Stay the Course Amid Market Volatility

October 30, 2023 11 min 17 sec
David Wong
CIBC Asset Management
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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, total investment solutions with CIBC Asset Management.

Entering 2023, we were facing a very challenging investment backdrop. We were in a holding pattern waiting for an economic slowdown and expecting the markets to respond accordingly.

Things haven’t been all that bad for asset returns compared to 2022 as we’ve seen 2023 unfold. And so investors can balance stability and growth in today’s economic environment in rather interesting ways. Almost 10 months into the year now still feels like we’re in that holding pattern, and so we would say that there’s no reason to abandon your long-term strategy. Stay focused on the strategy that’s designed to get you where you need to be in the long-term and don’t try to outguess the situation. 2023 is a great case study of why that’s the right approach.

That said, when we look around the investment landscape today, we are seeing some interesting things shaping up.

Interest rates are noticeably higher today than they were at the start of the year. The pain that’s been felt in the bond market so far this year is likely going to be in the rearview, we believe, as the hiking cycle nears its end. So it’s hard not to be attracted to the yields that are available in the market today.

When we see 10-year bond yields north of 4% for a credit risk-free federal bond in the U.S. and Canada, it’s hard not to be attracted to it after a long period in the prior decade where bond yields were under 2%. And we haven’t seen today’s level of yields since the end of 2007.

Now investors are rightly looking at these yields as a bit of a gift horse right now, taking its time to inspect what’s going on in the investment environment before accepting the gift of higher yields. But viewed from a forward-looking long-term lens, we may want to take advantage of these levels as soon as we can.

When we look at the data on Canadian bond yields via the index going back to 1983, when we take the starting yield of the index and look at the subsequent return one year out, we find that the return bears little resemblance to the starting yield. The difference is plus or minus 67% relative to the starting yield. But if we extend out the analysis to the subsequent return 10 years out, we find that the return looks awfully close to the starting yield. The difference is only plus or minus 15% relative to the starting yield. And this makes intuitive sense. As you get closer to maturity, bonds pay you back at par and any short-term price volatility simply goes away. The trick is to avoid the noise that surrounds us every day and stay focused on your return objectives. So if we stay invested and can ignore the short-term noise, there are more attractive return prospects for bonds today than at any point since 2007. That’s something that shouldn’t be easily dismissed just because it creates some discomfort over the volatility in the short term.

If you’re a long-term investor, you should be pretty excited about it actually, particularly if you’re sidelined in cash right now just because of nervousness over the headlines.

So if interest rates remain high but stable, that would actually be really good for bond returns. It would give us the starting yield back in the form of returns with lower volatility. Permanently higher rates might, on the other hand, create some repricing lower for equity multiples as the discount rate for future earnings would need to be adjusted higher. In that environment having a focus on the bonds of good companies with the ability to withstand higher rates should provide really solid returns.

For equities, it will be important to find special companies that have good business models that can withstand short-term volatility in any sort of repricing. You want to be very comfortable with what you’re owning in that environment as selling low is never a winning strategy.

So this might be an environment where having a close connection with an active manager could help investors contextualize what’s going on and provide the comfort to stay invested and focused on opportunities that managers are able to select out of the volatility.

If rates remain high but continue to increase ever higher and we get a bear steepener with long yields rising more than short yields, that would be a headwind for bonds. In that environment instruments like floating-rate bank loans would likely benefit as they have over the past two years. Over the past two years since rates started going up, floating-rate bank loans have generated returns of about 5.7% annualized while traditional bonds are down almost 6% annualized. So having diversification inside of your bond portfolio is a really good idea to have something working in any extreme outcome, whether rates are going higher or lower.

Now, central banks started cutting rates and if we got a repeat of the playbook from the prior decade where central banks seemingly respond to market weakness with looser monetary policy, that would actually be a very positive environment for risk assets.

However, the central banks have made very clear that inflation is their main focus right now. So the Bank of Canada and the Federal Reserve in the U.S. would need to be more certain than they are today certainly that they’ve got prices under control and that’s a big if. So we need to be prepared for any scenario to happen with a diversified portfolio.

That said, the assets that would likely benefit the most in our portfolio would be the ones that are a bit further out the risk curve, were administered rates to move lower. So think about global small cap or emerging markets and growth equities. Those would all benefit from lower rates. Bonds would also pull forward future returns and get repriced higher in the short term. So it’d be likely to be an attractive return environment for fixed income, at least in the short term.

The assets to avoid in advance of such scenario would be cash, not because cash would necessarily go down in value, but it certainly won’t go up in value, and that’ll be a drag to portfolios in the form of opportunity cost, which is why we recommend investors with a long-term timeframe to stay invested at all times.

Without question diversification should be the core to any investment strategy short of a crystal ball, so we would always recommend it. Prediction is hard. Preparation is relatively easier. That said, when we think about alternatives to diversification, I think really what the heart of the matter is is whether there are things that investors should have in the portfolio that they might not have today or they might’ve forgotten about. The late Peter Bernstein, one of the truly great market observers once said that you aren’t really diversified until there’s something you’re not comfortable with in your portfolio.

And so for many investors, giving up some liquidity in exchange for premium returns can be uncomfortable. But it’s been a strategy that’s been successfully used by many institutional investors who have the ability to do the deep research and identify good diversified opportunities in private markets.

Private credit, for one example, has higher yields than available in the publicly traded bond markets. And in the right hands, the credit risk can be managed very carefully by being selective to borrowers deemed to have a higher likelihood of paying them back. Of course, a good private credit manager wouldn’t put all of their eggs in one basket and would spread their loans around sectors and companies. Private assets are not valued daily by the voting machine of the market, but instead are valued according to predefined pricing methodologies on a periodic basis.

This means that they can be at least superficially less volatile, then they’re publicly traded counterparts. This can lead to an era of mystery about whether the volatility is artificially suppressed in down markets. So investors need to be very comfortable with the manager they’ve chosen and do their homework so they know what to expect in any environment.

One of the key risks that investors should watch out for is that equity market volatility could pick up if an economic slowdown becomes realized, and particularly if it is expected to be a severe downturn.

When we started the year, some gauges of market sentiment were quite bearish. If you look at investors intelligence, which does a survey on bulls versus bears, a ratio of bulls versus bears, the number of bears actually was equal to the number of bulls at the start of 2023. That’s actually quite rare and actually highlighted that investors were on high alert to start the year.

As 2023 proved this caution to be unwarranted we saw the bull-bear ratio reach three, meaning there were three times as many bulls as bears, which historically has preceded large market downturns.

Now that ratio has since come off the peak, but it’s important for investors to not get too complacent because that’s the condition for overreaction to any surprises that might come out of the economy or news flow in general. And one area that we’re watching closely is the impacts of mortgages and the higher interest rates and the impacts on mortgages for Canadian consumers. That’s yet to be fully felt here in Canada, and that could have some big negative consequences for the Canadian economy over the next couple of years. And if the market starts getting concerned in advance of that, it could be a headwind to equity markets.

The outlook for the next several months into the end of 2023 and early 2024, first of all, that’s a pretty short-term timeframe. Six months I would say is a short-term forecast, so take it with a grain of salt. That said, equities have had a good run so far in 2023.

We would be hard-pressed to get as solid of a year in 2024 through equities. Though arguably in the U.S. it’s been heavily concentrated in just seven stocks with the rest of the market having fairly muted returns this year. The headline shows that the U.S. market is up 15% in Canadian dollar terms this year, but if we actually equal weight the index instead of market-cap weighting it, U.S. stocks would only be up about two and a half percent so far this year. So if we focus on the glass being half full, there might be room for some catch up for the rest of the market that could buffer any overheating that’s occurred in the select few stocks.

Bond yields could have room to get lower if we hit a soft patch, something for investors who have been on the sidelines with cash to think about. They’ll be losing out on the opportunity cost of getting capital appreciation in the bond market in that scenario. And one thing that our data shows is over the long-term, the returns of a portfolio of bonds comes very close to the starting yield.

And so with yields at their very attractive levels today relative to any time since 2007, we believe that the long-term focus is something that people should look through the short-term horizon and ensure that they’re focused on the outcomes that they need to get to their investment objectives.

So even though we could see some softness in the economic data as the impacts of rising rates worked their way through the real economy, we would still caution investors to try not to outguess the market as the market has a way of pricing things in advance. So the obvious bad news is already assigned probabilities.

Stay focused on the returns you need over the longterm. Identify an asset mix that will help get you there using the unique opportunities that are available today, and let the power of time and diversification help you prepare rather than predict the markets.