All right. Good morning, everyone. Thanks for joining our latest market update webcast. With me is Kevin McCreadie, AGF CEO and Chief Investment Officer, and AGF Portfolio Manager, Mike Archibald. I'm David Pett, editor of the AGF Perspectives blog. Before we begin, I've gotta go through our administrative items related to our virtual event platform, as always. 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. 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.
For those of you that tune in regularly, you'll know that every quarter we run through our asset allocation committee's latest quarterly update. Without further ado, I'll hand it over to Kevin to summarize this quarter's changes. Over to you, Kevin.
Yeah. Thanks, David. You know, the way we're looking at the world right now, we're just kinda neutral on our equity bet, underweight fixed. Within the equity bet, you could see, if you go back one slide, you know, we continue to like the U.S. and Japan. Again, we're underweight Canada, Europe, and Asia ex Japan for reasons that we'll talk about, probably related to more as you think about where a recession will appear first. If you look to the fixed income slide, we are still underweight, but getting closer. We remain very underweight rate sensitive, so as you think about a world where rates are now higher for longer, and the bond market may demand more in terms of yield to buy that supply, continue to be underweight there.
Obviously overweight high yield, where we think when you're starting to approach coupons that are near 10%, and yet economies in the U.S. particularly, which are resilient, which make most of that market, pretty good opportunity. Then neutral on the emerging markets, given the backup on the U.S. dollar. You flip to the next slide, you can see from an alternatives and cash button, cash, which now yields, well north of 5% most places in the world, gives us a nice hedge, plus the alternative bucket on equities, to manage through some of the volatility that we're gonna see some in the near term.
Okay. Great, Kevin. Let's provide a little bit of context for the update. Maybe the question for you is, when you think of the backdrop, for equity markets, let's start with equity markets first. When you think about the backdrop now versus the past quarter, you know, what has changed in your mind, if anything?
Yeah. If you remember at the end of June, we had a really strong push on equity markets, right? Things had gotten a little hotter. You had central bankers all around the world saying, hey, you know, we're not done yet. Right? Again, this was in the backdrop of a very strong, late push on Q2 on equities, right? You're sitting here in the fall, and I'd say it's almost as if every central banker's got the same playbook. We may be at the level that is restrictive. The argument should no longer be how high, it should be how long. We're watching the data very closely.
I think the markets are starting to say, hey, you know, maybe they're starting to believe you're seeing fixed income, again, have a very volatile backdrop over this quarter. Again, starting to recognize that maybe this idea that rate cuts are anywhere near us is a little bit further out than people thought. I'd say those are the two big changes, which is this belief finally that maybe central bankers need to be listened to versus what we thought earlier in the year, or the market thought earlier in the year, which is that they should be cutting, right? That seems a bit longer now because the strength of these economies has been okay.
Mike, let's bring you into the conversation and maybe just a thought from you in terms of, you know, what's changed over the past quarter, particularly in equity markets?
Sure. I guess from my lens, and I agree with what Kevin had said there, the thing that's changed probably the most is just the trajectory of where earnings growth is. As we look back to the H1 of the year, earnings growth was negative for the first couple of quarters. We're really now at the point in time where we're gonna start to tip probably just slightly into positive territory. We've kinda lapped over the challenging periods that have occurred, you know, in the last 12 months, and now we're starting to look like we might be heading back into a period of actual earnings growth. You know, I think we're gonna have to, as Kevin said, we're gonna have to recalibrate to a number of things. Growth for the fourth quarter looks like a hockey stick.
It's almost double digits. I don't think that's quite likely. 2024 and 2025 earning estimates are both up about, you know, 12%, 13%, you know, for the year. When we think about the macro backdrop and what's been going on, that doesn't seem very likely to me. Nonetheless, I think, you know, there is some level of positivity that we can take away from earnings starting to move back higher. I think the other main thing, and I guess we'll probably talk about as we go through the call today, is just, you know, the change in the geopolitical environment that's gone on.
I think that introduces a whole host of, you know, tail risks, if you wanna call it that, to what's happening in broader equities, what's happening in fixed income, and what's happening in currencies. I think those things are gonna continue to in certain parts of the market, put a lot of pressure, in other parts of the market, probably be a bit of a tailwind, and we'll talk about that. I guess the last point I'll just echo is what Kevin said. I mean, if we sat here, I was on this call, I think 6 months ago, and, you know, yields had moved up quite a bit.
You know, with bond yields are now at 2007 levels, interest rates are at, you know, levels that we haven't seen for many people in 15 years. You know, I know the economy has been relatively resilient, but that pressure is still likely to come for the consumer. It's still likely to come for businesses. It's probably gonna have, you know, an impact on equity markets. You know, those are things that have changed. I think some of those are happening at a little bit slower pace than maybe, you know, I would've thought. I thought some of those things would've happened a bit quicker.
It hasn't, but I do think it's still probably likely to have an impact here as we move into the end of 2023 and into 2024.
Yeah. Let me touch on something, David, that Mike just said. It's the bond market, right? When you look at what's causing the equity market volatility, it is the bond market. You look at a day like today, just take a snapshot. Arguably, the geopolitical events overnight are troubling, right? The events over the last few weeks, very troubling, right? In terms of what it means potentially for oil, for a greater involvement of different players. You would have gotten up this morning and said, hey, you know, people are gonna flock into bonds. That would have been typically the thing, right? The safe haven asset. The two-year from yesterday morning was 5.11. It's 5.23 this morning. It has backed up significantly. The 10-year, which yesterday morning was 4.75, is now 4.92.
These are vicious backups, right? That's people saying, i need to get paid more, to take on fixed income from here. That, that is this idea that maybe people think rates are going higher. Certainly the bond market is going to do the Fed's work for them a little bit. Think about most things in life, they work off of the ten-year. Mortgages work off of the ten-year. Corporate bond buyers work off of the ten-year. As you push these yields higher, it makes it harder for everyone to borrow. Again, the Fed doesn't need to raise short rates. As long as this curve keeps going like this, it's going to take a fair amount of restrictiveness into play here.
Okay, let's pivot back to something you talked about, Mike, and that was earnings growth. We're sort of in the midst of U.S. earnings season right now. I believe the U.S. banks have all reported, and I think a lot of the big tech will report next week. Any surprises in terms of what you've seen so far from earnings season? Mike, I'll start with you first, and then Kevin, maybe some thoughts on that as well.
Yeah. It's a bit early, as you mentioned, David. I think we've got, call it, 30 or so S&P 500 companies that have reported, and it's heavily skewed towards financials, as you note. I guess I would just say a couple of things. The bar for financials is so low right now, just given the fact that there's, you know, very limited earnings growth. You know, loan growth is has been really sharply decelerating, just given the move that we've seen in rates, and just how stressed I think, or I shouldn't say stressed, but how, you know, how much debt some of the consumers globally already have. Earnings for the banks have actually come in, you know, better than expected.
We haven't seen a real uptick in credit, as we've been talking about internally for, you know, two months now, you know, the consumer looks pretty stretched here, right? They've done a lot of work. Their excess savings are probably being depleted. We've seen that on two calls from some of the major banks. We heard the same thing again out of Morgan Stanley this morning, that stock, you know, was off sharply today, 7.5%. I think, you know, the consumer, we've talked about the resiliency that the consumer has had, you know, that's still showing up in some of the retail sales data that we're seeing. We've gotta be getting close to the tail end of that.
I think the spending patterns of that we've seen in 2022 and 2023 are gonna change dramatically as we move into 2024. If we flip the script and start thinking about technology, which has, you know, been the real driver and the leader of the S&P 500 returns this year with the Magnificent Seven, those numbers are actually still gonna be pretty good from a growth perspective. You're gonna have high single digits, low double digits out of most of those companies. The question just is that gonna be enough to sustain the valuations that those businesses trade at? You know, I don't have an answer for that question.
Certainly, we're seeing a lot more volatility in those names in the last week or two, and they have corrected a little bit from the highs that we saw on the market in July. you know, the narrowness of the S&P 500 this year is still being exhibited with those companies really driving the, you could call it 14% return for the S&P, and the equal-weight index of the 500 companies is actually negative on the year. It's a very, very big divergence. you know, I think, we get Netflix and Tesla tonight, and then you get the other big guys all next week, so we should get a better idea from those names.
I would just say, I think the AI hype in a number of these names is probably been fairly well priced, and I'm not sure, regardless of what the numbers look like for this quarter, whether or not you're gonna be able to see any upward revisions to those companies. Wouldn't say I'm negative on that part of the market, but I would just say I'm cautious until we kinda get a better feel for what the valuation multiples look like. I guess the last point I'll just make here is, you know, the other economically sensitive parts of the market, so think consumer discretionary and think industrials, those stocks have held up remarkably well so far this year. If there is a slowdown in the economy, you're gonna start to see it there first.
You know, think about, you know, engineering, construction companies. Think about, you know, United Rentals of the world, those types of names. Those are businesses where you should start to see a pullback in operating activity. We're gonna continue to watch those names closely to see if that's what happens.
Can I just add to that too, what Mike said? You know, we're really early in the earnings season, Dave, right? We know that this Q3, based on the data that we've seen so far, the GDP data, is gonna be strong. It could be a 4-5% kinda number in the U.S. Very different than Europe, which is flat to negative. Canada, flat to negative, right? That's being driven by a bunch of things. That's gonna be hard to repeat in Q4 with some of the headwinds and weaknesses. If you look at the banks that have reported, these are the big guys. It's the JPMorgan's, B of A's, the Citis, right? They have multi-line businesses, fee income, they do trading income.
They actually lend very little to, you know, the average middle market and commercial real estate player. You'll get a better feel of earnings of banks when you get to next week, where the regional guys in the U.S. who have to pay up to keep their depositors, that their costs of therefore keeping a depositor in their seat has gone up dramatically with this higher yields. When someone could reach out to, in the case of the U.S., go to a T-bill and get 5.5%, right? That puts pressure on a bank to keep raising rates. I'd say you're gonna have a very different tale of the banking system's health come next week.
When you read through B of A, which I think is really the one to look at for the health of the consumer, and the same with Citibank. A lot of depositors, right, a lot of borrowers, a lot of credit cards. Credit card charge-offs is starting to look like Q4 of 2019. The low end of the consumer has kinda blown through their excess savings. Yeah, even though retail sales were strong yesterday in the U.S., it seemed to be driven by a couple of one-offs, Labor Day weekend, back-to-school buying, but the low end seems like it's really hurting. It's really being driven maybe by the upper end of the economy. I'd say the second point on earnings, we've gotten some staple companies come in, and when I looked at today, Mike and I were talking earlier in the call.
You're seeing these guys report 7% earnings growth, right? It's all price. 7% Procter & Gamble is the one I'm referring to today. 7% in terms of profit growth, 7% in terms of price. Volume's down. That too comes to an end. You just can't keep doing that, especially as inflation starts to cool. I'd say I would not read a lot, to Mike's point, in the first couple of weeks here, because the real economy is the one that's gonna start to report starting tonight and into next week, and you'll get some feel for it. Probably my last comment on that big 7 thing that Mike talked about, the Magnificent Seven or whatever. They kind of have. To the average person in the street, they've become the new staple.
They feel uncertain about all the stuff in the Middle East. They feel uncertain in the spring about the banking system with Silicon Valley Bank. Everyone's talking about a great recession, the most talked about recession of all time. They know what Apple does. They don't know how to value Apple. They know it makes phones and AirPods, et cetera. They know what Microsoft does. People crowd into the things they know. Where those things go from here is probably they kinda run flat to the market. They don't have to go down a lot, but the big boost that they had in the H1 of the year is probably behind them. That would be where Mike's point about the equal weight, which is negative, that's where the participation needs to be.
Those average stocks have to start picking up, and that would happen when they start to see that economic growth will recover from, again, some of these headwinds that we're about to talk about.
Let me ask you, just to follow up on that, Kevin. Your these, this Magnificent Seven, they're acting kind of like defensive stocks, do they exhibit any characteristics of a defensive stock now?
Yeah, here's the thing. This is different. I tell people this all the time. This is not 1999. Valuation maybe, yeah, but these are companies with good cash flows. They have real earnings. They, you know, It's about how much you wanna pay for them and what those growth rates, as Mike said, will be in the future. We've pulled forward a lot of things related to AI, by the way. When you can't get some of these chips, guess what happens? You over-order. The chip guys, they don't wanna disappoint any of their customers, so they allocate. They give everyone less than they ordered. If you know you're gonna get less than you ordered, what do you do? You order more. A lot of that's been pulled forward.
A lot of people know that China, for instance, was gonna ban some of this stuff. A lot of that's been pulled forward. Again, this is not about whether they're good companies or bad. They're actually really good quality companies that have just gotten probably well ahead of themselves because people have flocked into them because they know what Google does, they know what Microsoft does, they know what Apple does, right? They have become a little bit more staple-like for people than they would've been in the past. It's not so much as AI-driven maybe as it may be, I know what they are and I'll flock into them.
Yeah, I may add two quick things here, David. I think just also, almost all of those companies refinanced their balance sheets pre interest rates going up, so they have rock solid balance sheets. They do have some debt, but it's funded at, you know, 2% or less, for a long period of time, so that helps. They are huge, huge cash flow machines. In an environment of uncertainty, you know, cash flow is king, and these companies have a lot of it. They generate a huge amount of cash every quarter.
Other point I was just gonna make is some of the more leading edge parts of the economy, so think about airlines, think about hotels, those businesses have recently started to provide a much different outlook than they were providing one to two quarters ago. The airlines in particular, they've taken a lot of prices. You know, if you fly anywhere, you're paying a lot, and every seat in the plane is full. They've started to give a little bit less rosy guidance here out for the next three to six months. That, I think, is part of the leading edge of what we're trying to pay attention to figure out, you know, is the consumer fully tapped out?
I'm not saying that they necessarily are, but I think there's probably gonna be a bit of a change to the spending patterns that we've seen for the last, you know, call it 12 to 18 months.
On that front, Mike and Kevin, you can weigh in on this too, but I'm just curious. It's a more of a process question in terms of earnings season. You have the results obviously that come out, but there's also the guidance side of it. Where do you hold, w hat do you consider as more valuable to what you do? Or is it sort of a balance? Is it even? How do you approach that dynamic?
Both matter. You know, we use some factors to screen for both in most portfolios across AGF. You're trying to figure out, like, is earnings growth coming in on the reported quarter at the level that you expected? Really when guidance matters is when it's significantly different than consensus, okay? Most of our models here in the funds that I run and a number of the other funds that are run at AGF. We'll use some level of forward growth estimate, and that's gonna be based upon generally the consensus estimates for that particular business.
If those change dramatically based upon management guidance, and that happens quite often, around quarterly earnings season, then obviously the market will usually pay more attention to that, either positively if there's a guide up, as happened this morning with a couple of companies, Abbott Laboratories being a good example of that, or negatively if there's a big guide down. There's no sort of one-size-fits-all answer to this question, David.
I think, you know, we pay a lot of attention to make sure that the businesses are reporting numbers that we expected them to report, but also, particularly around this time of year because you're starting to get close to the end of 2023. Now more folks are focusing on 2024 and what those estimates are gonna look like. Businesses are starting to talk about 2024. Probably this time of the year is really when you're starting to focus, more of your attention on the outlook, but certainly look at both.
Yeah. I would argue we're at this inflection point, and to Mike's point, David, which is this quarter reflects, your stock has moved into this quarter. What you report will basically be assessment of the facts. Where we are all now thinking about, and to Mike's point, this inflection point of higher rates, finally, the consumer is starting to weaken much higher ten-year yields, which is where the average company borrows, right? It's going to be about what you say about this future as we get closer to the end of these rate hikes. The, y ou know, let's assume hypothetically, you know, if you made your earnings and they were just in line and your revenues were just in line, your stock is probably flattened down a little bit because you've moved into the quarter.
If you basically say that things are weakening around you in the future, they're gonna discount that quickly and take that down. I think we're at one of those kind of inflection points because we're getting into this kinda change in terms of the economic environment under us. You know, Mike talked a lot about the big tech guys being able to borrow and have literally made fortresses out of their balance sheets. Some of these guys aren't gonna borrow for years, and they've locked in at 2% and 3%, and they produce a ton of cash. You gotta remember, the average company in the middle market America, which drives the economy and Canada, doesn't borrow in the bond market. They borrow in the credit system through a bank, Private Credit market. They're paying 10%. 8%-10%, right?
Those are real pain points. Very different go-experience when we go into 2024 for these very, very large companies versus smaller companies and the middle market companies that don't borrow in the bond market. I'd say you're at this inflection point from earnings where we've had this big push on rates. We've been talking about the softening 18 months into these rate hikes now, almost 20 months. This is where you start to see things, and that's why I say this quarter, the guidance is probably more important than what you actually report.
One last point I'll just make on that. Like margins have been so resilient, right? We've seen that. That's obviously price has been very good and top line has been moving up, and that's largely because companies have been able to pass price through to end consumer regardless of the industry that you're in. Margins have been, you know, very, very resilient. There's a lot of things happening in the environment right now that could bring that into question. If inflation starts to roll over, obviously you have to take that in price. As the commodities have moved up on these geopolitical issues, that starts to eat into the expense side as well. I think those are things that we're really watching closely.
I've been surprised at how resilient margins have been, particularly for, you know, many companies in the industrial and consumer space. It remains to be seen if this is the quarter that it starts to bite or if we kinda glide through here again.
Let's talk about geopolitics a little bit more in depth. Mike, you mentioned it at the start of the call. How concerned are both of you with what's happened over the last week with respect to Israel's declaration of war on Hamas? And what kind of implication does that have potentially for what you guys are trying to do day to day?
Yeah. I mean, obviously, David, it goes without saying, terrorist attack of this magnitude is just horrific. You know, it's, you know, barbaric. Right. It's never good for any society. When it draws into this geopolitical arena of a broadening engagement, particularly with this idea that you can bring Iran into this, which brings the U.S. potentially into this, what does that mean? You saw this morning, Iran asking for a boycott of Israel oil. Israel, just to put some commentary around this, is only about 330,000 barrels, 330,000 barrels in terms of its needs. It can be met with other players in the region.
It's the prospect of this kind of stuff which, right, if you are worried about inflation and the idea we've already seen a push on energy, it's probably been the best performing sector, Mike, since the end of, probably second quarter, right? Because prices have gone up, right? If you put another $10 on this, you know, oil goes to almost $100. What does that do to gasoline prices? What does that do to a pinch consumer? Geopolitics, what goes on there, forgetting the tragic loss of lives on innocent people now on both sides, it's really gonna be around the impact it'll have on commodities supply chain. Let's assume you block the Strait of Hormuz, right? You don't have to do anything else, but Iran decides to not let ships through. That brings U.S. carriers into action.
The price of oil keeps, again, pushing higher, which means the consumer, again, who has to make choices. If your paycheck isn't going up and it costs you $1 more per gallon and you have to drive to work, guess what? You have to put food on the table, put gas in your car. You're not spending on other things. You will slow these economies down rather quickly. There is sensitivity to the geopolitics and what it does to, A, the underlying commodities, but two, consumer confidence. People start to worry about this stuff, they don't buy things.
I would add two points to that. I think, you know, as we bring in more participants into these geopolitical arenas, the possibility for miscalculation, I think by one or more of them goes up dramatically. That's really what worries me the most. If something very, very unexpected happens here, then it's very difficult to forecast those things. You know, that's probably why you're seeing the move in gold prices that you've seen recently. They've bounced, you know, call it around about $100, 'cause there is a bit of a fear premium that the market is buying. That's number one.
I think the volatility, and Kevin touched on this, you know, in commodity prices is, you know, has the potential to be very inflationary, just at a point in time when inflation is starting to roll down in most of the developed markets in the world, particularly here in North America. That may change the path of what happens with interest rates going forward. There's a lot of steps we have to kinda cross through or stairs we've gotta climb before we get to some of those things. I'd just say that they are inflationary, and I think the biggest point that I would echo is that these are gonna be dampeners on the growth outlook for the global economy going forward, right?
Oil prices go up, if they tipped into triple digits here or potentially even higher, depending on what Saudi Arabia and Russia decide to do with their output, you know, that becomes an instantaneous tax on everyone. That hurts, you know, Q4 and 2024 growth significantly, and that will require repricing in all assets.
Okay. Then, maybe, we could just talk a little bit about we're still dealing with, as investors, the Ukraine War as well. I'm just wondering the combination of what's going on today, if that just kinda multiplies the concern a little bit from your perspective, Kevin?
Yeah, I mean, we've talked a lot about this with Greg Valliere and others on this call over the last year. The world is a dangerous place, more dangerous than it's been in a long time. You know, Ukraine issue is not resolved. If anything, you would argue that their offensive has met into a standstill. You're heading into a tough place with the winter. At the same time, if you look at what's going on in the U.S., U.S. politics, the House of Representatives is a mess. There's another vote for trying to find a speaker today. Nothing is getting done. One of the issues, as you saw with the last speaker, was support for Ukraine.
When you have these, fiscal deficits running up around the world because of all the support governments had to do for COVID to keep their economies afloat, you know, people are looking and saying, how much more can we afford when we have these issues at home? The fact that Ukraine hasn't made great strides, in here, you could be bogged down, and all of a sudden, they have become page two story on the geopolitical front to what's going on in the Middle East. If you're in Europe, though, you're paying a lot, attention to it, right? You get a cold winter here, gas prices start to pick back up. You're looking at inflation rates just this morning in the U.K.
You know, we're seeing inflation in Canada trend now below 4% on a core basis. In the U.K., we're still in the numbers that's in the 6s. That's core. Headline's still in the 6s. That's, that's energy, it's food, it's a lot of things. While again, we don't talk about it's Ukraine is in is getting to a place where it, you know, this bogging down of things, and especially when it comes to the U.S. and other governments, we're gonna have to sit there and say, h ow much more can we afford to do here? It may force some changes there. I'd say you put them all together, you're dealing with a lot right now. Let me just touch on the geopolitical as it regards to the US Congress.
Greg is not on today, but his pieces the last couple of mornings have been pretty good about this. You know, if you basically don't have a Speaker of the House, you can't pass these bills through. The latest will be to try to tie a bill giving $100 billion to both the Ukraine and Israel at once. Nothing is getting through. There is some concern there that the longer this goes on, you're facing now probably another government shutdown in early November. None of this will be good for both of those fronts in the geopolitical side.
Okay. heavy stuff, guys. Let's lighten it up a little bit, but relative to what we've talked about, I, I, gonna ask for a big, big prediction from you, and this is regarding the equity market. Obviously we've rallied this year a little bit, and I'll talk about the S&P 500. Curious to know when you think we might reach a new all-time high on the S&P 500. Mike, I'll start with you, and then Kevin after that.
Sure. Good question, David. I wish I had the crystal ball. I think, you know, markets are gonna continue to be volatile. I guess if you were to peg me to a particular time, I'm gonna say the H2 of next year. I think we're gonna be in a period of volatility. There's gonna be an adjustment factor that still needs to happen to both earnings and to consumer spending, and that's gonna have an effect on the valuation multiple that you're gonna wanna pay for those earning streams. I would also just say, I think you're gonna have a little bit more uncertainty around this market as you get towards November of next year, which is the U.S. election. Typically after that, outcome, you generally see a pretty good rally in stocks.
I don't want this to be construed as me saying that next year is gonna be a negative year, or stocks are gonna go down a lot. I don't think that's the case. I just think we're probably in a bit of a sideways tape here. You're gonna have to be good at stock picking, and maybe you wanna have a little bit of extra cash here, you know, over the foreseeable future. If I had to get pinned down to a particular time, David, I'd say, you know. Maybe it's late in the fourth quarter of next year, after we get through the election and, you know, we're starting to figure out what the new run rate of proper economic growth is with interest rates at these high levels.
I mean, I guess for me, David, it's not too dissimilar from Mike. I think there is some seasonality that plays in the markets. We know that late November into December typically is a pretty good time. We're in the tough patch right here for markets. Could you see a drawdown from here if you're looking at markets of 3%-4%? Possibly. It's gonna be very volatile. If you see the bond market start to change, in other words, rates start to drop, which means either signaling from central banks that maybe they truly are done. None of them have a probability of raising rates here at this next meeting. The Bank of Canada, which meets next week, is maybe 15% chance of an increase. Highly unlikely they go.
Even the U.S. Fed, which has been talking about the fact they may have a little bit more to do, less than 10% for November. Even the Bank of England this morning, which began with that hotter CPI number, probably around 10%. Again, if you get some relief, if you get through these three events in the ECB, you may get a rally in bonds. People may start to believe that the, it's no longer about how high, right? We may react to high, and it's about how long, which is a different story. That may give you some relief with that seasonality if bond rates can drop here. So that if they keep backing up here, I'd say that the equity market is gonna be in a tough place.
I think the next leg for this market will be when you actually start to cut rates. That's gonna tell you that, yeah, things have probably gone too far. We've weakened things enough. Economies are actually starting to slow to a recession, maybe even in a recession. The risk is that central bankers stand on the sidelines with their arms crossed as the recession unfolds because they're still looking at inflation as being too high. Because we've conditioned equity markets over the last 20 years that every time you get weakness, the Feds and any central bank is gonna cut rates to bail you out. It just may take them longer to do the bailout this time. That may cause some indigestion in the first part of next year. I agree with Mike.
I think we get some new highs later in the year, because once you cut rates, what are you trying to do? You're trying to make it affordable for people to borrow money to buy things, to spur demand. Demand drives profits. You're generating profit growth. You're hiring people back. They're getting wage increases again. They're going out and buying sunglasses and jeans, and you start the machine over. That sets up a new leg for the market. Again, seasonally, you could have a little bit of tough patch in the next few weeks. You could see a pop toward the end of the year, and then it gets kind of this, when do we cut rates kind of thinking comes into play. We may disappoint because at the first batch of weakness, we just may not do it.
I'd suggest later in the year, next year, we probably move to a new part of the cycle as you start to cut rates.
Okay, great. Thanks for humoring me with that answer. Of course, forecasting is always a bit of a mug's game, but it sounds like, you know, there's a grind ahead for investors.
You know the answer to that, David. You never put a date with a number.
There you go.
You give one or the other.
That's right. Okay, let's get to some questions from those that are tuned in today. Here's one on the U.S. yield curve. Here it is. Kevin, maybe you first, and then Mike, if you wanna weigh in. The U.S. yield curve has been flattening. Is that a surprise, even though you have talked about the bond market today already?
Yeah. What we're seeing is something called a bear steepener. The curve has gotten steeper, meaning less inverted, right? We were probably inverted, meaning a two-year yield was higher than the 10-year by something like more than 150 odd basis points, probably six months ago. Today, that has that inversion. The two-year is only about 30 odd basis points higher. Normally, that happens, right, is because the 10-year comes down to meet the two-year. Okay? I'm sorry. The two-year comes down to meet the 10-year. What's happened here is the opposite. The two-year has kinda hung around and the 10-year has climbed toward it, right? We've seen this a couple of times in history. That's a reflection of this, maybe I need to get paid to own bonds, that the thing we call that term premium.
There is uncertainty in the future, right? Maybe these higher rates for longer, right? Maybe I do believe these central banks that maybe where the two-year yield is at 5.25% is where short rates have to go. Maybe I need to get paid something more in the future to own longer rates. One of the things I had talked to a lot of advisors last year, a lot of firms were out there pushing these long-duration products, meaning, you know, they're gonna long-duration assets or bonds are gonna rally as you get into this weakness. That has shown up. The damage has been done on the long end here by people expecting that to happen. What you're seeing happen is these longer end rates starting to climb. The curve is flattened out where...
Again, it's because the inflation has been stickier, central banks have been more stubborn, and they're telling you they're gonna be there on hold for longer. I'd say that what we've seen is bear steepener. you know, I would say it's caught markets off guard, but given the backdrop of inflation, probably makes sense.
Yeah. We've had, I think this view internally in our fixed income team is just there's an enormous amount of supply of paper that's had to come forward this year, just given where our budget deficits are in the U.S., and that's certainly put upward pressure on yields as well. I mean, again, the debt levels in the U.S. are just incredible at the current time. That certainly also played a bit of a role in this too, David.
Okay. Next question here is, what would the ideal portfolio mix look like today considering what's expected over the next six to 12 months. Then follow up to that also, what are some talking points we should be having with clients that have been suffering through this, last 22 months? Maybe that first question, I don't know if that takes us back to the asset allocation a little bit, but.
Yeah, it does. I would not be afraid of a 60/40 portfolio at these levels, okay? When you had yields going back you know, in the middle of COVID, that a 10-year Treasury was 50 basis points, right? A small change in the price of that bond wiped out the coupon. Okay? Up in here now, when you're looking at parts of the curve north of 5%, you can have a couple more hikes and bond prices can go down. There's still enough coupon to keep you out of a negative return scenario. Okay?
If you believe these recessions are gonna be moderate, which we currently believe when they occur, and defaults are gonna be low, and things like high yield, which is a much higher actually quality index today, given the fact that some of the largest borrowers are energy companies, which are actually pretty good balance sheets right now. Things like high yield near 10% are probably good. Things like emerging market debt start to look attractive in that low kind of 10%-12% kinda range. Things like private credit look pretty good. You don't need to own sovereign bonds. You can package a bunch of yields and make up your 40 to give you enough coupon to keep you out of it.
You start to move into next year where you actually see the weakness, and you probably wanna be overweight that 60 a little bit, right? Which is the equity side to pick up. The average stock, to Mike's point earlier, don't forget this, the average stock, if you equal weighted and gave Amazon the same weight as everything else and Microsoft the same weight as everything else, is negative year to date. They will start to participate off of those levels, and that's probably where you wanna make that shift somewhere into next year. I would not fear the 60/40 at all.
Yeah. Totally agree with where Kevin's at right now. I think, you know, being overweight fixed income makes tons of sense at these levels. On the equity sleeve, which is what I do, I would say you probably wanna be geared in the near term a little bit more towards larger cap stocks, just as the uncertainty reigns supreme, particularly on the macro side and with respect to earnings. As you said, though, when that shift occurs, you're gonna see a big move into early cyclicals that'll tend to be small caps, things that will work much better as the interest rate cycle starts to go from up to down. That'll be in a point in time when you're probably gonna wanna shift your portfolio allocation a little bit.
Too early for that right now, but certainly as we get through to, you know, maybe the middle of next year, into the third quarter of next year, that'll make a little bit more sense.
The other thing I'd say, David, too, for the first time in a long, long time, in, you know, 2+ more decades, cash, if you're really concerned about the short term, actually offers you, again, the ability to hide out and get paid something, especially if you believe inflation continues to climb down a bit.
Okay, maybe the second part of that question, just are there any kind of simple, you know, touch points, you know, if you're talking to somebody, just a little, you know, talking points about, you know
Yeah.
How people can kind of deal with it.
My bigger thing for all advisors today and people talking to clients is we're closer to the end of this part of the phase, right? Which is don't get caught up in whether it's one more hike or two, right? The damage is done, and we know there's a lag between 18 and 20 months from where we were, you know, at the end of the fall two years ago, where we were near zero, and now we're up where we are, right? Highest levels of rates since probably 2006, right? I would remember to tell people that the levels of things in 2006 actually look very similar. The 10-year bond in 2006 before the Great Financial Crisis was 4.6%. Inflation was running at 3%. The multiple on the market was about 17 times.
All of that's kind of where we are. I'd say. That was a pretty good backdrop, right? It's not the level of things, it's how quickly we got there, and we're going through this adjustment process. We haven't been in a cycle like this in quite some time. I'd say the second thing is, I don't believe, and we haven't talked about this is probably a discussion for 2024, you know, but people do ask me, are we going back to zero interest rates? I will tell you no. Another soundbite for people is we're gonna live in a world with a yield curve where you have to pay to borrow money, that's okay. It will mean economic growth may look different, right?
Returns on projects, financing that you may do have to look different. The world will be a little bit different, a little slower. Doesn't mean it has to be negative. Don't caution this volatility in this year. It's the adjustment year. Doesn't mean that we can't have a decent equity market off the backdrop of things at these levels.
I'll just add to that, David. I think, you know, obviously 2022 for fixed income investors was one of the worst ever, you know, 50 years, let's call it. Even the drawdown we've seen this year, it hasn't been, you know, it hasn't been great obviously, but it certainly hasn't been as bad as last year. I would say to Kevin's point, you know, we're getting closer to the end of that, your returns on the fixed income side of your portfolio should start to look better from here. Equities, as we talked about, have been very, very narrow, you've had to be in the right places. That's typically been large, liquid names.
I would just say my forecast kind of over the medium-term horizon is, you know, just given where debt levels are and valuations, you know, probably you're gonna see a lower five-year return for equities than we've seen, you know, in the past. That certainly still doesn't mean you're not gonna earn anything on those. I think it's just gonna be, probably a little bit lower of a run rate. Understand that, you know, certainly, clients have been pressured, obviously on the return side of their portfolio and then, you know, certainly on the inflation side, with respect to their bills. It has been certainly a tough period of time. I would just echo Kevin's point. Like, I know it's hard.
We're getting close to the end of it and, you know, things are gonna get better, you know, I think if we look out, you know, 24 months from now.
There's one more shift the markets have to make, David, right? Right now, good economic news is bad for markets. It's bad for the bond market if economic data is too hot. That means they fear higher rates or longer. It's bad for the equity market, which fears those higher rates. There's a point in time where we shift that bad economic news, which is now good for markets, right? Bad economic news, markets are rewarding and saying, geez, maybe these guys can stop raising rates. The equity market responds as well. The bond market rallies. There's going to be a point in time where bad economic news is actually bad, right? Bonds will rally and equities will sell off, right? That's probably the transition point that we have to look for too, right?
That means we're moving to the end of this thing, right? Where things are softening to a point where we can start to remove the restrictions that we've put in place.
Okay. Couple more questions here. Maybe I'll ask this one first, I'll direct it to Mike, 'cause obviously, you're an expert on the Canadian equity market side of things. Just a quick question, thoughts on Canadian stocks, just generally speaking, where we're at and where we might be going with them.
Yeah. The TSX has been a very trendless market this year. It's traded in a fairly narrow range up to the top and back down to the bottom, and we've just kind of been bouncing around up and down, up and down all year. There hasn't been a lot of direction in the market. I would say a couple of things that are gonna be important here going forward. You know, we remain quite constructive on the commodity complex at the moment, you know, energy in particular.
I do think oil prices don't even need to really go much higher from here, as long as they can kinda stay in this, you know, let's call it $75-$100 range, which I don't think is a heroic ask, just given the supply-demand fundamentals and what's going on, you know, from a geopolitical perspective. Energy companies are gonna continue to earn an enormous amount of money. Let's call that around 20% of the index, which I think has, you know, pretty good prospects on a go-forward basis. I think the materials space, you know, probably can do relatively well. That's gonna be more, you know, correlated to what goes on in the broader economy.
You know, there may be a little bit of volatility as we kind of reset expectations here, but that's part of the portfolio or, excuse me, part of the market should, you know, should lead out of the, you know, when rates start to get cut. Then, of course, financials, and that's really the big wild card here, okay? You know, I don't wanna go down talking about Canadian housing too much here, but, you know, banks are struggling right now. They're finding it difficult to have good credits to lend to. You know, and obviously the mortgage portfolios are gonna continue to come up for renewal here.
You know, call it 20% of homes are on or excuse me, 20% of fixed rate mortgages need to get refinanced every year, so there could be a bit of a challenge to financials, you know, in the near term. Valuations for those particular sectors, particularly banks, are getting near, you know, really blow-down levels, where if you have a you know, say, a three-year time horizon, dividend yields are very, very attractive. Valuations are cheap. Yeah, you might have to live through a bit of uncertainty here with respect to what growth looks like going forward, but I think over, you know, kind of a medium term, you'll do quite well. Energy is certainly the market momentum leader right now.
That would be an area of the market that I would continue to focus on in the next three to six months. You know, as we get through to, you know, kind of the peak in macro, if you wanna call it that, when rates start to level out and possibly come down, you know, Canada is a very early cyclical market and should do quite well.
Okay, here's a question. I have a feeling you guys will probably just Kevin in particular, you may wanna take this in a different direction than just answering the question itself. The question is, w ith everybody flocking to a high one-year GIC or guaranteed investment certificate, could it make sense to invest in longer terms now? Maybe if you can answer that question, but also I think there's a bit of a debate about GICs versus just a bond fund. Maybe you wanna discuss that too, and the pros and cons to that.
Yeah. As I said earlier, last year was the wrong year for people to try to put out and buy these longer duration assets, right? 'Cause we knew that central banks weren't done, and we knew the markets hadn't adjusted to this idea that they were gonna be there longer. That adjustment has taken place. As I've said, the steepener that we've seen, other than 30 basis points, hard to see rates going much higher. The tenure could go higher, but again, as I've said in my earlier comments, small changes in price aren't gonna wipe out the coupon from here. I'd say you can probably safely start to play into bonds now. Let's assume that basically, as I've said, bad news starts to be treated as bad news. The equity market's gonna go down, the bond market's gonna go up.
Your bonds are gonna do well to hedge your equities. That's not gonna be the case with GIC. Again, the ability to move into a bond product here versus a diversified bond product here, versus a GIC is probably the right time. You can hold a little bit of cash right now, but what will happen is, as central banks start to cut rates, the banks are gonna cut a lot faster too. You're gonna have your rates go down when you go to refi or that matures at a much lower rate than what you have today and you're gonna have missed that roll down in bonds as they start to cut rates, the bond market does quite well. I'd say it's an okay pivot here, versus where my comments would have been a year ago.
All right. We're getting close to time, so maybe I'll just give you guys a platform for some final thoughts, and then we'll call it a day. Mike, I'll start with you, and then I'll get Kevin to close this out.
Yeah, I guess I would just echo a lot of what I've said already. You know, we're in very uncertain times here, and volatility is gonna be, you know, a key piece of what happens in all asset classes for let's call it the next, you know, six months at least, I think, in my mind. Earnings growth is gonna be, from my lens, the most important thing that we need to get recalibrated here for equities. What does that earnings stream look like for the broader S&P 500 and then on a sector-by-sector basis is gonna be important.
We probably will get a clearer picture of that, as we get into next year, possibly the end of Q1, we should start to get a better sense on, you know, what the appropriate multiple is and where we are with respect to the macro environment. I think Kevin's talked about it a couple of times and certainly a lot internally, you know, we are very, very near the end of the rate hiking cycle, quite likely, and that will require a different set of thinking and allocation as we get into the rate cutting cycle. Those are still probably, you know, a couple of quarters out here at least, but once that happens, you're gonna wanna shift your portfolio a little bit.
You know, we're continuing to watch for some signposts along the way to give us some confidence that we're getting closer to that. You know, inflation will be obviously one of the keys, and obviously a little bit better, you know, environment for general macro overall.
Yeah. I guess for me that we're gonna have some volatility ahead, David. We're gonna have some headwinds around some of the data coming up. You're gonna have a GDP print in the U.S., which is gonna look very, very strong. Could be a 4% or 5% kind of GDP growth. Don't think about repeating that in Q4. Things will start to slow down. The consumer in the U.S. is about to start paying down a lot of their student debts again, which they haven't had. You have this political uncertainty around the House, a potential budget shutdown, and the issues geopolitically, as we've talked, all weigh on confidence.
At the same time, we also see from what the banks have reported and the big ones, Citi and B of A, that things are slowing in terms of credit charge-offs and other things. Again, prepare to make this idea of volatility, but we are closer to the end. Doesn't mean we're gonna have a negative market here in the end of the year. It's probably a sideways with a lot of volatility, but start to think about how you wanna position for 2024. I think that's really the, if we get that part of the portfolio right, which is when they start to cut, I think that's where, again, most investors see a recession and they you know, they panic. The reality is that the equity markets don't care about a recession.
They move in front of it. Short-term volatility, I think long-term opportunity.
Okay. Great stuff, guys. That brings our discussion to a close. Thank you as always to everyone tuning in today. On behalf of Kevin and Mike, we appreciate your time and support and look forward to sharing our insights with you again next month. Before you go, please make sure to click the Add Session button in your Attendee Hub to register for our upcoming market update events, including our next installment taking place on November 15th. To complete your CE credits today, please complete the survey available to the right of your screen or at the top of the homepage in your Attendee Hub. Please note you may only submit answers for your survey once. However, you may have the opportunity to go back and edit responses if needed. Have a great day, everybody.