Portfolio Positioning amid Rate Cuts and Market Risks

Text transcript

Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves. 

David Wong, Chief Investment Officer, Managing Director and Head, total investment solutions with CIBC Asset Management.  

I think the excitement around the Bank of Canada’s recent rate cuts and the impacts on investor portfolios has really been in the information where policy is going and the direction of policy, more so than the magnitude of policy rate cuts that have actually happened so far. And I think the market is, you know, really getting excited that we’re seeing concrete signs that the major headwind of rising rates on the bond market is behind us.  

And so, you know, the rate cut has been clearly supportive of the bond market and diversification for portfolios. We saw that back in June, where bonds in Canada had a positive return in a month where the Canadian equity market had a negative return. And while that sounds pretty much like common sense, it hasn’t happened all that often since rates started rising back in March of 2022. Since the Bank of Canada started raising interest rates in that period, the Canadian equity market has had 13 months where returns were negative, while the Canadian bond market in those months had a positive return only three times. That’s only 23% of the time that stocks went down in Canada and bonds went up.  

Now, if we look at the long-term averages, going back to the year 2000, the Canadian bond market actually has a positive return in 64% of the months that the Canadian equity market has had a negative return. So, it really hasn’t been an environment where we’ve seen diversification, or at least the useful kind of diversification from bond investments. And you know, with Canadian bond yields now at relatively high levels, and the direction of monetary policy now clearly moving lower, I think investors have really strong potential to see this type of useful diversification benefit in the portfolio, once again.  

With respect to how many more rate cuts we might expect for the rest of the year, I think the Bank of Canada, well, it’s clear that there’s only three more meetings to make rate decisions in 2024, so we’re kind of bounded by that. And the bank governor, Tiff Macklem, has said that, you know, the bank is not on a predetermined path, and so any actions continue to be data dependent. I think that’s been the common refrain for the last little while now.  

But all that said, I think economists broadly seem to be expecting at least a couple more rate cuts for the rest of the year.  

Inflation has come down quite nicely from the 2022 peak, which was above 8% in Canada, and we’re inching towards the target rate of inflation of 2%.  

Productivity in Canada has been positive, but not particularly robust, and we have seen the unemployment rate consistently rise.  

On the other hand, I think the Bank of Canada hasn’t wanted to get too far ahead of the U.S. Federal Reserve rate policy, and so the signalling at the July Fed meeting actually was very welcome in terms of giving the Bank of Canada some room to keep cutting rates.  

Now, ultimately, as we stand today, monetary policy remains restrictive in Canada and globally, and central banks generally remain cautious on inflation. So as a result of that, interest rates still present potential challenges for the economy. Certainly, if you look in the Canadian economy, the mortgage market, or mortgage holders that are up for renewal, you know, this is going to have major headwind on consumer spending unless rates come down meaningfully. And so, you know, the good news is, with the higher rate environment that we’ve been in, thanks to a central bank hiking cycle, they do have more tools now to respond to weakness, any signs of economic weakness with monetary policy. And so, you know, more aggressive rate action might be a possibility if any deeper cracks develop in the economy.  

Well, in the current market, investors might consider adjusting their investment approach by being open-minded about actively managed portfolios. With market breadth expanding in July, I think now is a good time to review the benefits of active equity management inside of an asset mix. Now, active management has certainly struggled in the U.S. market against the backdrop of heavy concentration in the top 10 names in the index. And you know, that’s really come off the back of spectacular returns from a very small subset of large stocks in the benchmark.  

Now, historically, this type of concentration does unwind, and when that happens, it has meaningful implications for how active managers perform versus the index. Now, there’s no question that the concentration around the top 10 names has been a major source of challenge for active managers in U.S. equities. But we know that when the index becomes less concentrated, it can act as a tailwind for active managers. 

Now, if we look at the data, if we look at the 10 years between 2000 and 2009, the S&P 500 went from 26% exposure in the top 10 names down to 19% exposure in the top 10 names over that 10-year time frame. Meanwhile, the median U.S. equity manager in the eVestment U.S. large-cap equity universe, which has over 1000 different members, the median manager beat the S&P 500 in nine of those 10 years.  

So, a very favourable environment for active managers when we saw concentration come down.  

Since the year 2010, the top 10 names in the S&P 500 have gone up from making up 19% of the index to almost 36% of the index today. And over that period, the median manager has underperformed the S&P 500 in 12 of the past 14 full calendar years. And the median manager has also underperformed year-to-date in 2024 so far, as well.  

So far in July, at least up to July 30, the S&P 500 has seen the top 10 names actually have a negative return on average in the month, while the average return for the rest of the index is actually up over 5%. So if this continues, it will remove a major headwind for active managers for U.S. equity.  

So in the current environment, I think it’s worth taking notice of that when making portfolio adjustments and reconsidering active management as something that will show definite benefits.  

When it comes to thinking about reacting to potential sector opportunities in the market, I think it’s important first of all to do it in the context of the outcomes that you’re looking to achieve as your starting point, then making sure you have a set of diversified assets that will get you to your goal. Now, the data shows that price appreciation in the long run in equities comes from earnings growth, but in the short run, the market pricing mechanism is really reacting to a multitude of factors, sort of like the concerns we’re seeing in today’s environment. And so ultimately, that over the long term turns out to be performance noise, and it’s always hard to predict where the most attractive earnings growth is going to come from. It’s even harder to get the timing right on that as well. And so that’s why we believe that a thoughtful, strategic asset mix that is diversified can cast a wide net to ensure participation in future earnings growth that smooths out any over- or under-enthusiasm reflected in market pricing. And so therefore a strategic asset mix is not meant to be changed as an overreaction to perceived opportunities unless it meaningfully moves the needle in the portfolio, and conviction is high.  

So, the real opportunity here in the current environment where rate direction is heading lower, is to review how much diversification is in your portfolio. Now, things that have worked for a very long time might see some reversal, and hindsight might point to interest rate direction as the key catalyst for that.  

Now, for example, if you look at the Russell 1000 Value Index, which is a measure of the largest U.S. stocks with the lowest price-to-book ratios, that’s underperformed the Russell 1000 Growth Index by 8.31% annualized over the last 10 years. Now, the potential impacts of this to an investor portfolio cannot be understated. An investor that chose growth stocks in 2015 would, on average, now have more than twice the amount of gains as an investor who picked value stocks.  

The underperformance of growth stocks in July has therefore generated understandable interest in the potential for a new trend to emerge. Now, if we look at the 45-and-a-half years since inception of the Russell 1000 Growth and Value indexes, you know their fortunes are actually quite similar in spite of that recent outperformance by growth stocks. So, over the 45-and-a-half years, the annualized return for the growth index is about 12.64%, and the annualized return for the value index is about 11.95%. So very similar, even with that strong outperformance.  

If we rewind the calendar back to the end of 2009, the 31 years since inception, annualized returns actually favoured the value index there. You know, if we stop the clock at 2009, the since inception returns for value was 11.62%, and the since inception returns for growth was 10.04%. So, leadership changes have occurred in the past, and we believe that they’ll continue to happen in the future, with the only uncertainty being timing.  

So, it’s worth considering right now how far away you are from your strategic targets in your asset allocation. Maybe a good time to think about, you know, rebalancing, if you haven’t done that in a while, because that drift can really take you away from your target mix and get you away from the diversified path that you intended to be on. 

One of the risks that investors should watch out for in the current environment is that, you know, volatility could pick up with stocks that have higher price-to-earnings multiples, given that the bar has been raised very high for earnings expectations. Now, we’ve seen in the market recently, in July, you know, very quick to turn its back on some of the larger names in the U.S. index, on any signs of less than perfect reported results or even outlooks. And you know, this could be an ongoing theme here, as we’ve seen, you know, things priced at quite high levels.  

Now, active equity management might be explored as a way to manage these risks, if managers are focused on diversification away from the bigger names in the benchmark and into names where valuations are more reasonable, and the fundamentals still look attractive.  

Now, of course, no discussion about risks here in the middle of 2024 would be complete without mentioning the U.S. election in November. There’s been no shortage of interesting developments on that front. Both candidates present some challenges for the markets in different ways. You know, Trump certainly with a more insular, you know, America-first agenda, the implications for inflation, for international stocks and other areas of the market could be negative. At least, that’s how it’s perceived.  

And with Kamala Harris, you know, there’s just uncertainty around her policies at this stage, early stage in her campaign, but likely to be consistent with what’s already in place under Joe Biden. And with Kamala Harris entering into the picture now, I think it’s really transformed the race into a more competitive one, which also means, you know, the uncertainty about who might win could introduce some market volatility for the next little while here.  

One thing that’s important to highlight through that is that election years tend not to produce unusual market returns in either direction, up or down. So, on average, markets have historically had positive returns, whether a Democrat or Republican is president. Also, regardless of who controls Congress.  

Now importantly, if we think back to the 2016 election, the Trump victory was supposed to be bad for emerging markets. But if we look back at the returns for 2017 the Emerging Market Index delivered returns of over 28%. Which is one of the best years on record for the emerging markets, well above their long-term averages. So ultimately, the market considers more than one event in its assessment of the future, and so trying to oversteer to a single risk is just not likely to be a beneficial endeavour.  

So, we believe the best way to manage around any potential election outcome is to be diversified and fully invested to capture the compounding power of financial productivity from good companies around the world.