As investors open their 2022 year-end statements and see the dramatic declines in their portfolios, they may find it hard to be optimistic, especially with a looming recession forecast by economists and in the news headlines.
Yet, for long-term investors, this market weakness may be presenting attractive investment opportunities.
To help investors position their portfolios for success in what may be another volatile year in the markets, I spoke with Michael Craig, head of asset allocation and derivatives at TD Asset Management. He shared his outlook for stocks, bonds, discussed potential market headwinds, as well as the traditional 60/40 portfolio. Here’s an edited transcript of our conversation.
Major stock markets worldwide were under pressure in 2022. Looking ahead, what geographical regions are you bullish on?
There are some long-term issues with China but in terms of making money this year we like China. It is really a play on a normalization of their economy as they made a radical shift in their COVID policy.
What are your thoughts on North American stock markets?
We are somewhat negative on the U.S. market, particularly U.S. growth. There will be places to make money in the U.S., but as a market whole, we are underweight on the U.S. for a few reasons.
It is still by far the most expensive market in the world on any type of valuation metric.
The market is expecting another rate hike or two by the Fed and then cuts in the second half of this year. I think one of three things might happen. One, we don’t get cuts and that would be a very bad situation because policy is tremendously restrictive right now. Two, we get cuts because we’ve gone into a deep recession and there will be time to add equities but it won’t be then because we’ll see the market sell-off. Three is where they tweak policy, they cut like 25 basis points, and I don’t think that makes a difference.
I would also say our earnings models are projecting a more material earnings recession than what’s currently priced in the market. As of today, the market is expecting about 4-per-cent earnings growth this year. We would say it’s probably more like negative-8 to negative-10 per cent. So you’ve got to see that wash itself out of the market before you get bullish on U.S. stocks.
For Canada, a few things here. One, if we go into a material recession, the energy sector will not perform well. And while there are certain supply issues for energy, the fact is that as demand falls off, oil is going lower.
Second, the Canadian economy probably has the most sensitivity to financial tightening because of the imbalance within our household sector with household debt. We’ve got a situation where people have taken on a tremendous amount of debt, much of which is floating, and rates are three times higher than they were when they took that debt on. The longer this goes on with rates remaining high, the more damage to our economy, and it’s a risk that doesn’t make me terribly excited about Canadian stocks. So we’re currently neutral on Canada.
When we spoke last year, you noted that the 10-year average return for the SuP/TSX composite index was between 6 and 7 per cent. Do you see a return to the historical average for the TSX in 2023?
I would be ecstatic with an average return this year.
So when you say you are neutral on the Canadian market, you don’t even expect a 6- or 7-per-cent return?
I don’t think it would be crazy if we’re having a conversation a year from now and North American equities are relatively unchanged.
Given this cautious stance on equities, what is your outlook on gold? Last year, you highlighted gold as an area of interest and the price of gold has been gaining momentum.
Gold was actually flat last year so relative to stocks, it actually did pretty well, and I think it does all right this year.
The positive drivers of gold are declining real interest rates and the sell-off in the U.S. dollar. Also, there’s the “weaponization” of the U.S. dollar after the Ukraine war and with the U.S. using the dollar as a tool to go after non-friendly U.S. countries. I think that this has been a catalyst for countries that aren’t necessarily aligned with the U.S. to start seeking an alternative means of trade to U.S. dollars. My sense is that there has been material reserve buying in gold by some of those central banks as they start to think about other means of trade. So there’s a geopolitical factor that’s actually pretty accretive to gold.
Given the declines in both the stock and bond markets last year, do you believe the traditional 60 per cent stocks, 40 per cent fixed-income allocation should reverse to 40 per cent stocks and 60 per cent fixed income?
The 60/40 is kind of the baseline, generic portfolio and it’s a great starting point. For your first investment, 60/40 is fine. But as you start to accumulate real wealth, you can improve the efficient frontier and potential returns by adding more uncorrelated assets. You need to think more to a total portfolio that would include stocks, bonds, international stocks and international bonds, alternative assets, infrastructure, commodities, etc.
I’m not going to debate whether 60/40 is the right number but I would 100-per-cent agree that fixed income looks far more favourable this year than equity – that would be a very high-conviction view of ours. This will be the year of the fixed-income market.
I think fixed-income returns will range between zero and double-digits this year. I know that’s very wide. So thinking about range of returns, if we were for some reason to see a sell-off and yields go higher, I don’t think yields are going to retest last year’s highs. Let’s just say they did, your total return this year would be zero – your coupon minus your capital loss would be zero. That’s your bear case. If yields go nowhere from this point forward, you’re going to earn 4, 5 per cent in fixed income this year. And if we get a rally with a reduction in interest rates by say, half, then you’re looking at double-digit returns this year.
What areas of the fixed-income market appear attractive to you?
Our focus right now is in the government market in Canada and the U.S. We do have some credit. We’ve upgraded our credit so it’s very high quality. We like credit more on the short end of the curve where you’re getting a lot of yield. And we are minimal high-yield bonds. I don’t think high-yield is attractive at these levels based on the high probability that we go into a recession.
Lastly, what do you see as the greatest risks to the markets?
We are very wary of a showdown on the U.S. debt ceiling this summer. The second thing, there is a huge disagreement right now between economists, the Fed and the market in terms of the path of interest rates in the second half of this year. Right now, the market is looking for cuts, the Fed is saying no way. My worry is they will only cut when things really deteriorate. Like inflation, where they were late and had to overdo it. If we go into a material recession, they’ll wait because they are so worried about inflation sparking up again, and more damage will be done until they use policy.
So those would be two things that I think are the biggest risks over the next 12 to 18 months.
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