Hello, and welcome to the Download. I'm your host, Dave Richardson, and it’s always a special time when we get Sarah Riopelle to join us. Sarah runs the portfolio solutions at RBC Global Asset Management. She is a great person to consult when we want to know what we should be thinking about in terms of positioning of overall portfolios based on what's happening. So, Sarah, welcome.

Thank you for having me. It's been a while, hasn't it?

It has been. And again, that's why we space you out a little bit more, because it is such a special visit.

Well, in all fairness, I’ve been a little bit busy with the markets as well.

No kidding? Has anything been happening? We talked to Eric Lascelles. It seemed everything was fine.

Yeah, very quiet. No, a lot is going on, as you know.

And it's produced more volatility. We've seen echoes of the last financial crisis for many of the people who would be listening; interest rates rise, banking sector looks a little wobbly and investors are trying to figure out how are central banks going to react to it. So what's your perspective on what's been going on? And again, I just want to be very clear: the echo of the global financial crisis that I'm referring to is just people's perception. That's certainly not the way that we view it.

Yeah, for sure. Let's get that out of the way up front. We certainly do not think that this is a repeat of the global financial crisis in any way, shape or form; so let's get that out of the way first. But obviously there's a lot going on in markets. I expect that anything I say today could possibly be different tomorrow, and that's because we remain very data dependent. Each new data point that we see, whether it's a jobs number or a Fed announcement or an inflation print, it's going to cause us to review the outlook and our forecasts and adjust as needed. So it's always true in markets that volatility is there and we have to adjust. It feels like markets are even more sensitive over the last few weeks and months to these data points and it's creating more volatility as a result of even small perceived misses to expectations. It's creating more volatility than normal. So in our view, this massive and sudden surge in interest rates that we've seen over the past year is almost certain to cause economic pain and we may be starting to see that now. We're starting to see some cracks in the financial system. Investors are concerned about those challenges in the banking system that you mentioned earlier, and they're concerned they could be a sign of worse things to come for the broader economy. Ample liquidity is being provided by central banks to ease those financial system stresses. But central banks have made it clear that they don't want to lose sight of that fight against inflation that's been so important over the last twelve months. Inflation is still too high, growth is still too fast, and these things are going to demand tighter monetary policy. So expectations that central banks are going to take their foot off the gas pedal, so to speak, I think might be a little bit premature. We believe that central banks are going to push ahead with planned interest rate increases. Investors are skeptical that further tightening will happen from here, but again, we remain data dependent, so we're going to have to see what happens. I think that the banking challenges in the US and also in the broader market are going to dampen risk taking to some degree, and they're going to tighten lending conditions. We think that that probably leads to a greater likelihood of recession over the coming twelve months. But these immediate problems have been dealt with. I think the strain on the financial system has prompted us to budget for further economic weakness. And with that in mind, our forecast is for a recession hitting probably in the back half of the year. But at this point in time, we expect a recession of mild depth and duration. Not a deep one or a long one, as we have seen in the past, but something a little bit more on the mild side.

Yeah, and we talked with Eric Lascelles earlier, and essentially what he was saying was that what's happened in the banking sector in particular over the last three weeks has really just upped his forecast. He already had a pretty high percentage on us going into some kind of a recession, and likely a short and mild one, but he's bumped his probability of that happening up just a little bit because it's starting to seem more inevitable that we're going to have not just a significant slowdown, but an actual recession.

Yeah, if he was saying we had a 70% chance of a recession over the last couple of months, he probably has bumped that to something like an 80% chance of recession. I don't know if that's what he said…

Wow, it's almost like you've already listened to the podcast with Eric. That's exactly what he said. You're bang on. See, this is how smart you are. This is why we talk to you.

I must have heard that on the last macro meeting that we had.

Yes. Or you're communicating telepathically. Again, we've got economic weakness coming. So how does that play out in the markets?

Yeah, well, compared to a year ago, I'd say we're in a much different place than we were in terms of valuation. So the selloff in both the stocks and bonds over the last year have erased much of the overvaluation that existed at the beginning of 2022. Looking at the fixed income market, remarkably, even though we've seen these massive losses over the past year, yields are not actually at outrageous levels relative to history. Rather, the adjustment that we've seen in the markets in terms of bond yields is just yields moving away from extreme lows and back to something that's closer to the average level that we've seen over the last three decades. And so, we've corrected that valuation excess in the bond market, but we haven't moved valuations to any kind of extreme. They're actually just more normal now. So at current level, the prospects for future returns has improved considerably. And at these higher yield levels, we believe that bonds can resume their role as ballast in a multi-asset portfolio, as that diversifier to equity-market volatility, which I think is going to be important over the next few quarters. And shifting to the stock market, valuations have been reset and now appear more consistent with the expected level of interest rates and inflation. We think the bigger risk in equities lies on the earnings side. At this point, earnings estimates are down about 10% since last summer and analysts are now looking for flat earnings in 2023 relative to 2022, but they're still looking for earnings growth of 10% in 2024. The reason that is a bit of a challenge is because if a recession does unfold, we think that we're going to need to see some more correction to the earnings side of the equation over the coming quarters. We looked at the last eleven recessions and earnings fell on average about 24% during those periods, and so there is still a little bit more room for earnings to come down. But let's look at the positive side of that. An outright decline in profits is probably going to be less severe this time. I don't know that that 24% number that I just mentioned is necessarily something that's going to come into fruition in this particular case because of our expectation of a mild recession. So while we remain concerned about earnings not yet contemplating a recession, that doesn't mean that we have significant downturn in earnings on the horizon. We just think that there might need to be some correction around the edges. There are still positive outcomes for earnings because if inflation comes down as we expect, if investor confidence increases, then we could potentially get a soft-landing scenario, and earnings don't need to correct from here. So I don't want to give you this doomsday scenario, but the key here is there is a variety of outcomes that are in front of us at this time, and we just need to make sure that we're positioned appropriately, depending on whether or not we come out on the positive or the negative side of those outcomes.

Yeah, as you say, these reports that keep coming— and every single one has an impact— seems to be going in the right direction around rates, which is good for fixed income, but you still don't know. We had some better numbers around inflation, but we're not out of the woods yet. And we certainly know from history that inflation can be surprisingly stubborn and resilient, in a way, once the genie's out of the bottle.

Yeah, for sure. And as you said, we're seeing a lot of positive signs of progress, especially on the inflation front, but we're just not ready to say that it's a job well done or that we've successfully tackled inflation just yet. I think we're going to need a couple of more months and a few more data points before we're able to say that.

I was doing a lot of speeches this week to large groups of realtors across Canada, and one of the things I threw out to the realtors— it was somewhat a rhetorical question, given the move that we've seen in interest rates, which you just referred to— and I asked: are interest rates high? And you see people nodding their heads. And I answer: well, no! If we take a longer-term historical perspective, interest rates are actually pretty normal. This is about the midpoint, as you say, of where we typically see longer-term interest rates move. They just seem very high relative to where we've been more recently. And so that move in interest rates is closer to being done than being at the start of the move. And so you've seen the valuation move in stocks, which has been based on that move in interest rates, and now the economic impact or how much are earnings affected, that could be the other shoe to drop. And that's why fixed income, as you say, looks pretty good. And equities, you still see that volatility there.

Yeah. I'm probably going to regret making this comment on a recording, but I really feel like the worst is behind us in the bond market. I think we saw peak yields last fall. We briefly revisited similar levels as the banking crisis unfolded a few weeks ago, but we didn't reach those levels from last fall. And I feel fairly comfortable that we can say that the worst is behind us in the bond market, at least for right now. But we do need to think about the equity side of the portfolios, though.

Okay, so you put it all together, and how are you positioning your portfolios right now?

Well, as I said, because of the variety of different scenarios that are in front of us, both good and bad, we feel that keeping our asset mix at a neutral stance— neutral in all three asset classes— is probably the most prudent approach until some of these scenarios start to play out or we get a little bit more confidence on either the positive side or the negative side. So the volatile environment over the last 15 months has provided us with many opportunities to adjust our asset mix within the portfolios. And what we've been doing is derisking the portfolios over the last year or so. And by that, I mean that we're buying bonds to reduce our underweight in bonds and we were selling stocks to reduce our overweight in stocks and now, after all of those trades, we are now sitting on a neutral asset mix. And I think that's really important to think about because it's not that we're saying we have a terrible scenario ahead of us, it's saying that we have a lot of different potential paths forward and we don't have conviction onto which one might end up happening. And so we feel that sitting at a neutral position until we get a little bit more conviction on either side is probably the most prudent approach at this time.

You almost have answered my next question, but I'm going to ask it anyways because it's just what I do. Typically, I think we'd agree that we're in the latter stages of an economic cycle. Typically, in the latter stages of an economic cycle, wouldn't you even have less risk on the table? In other words, wouldn't you be skewed more towards bonds and cash than stocks? Being in a neutral position, you're exactly where you would be, more in the middle of an economic cycle. What's different this time?

It's a couple of things. You have to balance the near-term risks with the long-term opportunities. Over the long term, stocks outperform bonds. As a general rule, we prefer to have an overweight in equities and an underweight in bonds because when you look out over the next two, three, five years, that is a trade that is going to benefit our clients and our portfolios. But you have to balance that against the near-term risks of, as we talked about, the possibility of another shift down in equities, the possibility that in that scenario, bonds could outperform stocks because they offer that diversifying characteristic in a multi-asset portfolio. And at this time, balancing those near-term risks with those long-term opportunities, we think that sitting at a neutral position right now until some of this stuff plays out, with the eye on increasing our risk assets or allocating back towards risk assets as opportunities arise, is probably the best approach.

And then Sarah, let's take the equity portion of a balanced portfolio, just as an example. Would the actual composition of that equity portion of the balanced portfolio be less risky than it was a year ago? Would you see a difference in the types of equities that you're holding within that part of the portfolio?

So my particular portfolios, I have not adjusted the holdings that I have, but when you look one level down, the underlying holdings would absolutely have adjusted within those portfolios to more defensive type sectors and away from more cyclical type sectors. I know that you have Stu Kedwell on your podcast sometimes. And he, I'm sure, has talked about some of the ways that they're adjusting their portfolios in the face of more volatility and more concern about the economy. They're probably shifting to more defensive sectors and away from cyclical sectors within those portfolios. And that factors all the way up into the top fund of the portfolio that I manage. It's going to come through at those levels as well. The other thing we're doing is that we do have positions on a regional equity basis as well. And so while we might be neutral equities from an overall equity asset class, within the regions, we do have some tilts depending on where we see the best value in the market.

Yeah, important when we talk about portfolio construction for people who are listening to this, you may see the big picture, a neutral positioning, but there is a lot of other stuff going on in a portfolio you're constructing within the bond portion of the portfolio and the equity portion. So you have to look deeper, which of course, when you're managing portfolios at the scale that you are, that's exactly what you're doing. You're looking, as you say, one layer down to make sure that the overall risk and positioning of the portfolio is exactly where you want it.

Yeah, you say one layer down, I'm probably looking at it five layers down. But yes, there's an enormous number of things going on within the portfolios, from currency hedging to tactical management, to managing within the different components of the bond market, the different equity regions. Within those equities, we're looking at style tilts and income paying securities and stuff like that. So I won't go into all the details, but there's an enormous amount of stuff going on within those portfolios that we have to be paying attention to at all times.

Yeah, I would have guessed four, but you're always an overachiever; five layers down. That's fantastic. I can get to one, so that's why I stopped there. So, Sarah, that’s really interesting. Again, always great to check in. We talk about the economy with different people, we talk about individual sectors or events that are happening. But it's always nice to catch up with you, to pull it back together to what's most important, how you put it together in a portfolio that makes sense. And what do you need to think about as all this stuff is happening. You do such a great job of doing that. So, thanks as always for your time today.

Great, thanks so much for having me.