Hello and welcome to the Download. I'm your host, Dave Richardson, and this is a special holiday edition of the podcast with our good friend Sarah Riopelle. We don't get to see you enough, Sarah. Why?

Thank you for having me. You know, the markets keep me very busy and so I have to carve out time to come and talk to you.

That's right. You're only managing a couple hundred billion dollars of assets?

Something like that.

Something like that. And the markets have been surprisingly good or strong over the last couple of months, so that number keeps going up, which is a good thing. Do you have any plans for the holiday, Sarah, that are exciting?

I'm hosting, so the family is coming to me. Kids are home from school and so it's just about hunkering down and getting reacquainted with them.

Which is always exciting. I've got my girls home, so I'm happy about that. So you have everybody home?

Yeah, kids, parents, brother, they're all coming. That just means I have to cook for everybody, which I guess is my day job during the holidays, as opposed to markets, which I do right now.

But very important for people to notice, you will never stop tracking the markets. It's a 24/7 operation. Even when you're cooking, you never stop paying attention.

Yeah, I have the iPad on the kitchen counter beside me with the Bloomberg on so I can watch bond yields in the stock market while I'm making turkey.

I know. Obsessive to a fault. But it's a positive thing. Speaking of positive though, we had you on in October, and at that point in time we had just seen a really unbelievable march higher in bond yield. I think at that point in time we were around 5% on the US ten-year, which is a benchmark that we talk a lot about on the podcast here. But now we've seen it turn around. We're now sitting, I think, as we're taping this right now, at 3.88% on the same 10-year. So more than 100 basis points down. We've had a lot of people talk about it on different episodes of this over the last month, but what in your mind has caused the reversal in rates here and the abrupt shift in the bond market?

Yeah, that's right. In mid- to late October, when we talked, the US ten-year, as you mentioned, the one we follow the most, peaked at about 5.02%. Around that time, we started talking about how appealing bonds were and more appealing than they have been in quite some time. At the time, what was pushing yields higher? There are several factors. We had a few months of increases in inflation, and so investors were unsure as to whether the inflation pressures had truly been resolved. Central banks were still somewhat hawkish as a result of that, so they were signaling the potential for further rate increases might be necessary to continue to tackle inflation. And governments were issuing large amounts of bonds to fund deficits. And so that was causing a supply and demand imbalance in the market with more selling than buying, which was pushing yields higher. So we've absolutely seen a shift in recent weeks. As you said, yields are now significantly lower than they were. And what is causing that shift? Well, inflation has turned lower again. A big driver of that is oil prices, which have come down. And so it's increasing confidence that inflation is, in fact, on that downward trajectory towards that 2% target. The Fed and the bank of Canada over the last week have signaled that short-term interest rates have likely peaked and hinted that the next decision could in fact be a rate cut. So the debate has shifted to more of «when» that cut might be coming, as opposed to «if» that cut is coming. The Fed's updated projections are for three potential cuts in 2024, rather than their prior forecast of one. So they've increased that. The market's actually expecting six. And so there's a disconnect between what the market is thinking and what the Fed is saying, but they're both saying that cuts are expected in 2024. And all of this has happened at a time when bond yields are being especially attractive according to our valuation models. While yields have already moved quite a bit, our models still continue to suggest that sovereign bonds are appealing and that yields still could move lower over the year ahead, which will generate capital gains for bondholders.

So we had Dan Chornous on last week, and he's just written a paper that I think is a really important read. And if we haven't, we'll make sure it's attached to the podcast link so that people can go and find the paper and give it a more detailed read. But he talks about the amount of money that's sitting on the sidelines. And we're talking about dollars that are really intended to be long-term investment dollars that are part of people's retirement planning, long term financial planning. And then he highlights this opportunity in fixed income. In your view, what are the drivers of that positive view? And how do you make that come to life in the portfolios you manage?

At some point, as I said, central bankers are going to have achieved their goals in terms of tackling inflation, and rates are going to have to come down. So as central policy rates can't be maintained at these current levels if the economy enters a downturn or if inflation shows those signs of falling towards that 2% target. And so we really expect that rates are going to come down. And so people who are invested in cash are not going to be able to sustain those higher returns for an extended period of time. And so the data is increasingly pointing towards rate cuts in 2024, likely sooner rather than later. That's going to drive returns of those invested in short-term instruments lower, but it's going to ignite returns in other asset classes, like bonds and stocks. And so now is the time to consider moving those assets out of those cash investments and into something else in the market, like government bonds or even stocks. The problem with these short-term investments is that investors will eventually need to roll that into something else, because sitting in cash for too long is going to impair their ability to meet their long-term investment goals in those portfolios. So where can they put that cash? Well, bonds are often thought of as a good first step, a good replacement for short-term investments. And now, because we've eliminated that valuation excess in bonds that we saw before, and valuations are much more reasonable, they can now offer better income at better valuations, and they can offer that portfolio diversification much more so than they have in the last two decades because yields were so low. With yields surging over the past couple of years, the bulk of that adjustment that needed to restore that proper level of compensation for fixed income investors has largely been completed. And we think there's a really interesting opportunity in the bond market right now. And as I said earlier, despite that significant move that we've already seen in yields over the last six weeks or so, we do still believe that there's potential upside in bonds from here. And our analysis suggests that we could fall as low as 3% on a US ten-year bond yield, and that's going to lead to mid- to high-single digit returns for investors. In addition to that coupon income that they're already going to be receiving, they're also going to get the capital gains on those investments as well.

Again, for listeners who listen regularly, if you've missed anything over the last couple of weeks, I encourage you to go back and listen to all of our guests talking about this dynamic that's taking place in the market and the opportunity that it creates for you in terms of positioning your portfolio. Now, whenever we see something positive happening— and very clearly we saw inflation in the UK out today, lower than expected, Canadian inflation is starting to get down almost into that one to 3% range the bank of Canada likes— there's always risk, though, that this doesn't play out. How do you look at the primary risks that are out? As an investment manager, you're always looking for those risks. You always think about the potential returns there, but you're always thinking about the risk. What are the risks out there that this does not play out the way we think it might?

Well, it's always about balancing both the risks and the opportunities and trying to position the portfolios to take advantage of the opportunities while also mitigating the risks. What are some of the specific risks? So, obviously, potential for recession is probably top of mind, given the amount of monetary tightening that's being injected into the economy already. Our view is that there's a high chance that the economy could stumble into a recession in the first half of next year. In this scenario, stocks could be vulnerable as earnings could decline in a recessionary environment. But as an offset to that, sovereign bonds would likely do quite well in the inner recessionary environment, as central banks are likely to cut rates aggressively in the face of that, as we've already talked about. Geopolitical tensions are another one. Our work suggests that geopolitical flare-ups tend to have short lived impacts on markets, but that's as long as they don't have a follow-on impact on the economy. Military conflicts like the ones that we've seen in some regions around the world over the last two years, if they intensify and have an adverse impact on the economy, it could have more lasting consequences on markets. So it's something that we need to watch closely. We're coming into an election year in the US, a presidential election in November. First, primaries are going to be starting in January. And so there's some uncertainty around what that outcome could look like, and it could introduce volatility in markets during 2024. Obviously, inflation, that we've already talked about. Our base case is that inflation continues to moderate and comes down to that 2% target that the Fed has. But there is a risk that inflation could stay more stubborn, stay higher than expected, and central banks could find themselves resuming rate increases. It's not our base case scenario, but it is something we do need to consider considering where we've come from here. And then, as we've already talked about, that reinvestment rate of cash. Short term rates are currently offering attractive yields, but if central banks start cutting rates, the yields on cash and short-term money market instruments is going to decline as well. So people need to consider that. So that's all the risks. Let's take the flip side for a moment and think about what are the opportunities that are in front of us in the market. Well, if the economy manages a soft landing, as many expect that it could, it's possible that the Fed has delivered the perfect amount of tightening to bring inflation back down to target without causing unemployment to rise or without pushing the economy into recession. That would be what we define as a soft landing. And in that environment, bond yields could continue to come lower, and stocks could continue to do well. So it's one of those perfect scenarios in terms of investing, where both bonds and stocks are continuing to produce solid returns. In addition to that, outside the Magnificent Seven— those seven mega cap technology stocks in the US that are pushing the US market higher— you take those out of it and equity valuations are not unreasonable around the world. This includes areas like emerging markets, Europe, Canada and even in the US where small and mid-cap and value stocks are showing pretty attractive valuations. So if the economy does indeed avoid recession and begins to re-accelerate, then investors could turn to those segments of the market where there's good value and attractive entry points and get some strong total returns out of the stock market. So, yes, risks to watch, but also opportunities. So it's about balancing the two of those in our asset mix.

I wanted to ask you one other thing, though, before we move on to portfolio positioning. We're going to spend some time and get a lot of guests on it through January with a forward-looking outlook to 2024 and thoughts on how that plays out in various parts of the world, but I think one of the dominant media themes of 2024, as you highlighted, will be that US election. I'm out talking to investors, and when I worked as a financial planner at different points in the past, talking to investors who are putting together a financial and investment plan, about keeping emotions out of financial decisions. One of the main things that separates the everyday investor from the professional investor, such as yourself, is that ability to look at things objectively as opposed to letting their emotions get involved. But what I would anticipate we're going to see— and we're already seeing some of it—, coming out of the US, as you move towards that presidential election next year, how do you look at things and many other things that happen day after day through history? How do you separate your emotions from needing to be objective around that decision? It seems like it's an impossible task for someone to do.

You know what, it's about leaning on experience. So I've been doing this a long time. Anybody who's managing assets around here has been doing it a long time. It's about leaning on your experience, being data driven. So making sure that you are focused on making decisions on what the data is telling you, not on what market sentiment or volatility is telling you. And remember that focus on the medium to long term, not on the short term. And if you're focused on the short term, then think of it as an opportunity as opposed to a risk. That summarizes it. In the last election, or when Donald Trump— we're not supposed to mention his name here, probably— when he was elected as president two cycles ago, we woke up and found out that he had been elected and it was «oh, my goodness, what does this mean for us?» The stock market in the overnight hours did not perform well. It was very concerned about the impact of Donald Trump as president. And so the US market actually sold off very significantly in the overnight hours. By the time the market had actually opened for the day, it had opened flat. And by the time it ended that day, it was actually up on the day. So it went from what we call limit down— so a very significant down in the middle of the night— to actually ending the day up finally. And that's because it took that twelve-hour period for investors and the market to digest the implications of Donald Trump as president. Was this good for the economy or bad for the economy? Was this good for the markets or bad for the markets? So it's very important to not have a knee-jerk reaction to a headline or to a new piece of news. It's about taking a step back objectively and analyze what does this mean for our outlook? What does this mean for bonds? What does this mean for stocks? What does this mean for the economy? And make informed, data-driven decisions on the back of that, not knee-jerk gut reactions based on emotions.

Yeah. That example of 2016 was such an important one. I know I was out speaking a lot during that fall period, and Canadians were concerned about the implications of what happens if. The long-term implications are likely a lot smaller than you would think from an economic and market perspective, because the system of government in the US is based upon checks and balances and sort of blocks any major shifts one way or another. We've seen that through all kinds of different administrations through my lifetime. Sure enough, you had that knee-jerk reaction down, but then again, things settled up. So if you'd had that emotional reaction, you would have lost. And we can point to 100 different examples of that through history where there's that knee-jerk reaction. Again, this is one of the things we try to stress through this podcast as people listen to avoid those emotional decisions, be objective, take a step back before you make that call, and make the decision then, and look to take advantage of times when other people fail to do that. And that's, I think, one of the hallmarks of what you do. We have Stu Kedwell on all the time. That's a big thing that I know he does in his investment management practice.

Yeah, we've done a lot of work on events over time, and whether you define the event as a market event, an event of military conflict, a presidential decision, something like 9/11, which was an unexpected and very unfortunate event. And we've analyzed all of these things over time. We probably have 30 or 40 of them that we've looked at. And the overarching theme is that they do have an impact on markets over the very short term, but over the coming days or even week or so— it's not a very long period of time—, they tend to play out, and the market goes back to where it was before the event and continues to move on based on the fundamentals in the market. So yes, there can be knee-jerk reaction impact, but it's usually not a lasting impact on markets because these are isolated events that, as long as they don't bleed through to the economies, generally don't have a lasting impact on markets. And so we're anchored with that information to know that when a new event does happen, we have that in the back of our minds that we say, okay, well, this is probably not going to be a lasting event in markets. So if the market does sell off on the back of it, then we would look at it as an opportunity to add to positions as opposed to being concerned and exiting positions.

And of course, there's events that create short-term positive bounces in the market that you don't want to get over-exuberant about. And this may be what we're seeing, the reaction to the Fed and their change of position. Some have suggested that this is one where things have gotten a little bit too heated. I guess we're going to see as we move into 2024. But that was a really interesting commentary about how you react to that, because I know how well read you are and how closely you follow pretty much everything because it ultimately does come into your view of markets, but keeping the emotion out. So let's get back on track in terms of the positioning of portfolios right now. Where are you positioned? Why don't we start with where you're positioned and then we can talk about where we maybe go after that.

Sure. Well, the positioning is probably just as a summary of what we've talked about so far in terms of how are we incorporating all of these views within the portfolios themselves. So as you can probably tell, there's significant uncertainty in this particular point in the economic cycle. While there's potential for a soft landing for the economy, our base case is one where the economy falls into recession over the next several quarters. So we factored that into our positioning. Because against that backdrop, we believe that central banks are likely to cut policy rates at some point over the next six months or so. And so we believe that that risk reward for sovereign bonds is appealing at today's higher yield levels because there's potential for them to fall further from here. And especially since they offer a safe haven status. So fixed-income assets can provide a balanced against a downturn in equities in a recessionary environment. And with that diminished risk of significant losses, because that valuation concern has been eliminated, we think there's better potential in the bond market than there has been in quite some time. So we continue to expect stocks to outperform bonds over the long term. This is where time horizon comes into play. In the near term, we think the upside for equities is more limited. And so given we're balancing the risks and opportunities, we actually have a slight preference for bonds in our asset mix relative to stocks. So we're currently a little bit overweight bonds which we funded from cash, and we are neutral equities within the asset mix. How do you summarize that in one sentence? I think the bottom line would be that we believe the environment right now looks good for bonds over the next three to four months. It's a little bit more balanced with a slight tilt to negative for stocks. And that's how we position the asset mix to reflect that view.

Sarah, I think we anticipate at some point. So rates start to come down; that's reflective of a weakening economy, still the potential that we have a soft landing instead of a recession, but more likely a recession than not, which could create some volatility in equities. At the point in time where you think equities become more attractive, how quickly can you change courses and move from that overweight fixed income into a significant overweight in equity? I would think at the point when that shift comes in markets, it's clear you're going to want to move to a fairly significant overweight position in equity. Is that something you can execute fairly quickly, and is it something that you traditionally do? Or do you do it in a more segmented approach?

As I said, we still believe that stocks will outperform bonds over the long term, and so we will be looking for opportunities to build up those equity positions as they present themselves. We don't have that much cash in the portfolio. So we're underweight cash in our asset mix, and so we would have to be selling bonds to build those equity positions back up. Luckily, we have a lot of levers at our disposal in our ability to change the asset mix quite quickly. We can buy and sell the underlying funds. We can use derivatives and other futures and ETFs in order to build up those positions. So we can very actively manage the portfolios and quickly get those positions to where we want them to be. The one thing I would say, though, is that traditionally we don't do— what's that saying?— put all our eggs in one basket. We won't go from 60% equity weight to a 65% equity weight in one trade. We do like to gradually build those positions up as we see opportunities in the market. I think when Stu Kedwell comes on here, he talks about dollar cost averaging a lot. So that concept's not lost on us when we're managing the portfolios either. And so we like to build up those positions over time as we see opportunity in the markets, as opposed to taking big giant leaps all at once. Dan Chornous, who's our chief investment officer, talks about many small things, not one big thing. We think about that with asset mix, too. Many small trades, not one big trade.

Yeah. Whether you're managing thousands, millions or billions, tens of billions, 200 billions, that incremental approach makes sense. And again, anyone who listens to this podcast knows that very clearly. Now a really important question for you as an asset manager and host: turkey, roast beef, ham, or is it a diversified approach when you have people over for dinner in the holiday?

Well, interesting. Our Christmas Eve tradition is cheese fondue. And our Christmas day tradition is turkey.

The cheese fondue would be like a small cap emerging market equity fund mixed into the portfolio?

Yeah, that's probably about right. And then the turkey is probably, what? the bond fund?

Kind of a bond fund. As steady as she goes. So, Sarah, thanks for being our last guest of the year. As I mentioned, we're going to spend a lot of time in January looking forward. We had Stu on just the other day. He took a look back at 2023. We've got Sarah giving you a view of where we are right now and what we're thinking right now and the positioning of portfolios right now. And we’ll get guests on in the new year and we'll be looking forward. So, Sarah, thank you. Happy holidays to you and your family. And happy holidays to all our beloved listeners. Keep listening and keep subscribing. Keep giving us those five-star reviews. You can't see my motion. I'm clicking. I'm doing a clicking motion. Like that's like something you would do. And Sarah, thank you for joining us so many times this year.

My pleasure. Thanks for having me.