting a fair amount of risk from that trade if you're not careful. I would suggest, you know, Tom was mentioning it earlier with regards to portfolio construction.
You wanna make sure that when you're, you know, if you're gonna tilt your portfolio towards this area, that you account for the fact that momentum is a big component of what you're actually getting exposure to. You know, I think Tom made another good point about, you know, there's a lot of attractive things out there at the moment. Yeah, we do think it's prudent to stay with the high quality, low beta for the moment. The answer is, by the end of the year, you're gonna be looking to get more aggressive. There's gonna be plenty of opportunity for that.
I think it's gonna be a you know story of first half of 2023 versus the second half, and I could see the factor exposures that you have in the first half look very different from that second half as people look to get more aggressive, more risk on.
Okay, yeah. Definitely it sounds like a tale of 2 1/2 in 2023. Okay, Tom, you're on. You get double duty. I want you to talk a little bit about fixed income and currency. Obviously very, very interconnected. Maybe a couple of minutes on both those asset classes for us.
Yeah. I think our I'll start with the FX side. You know, our view is still for dollar strength to be maintained through the early part of next year, and then start to top off, right? I don't know if that necessarily means a large decline or just more of a grind lower into the end of the year. A lot of it's gonna hinge on how initially how the, what the Fed does, but I think what becomes more important is how does the global economy do? In a global growth slowdown or recession, the U.S. dollar tends to do well, and that's because you have a retrenchment of risk. The companies invest less. There's less FDI going on around the world.
I think that's really gonna be the key in terms of how we think about global trade, how we think about the global economy, and where we kind of look economically throughout the year. I think there's still some tailwinds for the U.S. dollar, broadly speaking. I think Kevin mentioned Japanese yen. There is a currency that we do like because it has become extremely cheap. We look at a bunch of different indicators, and the one that is unambiguously cheap is Japanese yen. You know, partially for some good reasons why it's cheapened up. We do think that the environment is likely to be one that's more supportive for yen. Part of that is the rates picture.
If we do think that the Fed will be able to stop next year, which I think we are hoping they will be able to, and I think that's where the expectation is, that should put less pressure on longer term U.S. Treasury yields to continue climbing. We start to see some moderation there, which should be supportive for the Japanese yen. If we do also have subpar economic growth, at least to start the year, that's also likely to be supportive of the Japanese yen. That's the currency that we do like, mostly from the valuation perspective, but also think that there's a cyclical component that favors the Japanese yen as well.
In terms of bond markets, I did talk a lot about EM and credit, but I think the other side of it is just government bond yields in general. We have had a pretty sharp move, particularly in the first half of this year in terms of rising bond yields. We'll see where we end up this year, 'cause it feels like we can move a lot in the next couple of weeks. It does feel like we are set up to have a much better year for government bond markets next year, which is, you know, it's a pretty low bar for us to clear.
I think the other side of it is that because of the amount of carry we get, you know, whether it's 3%-4% yields in most developed markets, or kind of higher single-digit return yields in EM markets, that you are getting some pretty attractive entry points in terms of just thinking about where, you know, the opportunities are, even inflation adjusted, looking out over the next five, 10 years. I think there's an attractive opportunity from the pure yield side.
That kind of lends itself to being a good backdrop for the riskier parts of fixed income, whether it's credit, High Yield, could look at EMs, could look at other parts of the market that may not have as wide spreads as we like, typically as we kind of face recession. Their all-in yields are very attractive. If we are in a camp that we do think inflation will eventually moderate and get back towards normal, maybe not all the way, but at least towards normal, we can see these asset classes provide some really compelling real yields that we haven't seen in a very long time.
Okay. great stuff, guys. I wanna get to. There's lots of questions coming in from the audience, so I wanna get to those as soon as we can. I did have one last question, and maybe this is for Bill and Kevin in particular, but I do wanna talk about this alternative space. We've talked a little bit about equities. We've talked a little bit about fixed income. Alternatives have become a bigger part of people's portfolios are starting to grow. What's the outlook for that side of it? Are there opportunities within that broad space that investors should be looking at? Kevin, maybe I'll start with you first, and then we'll go to Bill.
I think what we've learned this year is, you know, that there's value in a portfolio, in portfolio construction to having alternatives. Not just things which are, you know, long-dated venture or things of that nature, but things that actually correlate and look differently. An anti-beta hedge that we use is up 15% year- to- date, and the S&P is probably still down at this juncture, I don't know, call it 15%-ish, 13%-ish year to date. The ability to use something like that inside of a portfolio, to use something like real assets in a portfolio, you know, if you think inflation's gonna have a hard time going from 4% to 2%, you're gonna want that in the future as well.
Then I think there are going to be pockets of things which provide you to either income, you know, like infrastructure. A liquid infrastructure product that, again, will have an inflation component but also give you a fair amount of income. I think the use of alternatives, while parts of the market have seen dislocation from it, I think is still going to be very, very valid. Even things like private credit, right? Despite what Tom said about the public fixed income market's finally looking attractive, there's still opportunities there as well.
Bill, just maybe an add-on on that.
Yeah. I'd just dovetail that, you know, if you look at, say, the prior 10 to 15 years, you know, you really didn't have to worry about inflation. The biggest issue was the fact that, you know, looking at global growth. A portfolio with just fixed income and equities would do exceptionally well. Now that, you know, you gotta be concerned about inflation, you know, it's not going away anytime soon. You wanna have something that reacts positively to higher rates, so there are alternatives that can do that. The other element that, you know, we tend to forget about, we've seen it, you know, in the U.S., is that, you know, volatility matters a lot. We've had people who basically were looking to retire, they're getting close to that point.
They experienced the big drawdown over the course of, say, the last couple years. Now they have higher inflation, so that pool of retirement assets are much lower. The fact that they're gonna need more cash flow because of inflation, and it's just a bad situation. When volatility gets higher, managing that volatility with some of the alternative products that can do that makes a lot of sense, so you don't have to deal with that sequence risk as you move on and get closer to the retirement. I can see, you know, alternatives serving both of those purposes in terms of providing alternative return streams, but just as importantly, providing ways to mitigate some of the negative effects that come from volatility.
Okay. Just to be clear, we're not talking about a, you know, a massive allocation to alternatives. I mean-
No.
A little bit can go a long way in terms of smoothing that ride for investors heading into the new year. Okay, let's go to questions. We've got tons here. And thank everybody for sending those in to us. Let's go back to the Fed and this idea of recession and there's a couple here. First question, simple one. Maybe not so simple to answer, but it's a simple question. When the recession happens, how long will it be? Again, maybe a bit of a forecast that tough to answer, but any thoughts on that?
Yeah, maybe I'll start, these guys can jump. I think again, it's gonna depend on where you're sitting. If you're in Europe, it could be longer, given the problems they're dealing with to get inflation under control, and the fact that they're probably in a recession already. If it's the U.S., it could be shorter, given, as we've said, the sensitivity to housing this time around is different, and it may be shallower. In Canada, could be earlier because we started earlier. Again, depending upon duration and severity, that one's a little harder. It's hard to pick. I don't think anyone on this call, and I could be wrong, I'd invite anybody to jump in, is looking at a severe, and long duration of a recession, certainly in North America at this juncture.
I would defer to others.
The only thing I would probably counter with is just given the amount of extreme central bank policy that we've seen over the past decade or two, with balance sheet use and such, and the resulting kind of episode that we saw this year in terms of really high inflation and kind of persistently high inflation, I do think that there's gonna be some reluctance from central banks to cut. Maybe not as early and maybe not as deeply as we might have seen in prior episodes. I think that might be the small outside risk that you get. All else being equal, maybe slightly longer, maybe slightly a little bit more painful. It's, you know, all else being equal, it's kind of a tough thing to gauge.
Do you think that there's enough, you know, fundamental reasons why growth should be able to rebound and heal on its own? You know, I think in the U.S., some of the factors that Kevin's alluded to. Also I think, you know, there's been this longer term theme of, I know Steve and I talked about a little bit about this, things that require investment, irrespective of what kind of economic environment we're in. You know, whether it's energy independence, whether it's dealing with climate change, whether it's rebuilding supply chains or reorganizing supply chains. Those investments are unlikely to happen irrespective of what kind of, you know, how long or what kind of recession we're in. I think that's gonna help guide most economies through this.
David, I'd add two other points to this, right? Which is you also, this is not 2008, which was a financial system issue, right? A systemic issue with financial systems around the world where we saw unemployment go to the high single digits in the developed world, even in Europe, mid-teens. We're starting at very low levels of unemployment around most of even Europe, I would say here. two, we're dealing with a business cycle recession here, where the classical raising rates too high. I think the difference is not the level of rates that we're at. These are highly accommodative vis-a-vis history. It's how quickly we got here and the adjustment factor. I think that's where I think it could be a reaction to that. This is not 2008 in terms of magnitude.
David, I'd just add the normalization point that's come out. I think it's gonna be a little bit of a different type of slowdown. You know, we're probably are most likely in a recession in certain areas now, housing for sure. I think you're gonna see, like some companies, their business models are just not gonna work now with their cost of capital have, you know, having increased so much. At the same token, you also have an economy that's been in very good shape, so you're gonna have other companies that are gonna continue to do well. I definitely feel as though it's gonna be a stock pickers type of environment.
Think of a barbell, where you're gonna be able to find companies that are gonna be able to handle this without too much difficulty, whereas there are gonna be other companies, you know, given the increase in cap-cost of capital, think of it as the normalization, that, you know, their business model is gonna have to change dramatically for them to continue going forward. A little bit different than think of your traditional, call it business cycle recession.
Okay, okay, here's one on the Bank of Canada, and it has to do with targets, inflation targets. Do you think the Bank of Canada will stick with its 2% target, or could they adjust to a slightly higher rate? The Fed has kinda done that to a certain extent, right? They don't have as a hard target on 2% anymore. It's sort of near that 2%. The question, I guess, would the Bank of Canada change their? Maybe, Tom, I'll start with you on that.
Yeah, I kinda don't think it's likely in the near term. Certainly there's a lot of things can happen over the next few years, but I think the bank, and I think most central banks want to avoid being reactionary and reacting to the current cycle because these changes should, in theory, persist through multiple cycles. I do feel like there's gonna be a sober look at this at some point because, and I think Kevin has talked about this in the past, like that 2% is kind of an arbitrary decision that was made a few decades ago, just kinda thinking that seems about right. A lot of central banks adopted it.
Whether that still is appropriate for the current state of the global economy, certainly there's a lot of debate around that. I think there is the potential for that to change down the road, but I just feel like central banks ought to wait until we're well past this episode and take a sober look at it.
Okay. Steve, I'm gonna ask you this question 'cause you've got your, you've got the mix with as director of research, you're looking at a lot of different sectors and a lot of different stocks. One of the things we're hearing a lot about is the upside potential in small caps, especially on the growth side. What are your thoughts on what leads the way next year? I guess a small cap, large cap question a little bit. Any thoughts on that?
Sure. I think Bill did part of the lead-in to this is through volatile environments, investors start looking for safety, they look for liquidity, and they're trying to reduce risk, you know, as they reduce momentum. Smaller caps don't tend to offer that, so by and large, they've been ignored through much of the cycle. That's resulted in valuation gaps and opportunity sets that are there. I think as the market becomes more risk-tolerant or risk-seeking, then the opportunity will arise for small caps here. Certainly, anybody who's got a strong valuation bias will be naturally screening into that group and looking for the opportunity sets there. 'Cause in some cases, you've got a couple of turns of valuation difference that you're trading off for the liquidity.
I should probably pass that to Bill 'cause that's, how's that a separate result?
Bill, did you have anything you wanted to add on that, too?
No. Steve, I would agree 100%. The only thing I'd add there is that, you know, small cap tends to need lots of capital to grow. With cost of capital much higher, you could see small caps continuing to struggle for a while here. You know, I think you hit all the big points for sure.
Okay, David, as Bill alluded to, you know, we've got a duration change taking place in the market. You know, we talk about it on fixed income a lot, but really, we're seeing it into the equity markets. And those businesses, firms, and opportunities that can be self-funding, and more importantly, can return capital consistently to shareholders, are probably in for a re-rating that's not fully taken place yet.
Because of that, when we come out of this, there could be a leadership change a little bit, right? In the new bull market, we could be seeing new sectors leading the charge the next time around as opposed to what we saw sort of over the last sort of decade, right?
Yeah. I think the good rule of thumb is, you know, whatever led you in the past is not gonna lead you through the next cycle.
There you go. Okay. here's a good question, and it has to do with, you know, there's a lot of high-profile investors out there who have gone really, really bearish, and they're selling off and, you know, they're waiting for, the you know what to hit the proverbial fan. The question is, why do you think 1929-type crash won't likely happen this time around?
Yeah. I mean, maybe I'll take that, which is... I mean, I know where that's the Michael Burry, who is a... He runs a short fund. He got... He made great hay in 2008, shorting the housing market in the U.S., right? I think we've already wrung out a fair massive amount of speculation in the market already. Whether it be the SPAC index, which is down 50% from its high, whether it is in crypto, which is, and we've seen with the recent news around that. I mean, we can go through them, right? There's been a real amount of excess washed out of this market already.
I'd say second, back to my point earlier, the economy's in pretty solid shape underneath this in terms of employment levels, et cetera. We don't see a systemic risk issue out there at this level. I do think you're gonna see a slowdown, I think because of the pace of what we just went through. There will be an effect of this. It'll show up in the consumer. As these higher prices start to roll over and rates start to price in a slowdown and come down, some of those pressures start to abate as well. I think the 1929 scenario, if we hadn't taken some of the speculation out, yeah, you would be worried. Frankly, we're getting back to normal, which is an adjustment.
You know, if we look at history and say a six handle on a mortgage is high, that would be wrong. A 10-year bond that had a 4 handle on it would be high, that too would be wrong. I would also lastly argue that now if you did run into a problem, and I agree with Tom, we're probably not gonna react right away, but you have the ability to cut rates again. Which prior to this, prior to COVID, we were at near zero for almost 15 years or whatever. If we had run into a recession, we had no ability. I don't see 29 as a scenario here because of some of the excesses that we've talked about being taken out.
Okay.
I think the debate is a simple one. There's a camp that says we're in a new bull market already, and there's a camp that says we're still in a bear market, right? You know, bear markets are two things. It's time and price. We've had a lot of price degradation, but have you really washed out everybody who wants to get out? That's the time function. It could be a choppy first part of the year.
Okay. We've probably got time for a couple more at least, maybe three. Question again about China's reopening, and whether, you know, whether that could drive the inflation back up globally, that reopening. Is there any concern there that all the work we've done to get it down is lost because of that reopening? Anybody?
Yeah, maybe I'll start, I think it depends on what part of inflation. As they reopen, certainly energy is gonna be in demand again. As Steve has educated us all over the years, this is a supply problem, mainly, meaning there's not a lot of new supply coming on. That could be a place where you see it. You know, the housing market's not gonna recover to the same place. Some of the pressures that we've seen with raw materials around housing may not be there. You'll see probably a pickup in commodities as they are a big consumer of things. Do I think we're going back to levels of things that we saw in COVID when the world was awash with cash? Probably not. That...
It is a risk that as they reopen, that you will run into higher prices. I don't think that we're looking at scenarios that we saw from 2+ years ago.
Steve-
Yeah. following up on-.
Right? Yeah.
Yeah. Well, following up on Kevin's comments earlier about the China restart, it's not going to be a toggle switch. It's not going to be a flip the switch and we're back to normal. China's gonna have to work its way through a long burn of sorting through COVID. The classic case today is, you know, having seen a release of the lockdowns, and you have the pictures that I'm seeing from downtown Beijing and Chengdu, nobody got the memo, right? They're either staying at home so they don't get sick or they're staying at home 'cause they're sick.
At the end of the day, once they get through that burn-through, the supply side should stabilize, right? The bottlenecks that we've lived with for the past few years should diminish and disappear. I think from that perspective, it is probably a bit of a saw between, you know, the supply side becoming more stable, contributing to lower inflation. You are gonna have that demand resurface and pick up again. Travel is gonna be a part of that as well. I think there'll be some pros and cons to that from the inflation side. Probably,
By and large, neutral from an inflation picture, but probably good for general global growth dynamics.
Okay. One more at least, maybe two, depending on what the answer is to this one. This is about the forgotten tool of monetary policy, quantitative tightening, QT. No one seems to talk about it, the question is here, you know, what is the impact of it while everything else is going, while rates are rising?
I think I'll start maybe, Tom, we've spent a lot of time on QT. For those in the audience, again, it's literally unwinding the bonds that we bought in QE. All QE was, basically David owned a bond, I was the government and said, "I'm gonna buy that from David." He got my cash, and he went out and bought stocks, a house, other things. When we do the reverse, when basically, you know, we're not buying David's bond, right? We're selling him bond, he has gotta sell something else. He's taking liquidity out of the market to buy that. All central banks have to do this. The U.S. is unwinding at a pretty good clip, as is Canada.
This becomes a story about liquidity in the markets, if there are no marginal buyers, and I'll give you an example. Banks are classically large buyers of treasuries in the U.S. or even Canada sovereign bonds. As depositors who sit on their balance sheet have other places to put money now, they can go to a money market fund and get a real yield. They actually, for the first time in 15 years, aren't probably leaving their money in checking accounts. At the same time, banks wanna lend money to their customers, their depositors are going for higher yield. They're not gonna be the buyer of those bonds that are gonna be put up for sale. Liquidity is gonna become the issue.
It's not gonna be solvency like 2008, but you're gonna see liquidity, which is gonna basically force the different central banks at different points to pull back on it. You're probably somewhere in the next, in the case of the U.S., my guess is in the next six months. It'll probably be a discussion point today in the Fed's conference call for sure. Yeah, David, something we don't talk a lot about, but we should, being more about liquidity than anything else.
Okay. If nobody has anything on that one, I will get to one last question. It's an oil question, and it's related to carbon footprint. With demand for energy increasing for the foreseeable future, how likely is the dependency on oil and therefore our carbon footprint likely to decrease any time soon? A broad question, philosophical question about energy and our carbon footprint. Steve, maybe I'll start with you.
Sure, I'll dive in. I mean, 2022 has been a great example of the interlinks between all of the different energy sources. We can't talk about oil in isolation, we can't talk about diesel. Let's use European energy, or even more specifically, the U.K. at the moment, right? Which is suffering through extraordinary energy prices. They fired up the coal plants. They're in, they're importing LNG. They're burning oil. They're burning everything except the dining room furniture just to stay warm. As we evolve from this, and part of this, you know, is due to the issues coming out of Russia, part of it's due to overall demand growth. We're not gonna solve it quickly.
Even as we introduce increased renewables into the blend, they are really only making up for the growth in energy demand globally, which makes it an incredible challenge to try to reduce the use of fossil fuels rapidly and in a meaningful sense. It will happen, but it's not going to happen to the pace that people might like or that COP 24 might prefer. Unless we get a meaningful change in the way consumers utilize energy and have real demand contraction, it's gonna be very, very challenging to lower our footprint. That's just reality.
Kevin, did you wanna maybe add a bit on that?
Yeah. I think we've talked about it. You know, we are one of the large sustainable growth fund here. It's always for us been about this idea of transition, and transition is gonna be a long-term thing, not an overnight thing. You've seen economies, as Steve referenced, in Germany, for instance, where after the Fukushima nuclear disaster, they shut down all their nuclear plants, right? They became dependent upon Russia's natural gas, right? That wasn't probably the right transition. I think it's a transition story over time that both of these exist into time until the technology and new innovation takes hold to actually get. That is the solution to this, is gonna be a technological one. You've seen some of the scientific advancements announced yesterday about nuclear fusion.
All of those will play out over time but have a technology driver to it. It is about transition. It's not overnight.
Okay. That brings us pretty close to time. Kevin, maybe I'll just, I'll give you the floor to just give us some final thoughts as we head into the last couple of weeks of 2022 and get ready for 2023.
Clearly we're not gonna see the pace of rate hikes that we just went through. Now it's just adjustment factor and fine-tuning and grinding to where we stop. I think the market has to get itself used to the fact that stop doesn't mean cut immediately to where Tom was earlier. All of that will create volatility probably in the first half of the year for sure. You have to anticipate that the Bank of Canada probably stops early winter, the US probably late spring. It's a question mark on Europe given the dynamic they're in, in the recession they're already in. That will amount with some choppiness. Earnings revisions are gonna play a part in this as you get into January and look at fourth quarter earnings. We've had a really strong dollar.
Many of the U.S. companies are gonna be hurt by that. You look at if you're sitting in Japan, earnings revision's been pretty good because of the weak yen, especially if you're exporting into a world that's still growing. I think the second part of this getting back to normal is what has this done to earnings. As we've had this higher levels of rates. I say that the back half of the year probably sets up okay as you get through. Even if we're in a recession and it's mild, we know one thing about history, the equity markets will actually bottom into that recession and move out in front of it while you're in it and price forward. If we think about that means probably a pretty decent...
Again, when I say decent, it's not a 20% type world, but you can probably see a positive single digit kind of world toward the end of the year. A normalization in fixed income, where I think today you're getting enough income, to Tom's point, that the price changes here actually, if in fact you get into a slowdown, are gonna benefit you on top of the coupon. A back half story, Dave, with a lot of volatility in the front.
Excellent. I think, I think people would take a single digit return when it's all said and done by the end of next year. Okay, thanks again, everybody, for your comments today. Fascinating stuff. Always a pleasure. That brings our discussion to a close. Thanks also to everybody who's tuned in today. On behalf of Kevin and AGF's entire investment management team, we appreciate your time and support and look forward to sharing our insights with you again next year. Since this is our last webcast of 2022, I also want to acknowledge the AGFers who work tirelessly in the background to make these webcasts happen every month. In particular, thanks go out to Courtney, Sharon, Marissa, Jason, and Leah. Without you, none of this is possible.
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