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Is Cash Still King? Dangers still lurking for Canadian Investors

In 2022 the popular 60/40 portfolio strategy – an allocation style of 60% equities and 40% fixed income – experienced the worst return performance on record for what has historically been a prudent approach to investing.

The Worst Years Ever For a 60/40 Portfolio
Year 60/40 Portfolio Reason
1931 -27.3 Great Depression
1937 -20.7 1937 Crash
2022 -16.9 The Great Inflation
1974 -14.7 1973-74 Bear Market
2008 -13.9 Great Financial Crisis
1930 -13.3 Great Depression
1941 -8.5 WWII
2002 -7.1 Dot-Com Crash
1973 -7.1 1973-74 Bear Market
1969 -6.9 Nifty Fifty Crash
2001 -4.9 Dot-Com Crash
1966 -4.8 1966 Bear Market

Source: NYU

By the end of the year, the S&P 500® was down -18.16% – the top-ten worst returns on record for the major U.S. market benchmark. Making things even more challenging, U.S. and Canadian investment-grade bond indices – traditionally a safer asset class than equities – also saw double-digit losses in 2022.

The main reason for this? Unprecedented and continuous rate hikes by Central Banks derailed most equity and bond return expectations. With the latest rate increase of 25 basis points, to 4.50%, on January 25, 2023, the question remains: Is Canada headed into a deep recession?

On our latest episode of the Generation ETFs podcast, Horizons ETFs’ Mark Noble, Executive Vice-President, ETF Strategy met with Candice Bangsund, Vice President and Portfolio Manager with Fiera Capital’s Global Asset Allocation Team to discuss what potential pitfalls could be ahead at home in Canada and abroad for the global economy after a tumultuous 2022.

Listen to the full podcast by clicking here, or hitting play below.


Mark: Do you expect us to see more of the same trends in 2023? What can investors expect for the first six months, or throughout the year?

Candice: In our view, we’re meeting that with a little bit of caution. We think it’s a bit of a head fake. Markets are clearly underestimating not only inflation but central bankers’ resolve in tackling this inflationary problem that we are seeing every day, whether it’s in Canada or the US.

So, I think this is probably a bit of a short-term rally. But we do expect that downtrend, regrettably, to resume throughout the year — just given the inflationary dynamics and the fact that we believe central banks are going to have to do a lot more to bring inflation back to levels that they’re more comfortable with.

Mark: What are those levels? Because, I mean, we can’t really expect a 2% target. That just seems insane based on our year-over-year inflation growth.

Candice: I think they’d be comfortable at three, three and a half percent. And, to be honest, the market right now is pricing in that goldilocks scenario soft landing where inflation comes down to levels where central bankers can actually take a step back and finish their tightening campaign – maybe this month or next month. Then the economy can achieve that soft landing, which would probably be a very mild form of recession.

Our view, of course, is much more gloomy and our sense is that inflation will not be able to come down to those levels of comfort, [and] that central bankers are going to have to raise interest rates more than they’ve even guided towards. It’s interesting, the Fed (Federal Reserve) has said that they’re going above 5% and that they’re going to hold rates there for an extended time. The market is pricing rate cuts. So again, like I said earlier, really just underestimating not only the inflationary narrative but also the resolve of central bankers in restoring price stability.

Mark: Just taking the other side of that coin, I have seen that all the major Canadian banks are basically forecasting that rates have either peaked or in some cases, they’ve got 100 basis point declines, which I was very shocked to see. But I think part of their rationale is that if we have an inflation-led recession, that recession will necessitate rate cuts. What is your view on that? Because I think some of the people that are investing in bonds right now are actually believing that we’re going to move to a classic recessionary environment where that’s actually a safe haven asset class.

Candice: Yeah, well, here’s the thing though, what they need to do … Central bankers actually need to create some demand destruction in order to bring inflation lower. The market has been very excited about the last few U.S. inflation reports, but if you actually look under the hood and look at the details, all of the deceleration has been concentrated in the goods segment, not a big surprise. Supply chains are slowly correcting, commodity prices have edged lower, new/used car vehicle prices are coming off. This is not a big surprise. What is worrisome though is that the more sticky services, tied to the labor market and wages, that’s actually accelerating. And this is the part of inflation, core inflation, that central bankers are really focused on, and this is the only part of inflation that they actually have control over. And so, how do you cool off the labor market and bring those imbalances back into a better balance? By inflicting some damage on the economy and applying more pressure.

So that’s why we think central bankers have more work to do in order to bring that inflation down, and it’s going to necessitate some collateral damage for the global economy

Mark: What parts of the economy do you think are probably the most at risk going into this new calendar year?

Candice: Well, obviously the consumer is at risk already, dealing with higher prices cutting into incomes. The housing market, obviously. It’s really just the interest rate-sensitive corners of the market that are likely going to see a lot of weakness. It’s interesting, though, just to give you a sense for how far behind the curve policymakers are, policy is still actually “stimulative” when you think about a real rate. That’s why we’re not seeing the labor market cool off to levels that are bringing wages down.

Like I said, there’s imbalances, of course, there’s labor shortages, but the thing is unemployment is still very low, jobs are still being created. This is really underpinning that the environment is still too stimulative and needs more tightening from here in order to cool off those services-driven inflation

Mark: In your most recent annual commentary, the Fiera Tactical Asset Allocation Team, highlight a 50-55% likelihood of a steep recession. Is that what you’re looking at right now? With the labour market so high right now, we are likely not going to be starting to see a recession until [the labour market] starts to drop?

Candice: Yeah, so our base case is for a deep recession. As you see, all of our scenarios are really revolving around some sort of economic downturn. And now the magnitude really hinges on the inflation backdrop, and, of course, then the reaction function from central banks. So, our base case for that deep recession is really that inflation remains elevated. Maybe not at these levels, but like I said, not going back to that three, three and a half percent. Probably somewhere in the four, four and a half percent. Central bankers will not be comfortable going on pause at that time, so they’ll have to raise interest rates more and create that demand destruction. That’s the deep recession scenario. The shallow recession scenario, which is the next scenario at about 30% probability, is the consensus view essentially for the soft landing.

Mark: Have we had a precedent though, where we’ve come off such a nasty year — like last year — and it just continues for the next year? Because… most calendar year returns, you usually get a bit of recovery after a negative year. I think [we’d] have to go back to maybe ‘74 or ‘75 to see a double-year hit to stocks and bonds.

Candice: Yeah, it’s very rare. So regrettably, the outlook for us doesn’t really have history on its side, but like I said, we’re in unprecedented times. And, while it’s nice to see some green on the screen here early on in 2023, like I said earlier, we’re cautious, because we don’t think the worst is yet behind us. When you think about equity markets too, Mark, last year, the declines were also driven by high PE ratios (price to earnings), right?

Mark: Yes.

Candice: PE contraction, tighter financial conditions, higher interest rates, inflation, all of these things drive price-to-earnings multiples lower. What we haven’t yet seen is any sort of adjustment to the earning side to reflect this economic reality. Even if it is just a slowdown or a moderation, that hasn’t yet been baked into the market. So that’s where we do see a bit of a disconnect, and some potential vulnerability when it comes to equity markets specifically.

Mark: And that segues really nicely into my next question: from a tactical asset allocation perspective, your team is underweighting equities, right, going into 2023?

Candice: We are at our maximum underweight stocks. We were underweight all last year, so it’s difficult to get too confident when markets are down across the board like you said. But we were positioned for that. We were overweight cash last year, we were underweight bonds, underweight stocks, and we are positioned that way again, going into 2023, in anticipation of another down leg in the stock market.

Even bond markets, we do expect more downside there, just given our expectations for interest rates to move a lot higher than where they are today.

Mark: Well, let’s segue that into the natural follow-up to that is, if I am not going to get generally good returns in stocks and I’m looking at risk in investment grade bonds — I believe you got about a negative 8% return forecast for that — what do I buy?

Candice: Well, I mean, it goes without saying that cash is king these days. Every time the central bank lifts interest rates, it’s getting more attractive by the day and at a very low level of risk, obviously. So that’s a good place to park while we wait this out.

But also, the very unprecedented year in 2022, where, as you mentioned earlier, the positive correlation between stocks and bonds, both down double digit, [was] historic. This has really underscored the case for private markets and a well-diversified portfolio, particularly when in search of stability and yield, something that was very important last year. So, while private markets obviously deserve a place in a well-balanced portfolio in all macro environments, it’s really an environment like this where stocks and bonds are moving in the same direction lower, where they really validate their place in a well-diversified portfolio.

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