Hello and welcome to The Download. I'm your host, Dave Richardson. Boy, this is an exciting day for me. We don't get her enough; one of my favorite people, I've worked with her for a long time. She's just the absolute best, Dagmara Fijalkowski, who is the senior vice President, portfolio manager, fixed income, currency, kind of everything. Dagmara, great to have you. Great to see you. How are you doing?

Excellent. Most excellent, as one of my colleagues says.

Most excellent. Well, that's fantastic. As I often say, I know something from an investment perspective has crept out into the general news when my mom calls me and before she asks how the kids are doing, she asks me about it. Like when my mom called me the other day and said: what about inflation? Clearly, inflation is on people's minds. And so, we've seen, last week, the US reported CPI at a level we haven't seen since the 1980s. Yields across the curve have moved from zero in the middle of 2021 to rate in around 2% on the ten-year in both Canada and the US. We've got the central banks in most developed economies around the world starting to look at tightening; the Federal Reserve, all kinds of thoughts swirling around about how often they may raise rates. Could you assess where you think we are in terms of inflation? And where are we in central bank policy and how does that impact what you're doing, and looking at all of the fixed-income portfolios that you oversee?

Right. Pulling out my crystal ball. Well, I'm not surprised about your mother's question because inflation is at the top of investors mind; it’s at the top of central bankers mind, and perhaps more importantly, at the top of politicians minds. 7.5% was the last release, as you said, last week in the US, the highest it's been since the 80s. In Canada, it appears to be slightly more contained; it's at 4.8%. You have to go back to 2003 to see similar readings. 2003 is the year my daughter was born; it's a long time. She's in the first year of university. Inflation has been rising steadily since mid 2020, right after that bottom during the post-Covid fear. And it has been rising on account of both supply and demand. Let's think about demand back to that time. Consumers were confined to work, to study and to spend their vacations at home. They embarked on a whole range of home improvements, including buying four years’ worth of technology in one year. They had means for it, too, because unlike in normal recessions, even if they were not working, their incomes were replaced by generous government benefits, so they could afford these purchases. Now, on to supply. Early on, some suppliers limited their production. I remember stories about companies canceling their chip orders, expecting lower demand, like in a regular downturn. Of course, when they realized that demand is actually growing, they were to catch up, they had to catch up. Their production was hindered by limitations related to closed factories, reduced shifts, due to social distancing, and quarantine labor. So, our analysis, also that of the Fed— we are aligned in that area—, suggest that many of these inflation drivers that kicked in post pandemic will be waning this year, in 2022. Some as soon as in early April, because of the base effect from the price increases last year. Others in line with unclogging of the supply chain channels which are now delivering late Christmas presents. Yet others, with the decline in Covid infections and opening of the economies. And as the economy is open, the consumption should shift from goods to services, lessening pressure on prices of goods. Let's think about the example of energy, because it's a big component of inflation readings. Oil prices increased 50%, year over year, in that latest reading. They would have to increase another 50% for the inflation effect to be the same in the coming year when it comes to sourced from oil prices. Even Russia's invasion of Ukraine scenarios don't forecast $130 oil. That's definitely a tail risk. But because of this potential risk being so well telegraphed, I've seen forecasts that actually may lead to $5 to $7 increase in price per barrel. So oil prices are unlikely to add as much upward pressure to inflation as they did in 2021. Many other components are also expected to decline as supply bottlenecks ease. The two main inflation components that are not expected to decline are rents— it's called OER, owner equivalent rent component, which is slow moving, based on house prices, so it's very likely that very little would come from there— and potentially wages. So let's focus now on wages. With regards to wages, they may not decline, but I'm not sure that they will be rising more. Let's look at Atlanta Fed data— that's a very helpful website, you can just google «Atlanta Fed wages» and it takes you right there. They track wages for employees with so called low skills, medium skills and high skills. And they show that wages for employees with low skills caught up, during the pandemic, with wage growth for employees with medium to high skills. That's a good thing. That's good news, because you have to look at it in the context of federal minimum wage in the US at $7.25, that has not increased since 2009. Now, twenty-nine States have higher minimum wage than federal; the highest is in California at $14 an hour. I'm not sure, but I think that even if wages during pandemic went up from $10 to $15— a 50% increase—, because of labor shortages covered reluctance to go to work, etc., I don't think we should be expecting that the same people will get another 50% increase in the next twelve months, because that would imply now they have to go from $15 to $22.5. And if they stay at $15, they have no impact on inflation. So they don't have to decline; they just have to stop rising at that pace. The Fed is expected to be aggressively hiking rates in the first half of the year. Aggressively, because they are under significant pressure from the politicians. We started from talking about your mother and also politicians having inflation on their mind, so that aggressive pricing is 100-basis points of hikes before the end of June. That means that if that's achieved more than one hike per meeting, the market is already assuming 50-basis point height within the next three meetings. Looking at growth expectations, though, you can see that purchasing managers indices, which are good predictors of short-term growth, they had picked last year and they have been on the downturn since then. So, growth is slowing. And now let's imagine ourselves sitting here not in February, but towards the second half of the year. Let's say, it's nice and warm outside. We are heading into the second half of the year. The Fed is now seeing peak inflation in a rear-view mirror, and growth slowing down because not only it had been slowing down, but also they put brakes hard on by hiking 100-basis points before the end of June. And they started reducing the size of the balance sheet, which affects the bond yields on the far end of the curveball. So, it's very likely that the pressure now will stop focusing on inflation and start worrying about slowing growth, also because the US is then going into midterm elections. So it's a fascinating puzzle because it has many pieces which I think are being printed while we are already starting to put the corners on our table. So we don't have all the pieces yet. My point is that what is happening now has largely been priced into the market, between early November last year, when October inflation numbers was released— and in late November, during which the Fed started being very uncomfortable with the word transitory, because they didn't see the drop in inflation. By late November, they started getting information about Omicron variant, and that accelerated, amplified that fear, because that meant that the supply chains, which they expected to be unclogging, will be stuck a bit longer. In early January, the Fed released its minutes from mid-December meeting and we've learned that now they are seriously worried about inflation and that not only they are thinking about raising rates but also reducing the balance sheet as soon as after the first hike. So that's a completely different game plan. The information that we were given in the course of the last eight weeks has changed the odds and pricing in the market and everybody is catching up.

Dagmara, I think now everyone understands why I heap so much praise on you at the front of the broadcast here, because that is just a fantastic explanation of everything that's been happening and the cause and effect of Covid and how politics rolls into this. And just the plain math, because the mathematics on this— and that was such a great explanation in terms of the minimum wage has gone up to $14, that's a 50% increase, you've got to get up to $21, and that's just not going to happen. So the math is going to work against high inflation alone. Not to mention that we've already seen longer-term rates increase for all the reasons you articulated. And the Fed is going to be catching up at the short end a little bit and quite aggressively at the front end. So that leaves us, particularly conservative investors retiring, and investors who are in retirement, to generate income off fixed income. And you’re probably in the hardest spot because you have to manage billions of dollars of fixed-income portfolios under this scenario. How do you do it? How do you manage fixed income through a period like this? That's just so different from what we've experienced for at least twenty, arguably forty years.

You put your finger at the heart of the matter; what the market has done already, all that I said and this change of information and adjustments in the market, all that really translates into the conclusion that the era of easy monetary policy is over. It’s ending as we speak. But let's just highlight that that’s before the Fed hiked even once. While they are still buying securities every month, they are still easing in the bond market, the market has priced significant tightening. A lot of monetary conditions tightened and interest rates have moved a lot. Between end of November and now, the ten-year bond deal in US moved up by 60-basis points, and two years, by more than 100-basis points. So, the front end, where the Fed has most influence, moved twice as much as the back end; two at least, twice as much as the back end. The fixed income market by this time next year is already pricing Fed funds rates to be at 1.75%. That's six to seven hikes already baked in the cake. And as I said earlier, the hikes are front loaded by June; we're talking about four. So, one 50-basis point hike is already assumed in the market, which is the worst-case scenario really. Moves in ten-year bonds and two-year notes last week, on Thursday, after the CPI release, and on Friday, after Bullard's comment— James Bullard is the President of one of the Fed banks, regional banks, and he commented that he's in favor of strong hikes—, 50-basis points is quite possible. So, very hawkish, end of the Fed spectrum. These comments combined with the CPI was a double whammy for the market. On one day, the change on yields on two-year notes and ten-year bonds were in the top 1% of daily moves that we had observed in the past thirty years. These are signs of market panic. Again, the Fed hasn't done anything yet, hasn't changed rates once. So what we learned over the years is when in doubt, follow the curve. It's like the yellow brick road. Follow the curve. The two stands curve flattened 40-basis point since the beginning of the year. It's flattened 60 since the end of November. So really, we're talking for December and January— the two months where most of this happened— 60-basis points. The two stands, this kind of beacon of the path going forward, it's already at a 44-basis points difference. So you get premium of 44-basis points for ten’s versus two’s, which was over 100-basis points in November. That 44 is as little as it typically is when the Fed is at least halfway through the hiking cycle. Again, they haven't done anything yet. In the meantime, the longer-term inflation expectations have come. So when we talk about inflation expectations in the market, we look at so-called break-evens on inflation linked bonds. Sometimes we refer to them as Tips, treasury infection protection securities. And those break-even speak last year in November were at 2.8%, and now they are at 2.5%. Lower on 30 years; they picked last year at 2.5%, now they are at 2.2%. That's the number that we should be comparing to that 7.5% inflation reading right now. So that bound market is not worried by pricing the 30-year inflation of 2.2%, the ten-year inflation of 2.5%. The more esoteric measure even, which digs deep into the structure of the inflation protection in the market— it's called five-year forward—, and that's at 2% down, for 2.4% peak last year. So the Fed hasn't tightened yet, but the market has executed a very real tightening. Real yields have increased by 60-basis points. And as I mentioned, PMIs are suggesting that growth will be coming down. If the Fed executes all these hikes that are priced in the market, I would worry about growth, not inflation. That's what the market is telling us. That's what the curve is telling us. That's what those break-even inflation points are telling us. My hope is that they will not have to worry about growth, that the inflation will decline just enough to not tip for the measures to bring inflation down, to not tip the growth into a recession. But that risk is growing every day over the past week or so, because the market is fearful that in the fight of inflation, we're going to kill economy.

But you ultimately think that they are going to be able to strike the balance?

That's our base case.

That's your base case. Just like I know with my kids. I've got two teenagers. We talk about them on the podcast from time to time. My wife and I will both do things to very clearly message out in advance, and the behavior will be altered just by the messaging before you even have to come in with the punishment, so to speak. And believe me, we're not that hard Dagmara, you know that we're pretty easy going with the kids. Punishment is pretty light in our world. But nevertheless, just to make the analogy stick, we'll say that the Fed has done so much just with their voice and just out in the market, and then they'll ultimately have to do some tightening. But they can be very careful.

They'll deliver it. If they don't deliver, the market will quickly actually bring yields down. So the market believes them, takes them at their word.

Which is important in parenting, too. You've got to follow through. «We're going to take your phone away; if you don't do that, you have to take the phone away for a day». But in the end, the Fed may not have to do anywhere near as much tightening as what the market is thinking right now, right?

Yes, that's the point about the market, pricing extremely aggressive scenario. The Fed is telling them three, right now. The market is pricing six to seven. But the Fed is telling the market, wait a minute, we don't know everything. We have to wait to see how things evolve. So that's why I was saying, okay, let's imagine that they sit here in July and look back, and inflation is no longer a problem, growth is slowing down. There is no reason to bring seven. But we want to know that for sure. That's our kind of base-case assumption. The market is making the worst-case assumption right now.

Sure. I think one of the biggest questions, and it comes back to investors who again look a lot like my mom; they're in retirement or they're very conservative investors, they have more than half of their portfolio in fixed income typically. So how can you, as an investment manager, in this environment, protect those investors? Or is it going to be a little bit of a rough ride for another little bit, and then ultimately, they'll benefit from where we come out with higher rates? How do you see this balance out for that type of conservative investor?

I think a lot of the rough ride has actually happened. Because as we talk, the market has already priced the worst case, a big chunk of it. It's volatile, but that volatility doesn't apply only to fixed income. The fixed income, especially ten-year yield, are the cornerstone of pricing for many other asset classes. This type of inflection point in the cycle, when the monetary policy switches from easing to tightening, is going to bring definite volatility into the market. Can we protect investors entirely? Not so, but we can mitigate. We can never assure that you will never have a loss, but we can mitigate impact to a large extent through various measures. And part of it is very much long term. So we're looking at what makes sense from the long term perspective for these fixed-income portfolios. That doesn't mean that there won't be short-term pain. We have lived through the short-term pain quite a bit, but we are going to use the markets opportunities to set up for better returns down the road. Actually, rising interest rates for fixed-income investors is a positive thing because you get to invest at higher yield, unless you sell it at the top, and you are not going to be able to harvest those higher yields. So we set portfolios to prepare for different scenarios and risks. Again, we don't have a crystal ball. That's what we think is the base case, the tail scenario, and our portfolios are set to perform better or in an acceptable way given the scenarios that we assume forecast going forward. Diversification into global bonds is always the core for our portfolios. Diversification into credit. We don't just take the sovereign risk, we get compensated a little bit more. It can improve performance under a variety of scenarios. Our inclusion of asset classes that are fixed-income compatible but less correlated with core fixed income, like emerging market foreign currencies, which we include in some of our portfolios. For example, in January, when Canadian Bond Universe was down 3.4%— a painful month for bond investors—, EMFX as an asset class was up 1%. And we do utilize this asset class in our fixed-income funds and pools. Shorter duration, of course, helps. So hedging bonds by selling futures is another strategy that we can implement if we believe that interest rates are going up. Tilting towards markets where rates are not expected to go up as much as in the US or in Canada. There's another strategy. For example, we believe that Chinese government bonds are not going to go up in yields as much as in US and Canada. We had an overweight in that market on a currency cash basis. So, no currency risk, just sovereign risk. That was helpful. There are also, as I mentioned before, specific bonds that are targeted at interest rate increases due to inflation expectations rising. They mitigate the downside risk in rising-rate environment, assuming that rising-rate environment is driven by inflation expectations and not by growth or real rate rising up. Actually, a good example was in January this year when inflation expectations were coming down— as I mentioned, they peaked last year— and real rates were going up. So nominal yields on the bonds were going up and the inflation protection bonds delivered twice as bad return as Canadian Bond Universe. Minus 7% for the month versus minus 3.5%. Because it wasn't about inflation, it was about the real rates rising in January.

So Dagmara, with all that said— and it's a lot—, how do investors approach their fixed income investments now and in the medium term, in your opinion?

That's a great question. I think investors need to think about their long-term asset mix in the context of lower-return expectations from all asset classes. Remember that ten-year yield is a core building block for pricing in capital markets. With long term fair value of ten-year yields between 1.5% and 3.5%, which had been, in our view, biased lower to the lower half of the range post pandemic, we are nearing the level of yields between 2% and 2.5%, where I would be very wary of reducing fixed-income allocations further. If anything, our bias is to reduce our shorts in fixed income in our balanced portfolios. Rising yields mean that future expected returns for bonds are more attractive. By selling after the yields increased, investors would have experienced the pain of rising yields without harvesting the benefits. Eric Lascelles, our economist, tracks multiple measures of economic cycle to get an estimate of a combination. And according to his latest work, we are most likely near the middle of this economic cycle. But Eric cautions that this cycle is moving along at an accelerated speed and may be shorter than a typical cycle. The central banks globally are removing liquidity using measures and sequences and tools that they have not tried before. This is an unprecedented situation. Importantly, central banks are tightening into a slowing growth; not typical. So it's a very real concern of ours that this cycle will be shortened as a result of Fed's aggressive focus on inflation to the detriment of growth. We all are hoping for a soft-landing outcome. Perhaps it's even our baseline scenario, bringing inflation down without choking growth and damaging market sentiment. But if that scenario fails, the risk is bigger that 2023 will be a year of recession. The left-tail scenario has been increasing in odds every day for the past couple of weeks, and the path of yield curve flattening driven by belatedly aggressive Fed is warning us about it, and that's before we even consider the geopolitics and the potential for risk from that. So as I mentioned, we think that a lot of the bad news for fixed income is pricing. And given that, and given the valuation of bonds in a post-pandemic scenario and the risk of slower growth, we are reducing our underweight in fixed income, but certainly not selling it.

Which again, is counter to what a lot of people are thinking. But they've got to get into that mindset, as you've explained so clearly; it’s been painful, but a lot of the worst is behind. And if we are going to be moving towards the latter stages of the cycle, that's when you'd be adding the fixed income. It feels like you should be doing one thing, because you're hearing the inflation report, but in fact, you're reacting to something that's already happened. You need to think or look forward, you need to be positioned in your fixed income for the next five years, not the last five months. And that way you'll get to the right allocation and that actually suggests holding onto your fixed income.

By the time you get that call from your mother, it's very much an assumption that many other people heard about it and positioned for it.

Yes, my mother is guaranteed to be a little behind the crowd and typically to call at exactly the wrong time. She normally calls in the middle of taping one of these podcasts and interrupts it. She's just like most mothers, she's got that timing. But this call always comes with love, though, Dagmara, and as always, we love hearing from you. We can never get enough of your appearances here. Thank you so much for your time. I know how busy you are right now. Again, just a fantastic summary of everything that's been going, on how to think about fixed income, because that’s on so many investors mind, so thanks for your time today.

You’re most welcome.