Hello and welcome to the Download. I'm your host, Dave Richardson, and it is a very special Download today because my good friend, chief investment officer of RBC Global Asset Management, Dan Chornous, is joining us this morning. He's a super busy guy, so we don't get him often, but when he has something really important to share, we love to get him on. Dan, welcome to the Download this morning.

Thanks for having me, Dave.

So, Dan, we had you on very early in the series when basically nobody was listening to the podcast. Now that we've got this massive audience, it’s important to get you back. And as a background, you've been in the business for three or four years, is that it? Or do you have a little bit more experience than that?

A little bit more than ten times that, actually. But thanks for that.

You still look very young. They can't see that. But it's 40 years of investment management experience.

The way markets are acting in the last few days makes us all feel young, It's just a great time out there.

Well, yeah, so hopefully we'll get to that. But what we're going to focus on specifically, at least to start the conversation, is you've written a paper, a really important thought piece. And again, I've known you or worked with you for over 20 years now, and although I think always long-term bullish on the market— as I think we all should be— you very rarely stick your neck out and say: I think this is an opportunity that everyone should really look for. I can remember a couple of times over the 20 years when you've gotten super excited about a particular area of the market and the paper that you've written is around the bond market or fixed income in general. And sure enough, since you've written the paper— I wish we'd had you on about three weeks ago, we would have looked really brilliant at this point— but talking about how exciting the bond market is right now, why do you think it's such a good time to look at the bond market? Obviously, the last month has told that story, but there's still more to come. And why do you think the bonds are so attractive right now?

Well, there's really been a tremendous alignment of factors that have pushed the bond market forward and almost a rare nesting of it. You usually get a few things indicating one way and a few things the other way, and then somewhere in that mosaic, you come up with an opinion. Rarely, as you said, but sometimes in the arc of history, you look at these things and say, this is all moving in one direction. And you've come through a period, too, where you can get lulled to sleep by looking at the economy. Fed tightens. Economy is supposed to slow. It kind of slows, but not enough. So there's more tightening ahead. It's sort of like the story all over, it's Groundhog Day, so you need metrics or charts or algorithms or something to kick you in the head and say, hey, things just changed. You got to wake up and move. And that happened about a month ago. So what changed? Well, inflation, which has been the target of this period of tightening throughout the world, has clearly come down from its lows, and there's now increasing confirmation that it's on a solid track towards optimal levels of around 2%. It's not going to get there over the next few weeks. It's probably going to take a year to 18 months to actually anchor it at 2%. But the work has been done on inflation, and that sets up the next cycle then for interest rates, stock market and the economy.

So, Dan, we saw yesterday the Federal Reserve out with their decision on rates for December, along with— not to you, but I think to some market participants— a bit of a surprise around the extent to which they've suggested that they're going to be lowering rates next year. This is all part of this alignment of forces where they're saying, yeah, we've got a lot of the work done on inflation. They're never going to admit until inflation, as you say, gets anchored, which might be 12 to 18 months from now, as you say. They're not going to admit that the fight's over. They've got to make sure that everyone keeps thinking they're vigilant and they're watching and they're not going to let this repeat of the 1970s happen. And we've talked with several of your colleagues about the 1970s and what happened back there. But yesterday was kind of a confirmation of what you wrote in the paper, was it not?

Well, I think what happened yesterday was very much that the dovishness of Jerome Powell in particular took the market by surprise. Now, the market might be out over its skis here, but directionally, I think it's hard to disagree with either Powell or the message from the bond market, in particular, because he said: so far so good. He's not going to spike the ball. That would be crazy to spike the ball, because he needs to make sure that we maintain this track. But you mentioned that we weren't surprised— and thank you for that—, but what we did do was build roadmaps for what happens when the Fed tightens. And it was remarkable. This is one of those things that tipped us that we're nearing the end of something, not only partway through, and we need to be ever vigilant watching for signs from markets in the economy. So that roadmap showed that once the Fed starts tightening, we all worry about recession, but it takes a long time for that tightening to feed through to the economy in full force, about 21 or 22 months. And that's kind of where we are right now, actually, because it was the spring of 2022 when the Fed started tightening. At that time, 80% of forecasters were looking for a recession, got bored waiting for it, and started forecasting a soft landing, which might actually be correct now. But you pile on not only rate hikes, but massive decline in the rate of growth of the money supply, the reversal of quantitative easing, essentially quantitative tightening, and what you have is a huge amount of weight now holding the economy back. It's going to move it towards much lower rates of growth in early 2024. So we can talk about that. But the most important thing is that the target of all that tightening wasn't to put the economy into recession, really. It was to slow inflation. And that's now been delivered. We were at a 9% inflation rate a year ago. We're now at 3% and falling. So it's been remarkable. And the other thing, as we move through this period of tightening— you used the word anchoring a moment ago—, it's really critical that inflation expectations among forecasters and investors are actually still anchored towards that 2 or 2.25% level, so that the Fed can look at this thing and say, it’s looking like mission accomplished here. And so, the need for additional levels of tightening isn't there. And then we go back to that roadmap and say, okay, what's the next step if they're through tightening? Well, actually, typically they're through tightening about eight months before a recession takes hold. Since they stopped in July, if recession was to take hold, it's probably going to happen in the first quarter of next year. So that part of the roadmap is just that: you expect the economy to slow, maybe not pass through recession, but slow in any event, and four months before that critical date, they actually start cutting. Now, none of us thought cutting was going to happen until mid 2024. And we're generally stepping around one or two cuts. Because of this statement yesterday, the market has gone from expecting three cuts in 2024 to six cuts. So very substantial easing is now built into prices. Now, that might be aggressive, and as I say, the market might be over its skis. And that happens. And there'll be a setback before we move forward again, if that's the case. But you can see a remarkable change. But it actually sets up pretty well. Now, the other thing we know about this roadmap is that when the Fed starts cutting— which is again four months before the maximum pain for the economy—, yields tend to peak. And they peak not only at the same time, but at the same level as short-term interest rates. A month ago, we got to 5.02% on a ten-year bond in the United States. Pretty close to 5.25, 5.5%, for the short rate. So that set up as well. We were confident that inflation was on track. The roadmap said: this is where things start to transition. We got more and more signals from the economy and markets that it was happening. Dave, you and I have talked also about the amount of cash that stacked up on the sidelines. This is what fuels rallies like yesterday. There's $6 trillion of cash in American investors hands. I believe that you and your team pasted together some numbers and it looks like there could be like a trillion or something in Canada. Something like a third to a half of that shouldn't be held in cash through the cycle. It's an unnatural position for it because it's only going to earn 1 or 2 or 3% or something like that, and it doesn't really help portfolios achieve their long-term goals. That cash stacks up when people feel it's really murky out there. They don't know what's going to happen. They're afraid of the economy. They're afraid of markets. So quickly, or gradually, that money has got to come back into the market. And that's what fuels things like yesterday's explosive rallies.

And that's why this paper provided so much clarity around the thinking of that move you need to think about making. Everyone has to make sure you get the right advice, make sure you talk to a good advisor, make sure you're doing something that aligns with your long-term objectives. But there are those times when everything aligns, and you've got to take that serious look at where you're going to position yourself for the next phase of the cycle. You mentioned that the ten-year rates in the US got just kissed up over 5%. Overnight, they fell below 4%. That's how big this move has been. You've talked about those expectations— three cuts next year, up to six now, the market is forecasting. So the positive has obviously been built in. Huge rally in stocks, and obviously that's created just the interest rate movement. Great rally in bonds, too. But we talk about that recession. Does the flip side of this say, hey, just wait a second here. Maybe all of this weakness that might require three or six cuts in rates says that maybe the economy is a little bit weaker than we actually thought it was and this recession that we've been waiting for might actually happen. Does that worry you at all, that things might be even weaker than the market's expecting? I know you and Eric have been pretty much on track that this likely ends in a recession. Not a severe recession, but a recession. Any trouble signs out of what was said yesterday?

I think yesterday was entirely positive for the economy. It's really quite remarkable how dovish the messaging has been. They didn't even try to tone expectations. They didn't quite say the rally is on, but it felt like that. But let's talk about the economy. First of all, the economy now, whether it goes into recession or not, is kind of unimportant to the bond market. It remains important to the stock market. The bond market is focused on inflation. Of course, a weaker economy will deliver less inflation, but we all figure it's going to 2% anyway, so we kind of ticked that box. The stock market, though, is dependent on how weak the economy becomes. And that's where soft landing versus hard landing is worth discussing. I'll talk more about valuations in the bond market, if you like, in a minute, but valuations in the stock market are actually quite attractive right now. In particular, if you take out the Mag Seven, you can see that even in the United States, that the markets, by going sideways to just a bit up over the last 18 months, but while the economy continued to grow earnings, have removed the valuation excesses that happened in the post pandemic rally. So that part, that half of the equation, is well looked after and in fact, in some cases, more attractive now it's been in ten or 15 years. But the problem is, to keep the rally going, you need to pump in earnings. And if the economy falls into recession, even if it's a mild recession, earnings are going to be flat to down, because margins are still a bit high. You lose pricing power in a weaker economy and you're probably going to go through a down period in earnings. Now, that's what usually happens. But even looking at that roadmap just to size that, in a normal recession, it's eight months from the beginning of the recession to the end of the stock market bear market, which means that by the summer of next year, this is all going to be behind anyway. And if we actually don't pass through a recession, you get nominal GDP positive— call it 2% or 2.5% inflation, and even 1% growth, which is pretty close to what the Fed's targeting—, you're talking about 3 to 4% nominal growth. You can have earnings growth. It won't be a lot, but at that point you're looking forward to a firming economy in 2025. So the stock market starts to look a little more interesting, we thought, as well. So the setup in both markets, I think, is markedly different than it had been leading into.

Dan, let's get back to bonds and your paper. One of the things that I've been talking throughout the fall and sharing with investors is this idea that you need to realize that as rates have popped up— so you get up to 5% on a ten-year and even higher on two-year bonds and treasuries—, the bond market starts to look a lot different, because now I actually get paid to hold a bond. It's not like in 2020 at the bottom when I'm getting paid virtually zero to hold a bond. So I'm getting paid to hold a bond. And then when rates turn and start to go down— and we've seen that happen now, and that's the expectation—, you can get some pretty unbelievable returns out of the bond market. So you gave some examples of that in the paper, and I've heard you talk about it, maybe tell the listeners just how powerful that move can be with a 1% move. And hey, we've had the 1% move already. But we think rates are still going to go down more. So how powerful can the returns be in the bond market when you see a move like this?

Well, it's a bit of a coil spring when you move in an opposite direction. So let's set that up first. We came through one of the most devastating bear markets in bonds, maybe the worst one we've ever seen. And why did that happen? Because we were at 150-year lows in interest rates, and they were at non sustainable levels. Those of you that build or have portfolios, recognize that a bond yielding at 1.5% isn't much use to you, for all the reasons we just said. It doesn't give you a coupon, it doesn't give you cash flow, it doesn't give you negative correlations to equity prices, because it's got long duration at that point. So it's just useless in the portfolio setting. So what happens? Real interest rates are negative. So the after-inflation rate of interest that you're receiving was negative. That's not sustainable. Why would you defer consumption into the future and earn a negative payment for doing that? Just consume today. So that's not sustainable. It only happens in a crisis condition. So when real rates started to move up towards the zero to 1% level that we expect, it triggered, as I said, the worst bear market that we've ever seen. And actually, big negative returns in the bond market. Why? Because there was no coupon to offset those losses, where there usually is a coupon that dampens the total return loss during a bear market. And of course, as the Fed was pushing up short term interest rates, it almost mechanically pushes up long bonds. You see that piling on, going on as well. But our model showed that you came from acute valuation risk through the neutral zone, to the point where valuations of the bond market were more attractive. For the first time, you had an undervalued bond market in over a decade. So that's the positioning, when you got above 4.5, 4.75, and then you got to 5%. So then you get to 5%, it starts to get people talking about higher for longer. Maybe 6%. But it dawns the realization that, hey, the battle might be won here. So you set up the next cycle from a very attractive valuation zone where you've got a massive amount of bearishness, and there's other technical things at work that push the yield much lower. Now, we thought that in a perfect storm, you could earn double digit returns in the bond market. And Dave, you were out there early, actually. Congratulations, because you were talking about some of the funds that would position you well for that. It seems unbelievable, as the world is looking for 6% interest rates suddenly, that it’s time to wait into the bond market. But some of that pressure has now been released. Just this morning, before the call, we worked on this. First of all, where are valuations? They're reasonable. That's not a problem. And as inflation continues to decline towards that 2%, they'll remain reasonable for some time. If you move to 4%, which was the high end of our targeted range from here, you'll still earn 3% on a ten-year bond, because you lose a little bit of your coupon as the price goes down. But if you move to 3.5%— and I don't think that's unrealistic even in a soft-landing environment— you're talking about 8% total return. So all of a sudden, these bonds are interesting, not only for their return potential, but also because of the coupon and also because of their utility in a portfolio construction context. So that's why there was this big pressure to get in what we've seen over the last several weeks, which highlighted yesterday. Completely different valuations, a higher utility and a very different setup for bonds than we've seen really for over a decade.

And we're going to get one of our favorite guests, Sarah Riopelle, who you know well on the podcast, hopefully next week, because she does a lot of the portfolio construction in her world. And I know that you generally have a bias, as I do— mainly, I've learned that from you over the years— towards equities. I'd like to be overweight equities when I can. Where we are with bonds, and then again with the potential still for a slowing economy, that creates a little uncertainty around equities. You're actually sitting, in terms of portfolio construction, for one of the first times in the last 20 years, your bias is towards bonds right now, at least for a little while longer. But that could change pretty quickly, couldn't it?

Well, it's a great observation. We actually spent most of the last decade selling bonds and moving them down, at one point, about 18 months ago, to the lowest or the biggest underweight we've had in our recommended asset mix, I guess, that we've ever had in almost 25 years in history. And the reason was this acute valuation risk, and that we felt that real rates were not sustainable. And that actually turned out to be the case with the massacre in the bond market. But as the rates were tightening, yields were rising, the economy was getting more and more dicey because of that tightening. There are periods where bonds make a lot of sense relative to equities, so this was one of them. My bias towards equity really relates to time horizon. For most people, their savings horizons are long enough that they will survive. If you don't use leverage, or a lot of leverage, they will survive to the next cycle. So if you get it wrong, ultimately you're going to go on to a new high. So time is the greatest insurance on an equity portfolio. And when you look at long-term returns then, you can say, gee, for long term, if I can earn 7% on an equity and I can earn 4% on a bond, why would I ever own fixed income? Well, because there are these bad periods, and that bad period happens after you have a huge amount of tightening. We're working on this right now, but there's typically a window of about six to eight months where, if you do have a slowdown in the economy, if you do enter a recession, fixed income actually does do better than equities. We're not so sure, though, that the economic environment will get so bad that we want to go underweight equities. So we have to make choices here. So we're a bit overweight fixed income, right on neutral on stocks, and we've got almost no cash to put to work.

Dan, it's been a crazy four years. If we go back to, where we would have been sitting at this point in 2019. So say we're sitting here in December 2019. The economy is kind of chugging along and we're heading into an election year and maybe things are starting to get overheated, and we're worried about rates popping up then. And then Covid hits, and we go through everything with COVID. Then we have this massive, unexpected bounce back in all risk assets, housing, stocks, and then particularly the riskiest areas of the market. Then we go through 2022, the worst bond market we've ever seen. And of course, stocks pull back at that point. 2023 has ended up being a pretty good year. And as we look forward to 2024, especially once we get through, as you say, that dicey period where you figure out just how much the economy is going to slow down, 2024 is starting to set up pretty nicely. We look at pretty decent returns in fixed income, and ultimately, we're going to see stocks start to look quite a bit more attractive.

Well, I think whatever's going to happen as a result of the tightening that we've seen is going to play out over the next six to eight months. We're going to know over the next two months, three months, about the risk of really dipping into negative territory in the US economy. That seems less and less likely. But how mild would a mild recession be? So 2024, the second half, at the very least, we're going to have a lot more clarity than we had through 2023. And markets are signaling that they're getting more and more comfortable with that.

Well, Dan, thanks again for joining us today. It's always a treat to spend some time with you, and hopefully you and the family have a fantastic holiday season. It's always nice when you write something like you've just written. You come as an old forecaster— I say old, but from the experience perspective, because we're both right there— but an old forecaster comes out and says, hey, this is something people should be paying attention to. And you write that paper a month ago, and now you can look back a month later and say, wow, maybe this 40-plus years that I've been doing this and all this studying and obsession with the markets that I've had, maybe I'm pretty good at this after a while, right?

I feel like Gordie Howe going back into the NHL. There are rare times, as you started this, when there's an alignment and all of the metrics and charts and algorithms, they all point in one direction, and that happens so seldom. And that happened this fall.

Well, Dan, thanks for your time today and have a great holiday season and hopefully we'll connect. We got to get you on this a little bit more often in the new year. That'll be my New Year's resolution because I know you're always so generous with your time. So hopefully we'll catch up and see you soon.

Thank you very much. I want to wish the best of season to everybody and all the best for 2024 and also to thank you for the trust that you put in with us, not just in 2023, but for so many years. Thank you very much.