In this Fall 2024 edition of the Pinnacle, we pose questions to Jim Bantis, Senior Portfolio Manager and Head of Asset Allocation at Ascendant Wealth Partners, on topics such as interest rate policy, the upcoming U.S. election, recent stimulus announcements out of China, and the change in equity market leadership that is taking hold. Before we get to this interview, a quick recap on the markets.

Market Update

The third quarter of the year saw strong performance across both equity and fixed income markets.  We highlight three key developments that have benefitted our portfolios and our positioning, which we have noted in previous editions of the Pinnacle:

Broadening Equity Markets

We observed a shift in market leadership as U.S. Mid-Caps outperformed their Large-Cap counterparts, indicating a move beyond the dominance of U.S. large-cap technology (commonly referred to as the Magnificent 7). We remain constructive on U.S. Mid-Caps and the valuations remain more attractive than U.S. Large-Cap equities, despite a similar earnings growth profile. In addition, Canadian stocks led global markets, benefitting considerably from declining interest rates.

We have modest exposure to U.S. Large-Cap securities and there have been select beneficiaries, particularly in the technology sector, that have benefitted from the proliferation of artificial intelligence.  Our portfolios are positioned with a range of equity exposure, diversified across sectors, styles, market capitalization and by geography. 

Bonds – Strong Quarterly Performance as Interest Rates Fall

The beginning of a long-awaited rate cutting cycle began with the Bank of Canada reducing rates by 0.25% in June, followed by two more 0.25% cuts in July and September, responding to lower inflation and softness in the labour market. The U.S Federal Reserve also began reducing interest rates in Q3 with a 0.50% cut announced by the Federal Reserve on September 18th.

Bonds greatly benefitted from the recent central bank policy changes, and we continue to prefer intermediate bonds (maturity profile of 3 to 5 years). We view private credit (such as Direct Lending), leveraged loans, and high yield bonds as attractive opportunities for additional yield enhancement, as the U.S. economy continues to grow and hence we expect credit defaults to remain lower than average.

In Canada, after several quarters of inversion, the yield curve has flattened. The decline in interest rates across the yield curve led to price appreciation across all maturities – notably, our shorter-term bond holdings benefitted from a more pronounced decline in yields. The chart below illustrates the shift in the Canadian yield curve from June 30, 2024, to September 30, 2024:

Canadian Government Bond Yield Curve

Change in Government Bond Yields from June 30, 2024 to September 30, 2024

Source: YCharts

 

Interest Rates Expected to Decline – Reinvestment Risk of Cash

Despite the uncertainties surrounding the anticipated magnitude and pace of interest rate cuts, we believe that interest rates will continue to decline. Locking in current yields in high quality investment grade corporate bonds with three-to-five-year maturities, offers a higher return potential than keeping money in cash or equivalents, such as High Interest Savings Accounts and other floating-rate options. Historically, cash has underperformed bonds during rate cutting cycles, and we think this will remain true again. Discount bonds remain a focus and they also provide tax advantages for our taxable investor clients.

We strongly encourage you to review your cash, cash equivalent and floating rate products held independently of our portfolios. Please contact us if you would like to review higher yielding alternatives or if you are looking to benefit from more tax efficient fixed income investments.

Asset Allocation Views

With interest rates on the decline and risk assets experiencing strength coming into the last quarter of the year, we thought a discussion with Jim Bantis who heads up the Asset Allocation Committee at Ascendant Wealth Partners, will help share the team’s insights with how we are viewing the world.

 

What do you make of the U.S. Federal Reserve’s jumbo 50bps interest rate cut in mid-September?  Do you view this decision as their admission that they are worried about being behind the curve – as they were often criticized back in late 2021 when inflationary concerns proved to be more than transitory?

The big headline is that elevated interest rates have brought inflation down to near target levels, paving the way for monetary easing to spur economic growth into 2025. A synchronized global rate-cutting cycle has begun (save for Japan), and the U.S. Federal Reserve’s recent 50 bps cut has underscored this expectation.

Debate continues whether the Fed is behind the curve. Central banks often overstay their welcome on both sides of easing and tightening, but only time can judge the effectiveness of their policy decisions. The economic data shows a growing U.S. economy with GDP increasing by +2% in 2024, 254,000 new jobs created last month, and a near historic low in the unemployment rate at 4.1%. This supports the view that the Fed is on track to achieving a soft landing as well as their dual mandate of price stability and full employment.

The market is pricing in cumulatively more than 100 bps of cuts between now and mid-June. That does not seem unreasonable given the conditions we have outlined. If the economic data weakens materially over the coming months, more Fed cuts will be coming, and if the data remains solid, the Fed’s policy will have time to adjust. The bottom line is this is a favourable backdrop for solid corporate earnings growth for the balance of 2024 and early 2025.

 

While it’s unlikely that we see administered interest rates fall as low as the COVID 2020 lows where interest rates were essentially zero, at what point do you think evaluating other fixed income investment alternatives should be under consideration?

After years of having very little interest rate exposure in the fixed income component of our portfolio, we added short-to-medium term bonds last year, anticipating the end of rate hikes with falling inflation. Despite some fluctuations, rates have trended down since October 2023 and markets expect further cuts into 2025.

U.S. corporate bond spreads have narrowed to the lowest level in more than three years as investors are more concerned with declining cash yields than the level of credit spreads. This is happening at a time when corporate balance sheets are largely in good condition and credit default rates are below historical levels. Many of the largest companies have enough cash on their balance sheet to pay off the entirety of their borrowing today, and have reliable and increasing profits (as opposed to deficits). A company like Apple arguably appears more credit-worthy than the U.S. government. Net leverage has come down broadly across ratings, and the quality mix of the high yield market is higher rated than in the past, with 50% of the index in BB rated credits today. Therefore, the ability of credit to withstand a modest growth slowdown is far better than it is in the equity market.

For these reasons, we continue to favour specific areas within fixed income and corporate credit, focusing on total return via attractive yields and the prospects for capital appreciation to enhance tax efficiency. We think the current environment offers unparalleled opportunities for corporate bonds, particularly in high yield and private credit, as opposed to government bonds.

 

This quarter was another good reminder why broad level equity diversification is beneficial with a number of the big U.S. technology leaders underperforming other market segments (viewed as a healthy market signal as new leadership emerges with the market broadening out).  What are some of your observations in terms of broader earnings growth for this year and next – are markets strengthening due to multiple expansion or revenue growth or are there bigger drivers at play?

Zooming out, the top 10 mega-cap companies in the S&P 500 are terrific franchises and have strong fundamentals and make up a meaningful part of the markets’ operating income and free cash flow. They also spend, by far, the most on research and development, suggesting their large moats may not erode for a long while. We own these U.S. companies in our investment portfolios. However, their high valuations (31x Forward P/E) and significant concentration of the market (comprising 36% of the S&P 500) suggest a cautious approach, potentially hindering further capital appreciation. To mitigate these risks, we have diversified our equity investments across various styles, sizes, and geographies.

Recent trends show 'mega-cap fatigue' with the Nasdaq down 1% over the last three months, while Canada’s S&P/TSX was up 10% and U.S. mid-caps equities appreciated 7%. Technology continues to drive U.S. corporate earnings growth, but other sectors are starting to see improvements for the first time since late 2022, indicating a broadening market. Lower costs and better productivity are boosting mid-sized firms' margins, and looking ahead for 2025, analysts are projecting a convergence in earnings growth between large-cap and mid-cap companies, with both expected to be in the low double-digits. 

In our view, mid-cap growth companies in the U.S. and dividend growth equities in Canada, are compelling due to attractive valuations, loosening monetary conditions, and the high probability of a soft landing in the United States.

 

Recently the Chinese government has announced some sizeable measures to stimulate its economy that the market is trying to interpret. Is this China’s Mario Draghi moment? What does it mean for global markets and our portfolio positioning?

To give a historical perspective, in 2010-2012, the Eurozone was facing a financial crisis and the Euro itself was being questioned. The recently appointed head of the European Central Bank, Mario Draghi, in a speech in the summer of 2012 said that “the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." That speech and the following ECB policies were viewed as a turning point to stabilizing the Euro and the Eurozone market.

Fast forward to China today, the Chinese economy is certainly slowing which has made their “5% growth target” difficult to achieve, but it does not appear in crisis. As such, global markets are paying close attention to Chinese authorities and their recently announced jumbo monetary stimulus packages to see if it’s beyond a short-term fix.  The package is focused on reducing the deflationary pressures in China, stimulate consumer spending, ring fence real estate property problems, and keep the economy’s growth rate above 5%. The stimulus package includes a cut in bank reserve requirements, cuts to key interest rates, central government loans to local authorities to buy up unsold real estate assets, and a reduction of the capital required to buy a second home from 25% to 15%.

What does this China stimulus package mean for our international exposure and to our investment portfolios? Even though we have very little direct exposure to China, we are inevitably indirectly exposed in our portfolios. China is the second largest economy in the world and is the European Union’s second-most important trading partner behind the United States. For example, shares in European luxury retailers, popular with China's urban middle class professionals, should benefit from an economic spark in the world's second largest economy. 

While the stimulus package should be a positive for the Chinese economy in the near term, it’s too early to say with conviction that it will spread to Europe and the United States.  Currently, we are not making any asset allocation changes to our portfolio as a result.

 

With the U.S. election right around the corner and a big political issue of trade protectionism, how do you view our non-U.S. equity positioning with a possibility of tariffs being imposed on imported goods to the U.S.?

Trump's proposed 60% tariffs on Chinese imports and 10% tariffs on other countries might spare Canada until the 2026 USMCA review. However, a review of USMCA could result in additional tariffs on Canadian exports to the U.S. for sectors such as automotive, steel, forestry, agriculture, and dairy. Reducing trade volumes would have a negative impact on Canadian railway companies, diminishing the benefits of the merger between Canadian Pacific and Kansas City Southern given their Mexico-U.S.-Canada footprint.

Vice President Harris, for the most part, will likely continue with President Biden’s trade policies. Having said that, in the past she has supported trade restrictions based on environmental considerations.

Regardless of the U.S. election outcome, we expect a shift towards protectionist trade policies that prompt companies to re-think their manufacturing strategies and operations. Unlike changes to the tax code, U.S. Presidents have wider latitude to take unilateral action on trade and tariffs. As such, our Canadian equity exposure will be under review depending on which administration wins and as trade policies and tariff announcements become clearer.

 

Another U.S. election question for you and if you can share your insights related to the fixed income positioning.  It appears no matter who is victorious and becomes inaugurated as President in January 2025, the deficit issues and increasing debt load to the tune of $35 Trillion in the U.S. will not be immediately addressed.  How does this impact the positioning of our fixed income exposure and is this of significant concern?

Escalating U.S. government debt levels warrant observation but does not currently pose a major concern. If you were to consider the broader level of national debt, which includes government, corporate and household debt, the U.S.' debt levels are comparable to those of other G7 countries, and noticeably lower than Canada’s total debt load. It's important to acknowledge that government spending, financed by debt, has been instrumental in generating robust investment returns across various asset classes. In fact, two major economic events over the last 15 years – the Great Financial Crisis in 2008 and COVID-19 in 2020, required government intervention and spending to help stimulate the economy given the depressed conditions.

The below table shows a comparison of total debt as a percentage of GDP across select major developed nations:

Debt as Percentage of GDP

Source: RBC Global Portfolio Advisory Committee, International Monetary Fund (IMF). Percentage of 2022 GDP includes bonds, loans, and debt securities.

The U.S. faces little risk of default with its capacity to print its own currency, but inflation remains a tangible threat. In addition to persistent budget deficits, an aging population and the introduction of new economic tariffs, could exacerbate these inflationary pressures. We regularly watch the U.S. Treasury auctions – should the U.S. Treasury fall short to create sufficient demand for their debt securities and they experience a failed auction, this could destabilize global financial systems. However, such an event has not occurred to date, and we expect the political leadership will do whatever it takes to avoid a sovereign default.

We are focused on the “belly” of the yield curve (intermediate securities with a maturity profile of 3 to 5 years). We have avoided the longer maturity profile of bonds as we believe the lack of fiscal prudence in the U.S. may lead to an oversupply of long-term debt and in short, we anticipate that the yield curve will continue to steepen as a result.

 

Closing Insights & Webinar Announcements

Year-to-date returns across major asset classes have generally been positive with minimal volatility in 2024. Risk management remains key to our strategy, and we continue to advocate for portfolio diversification amid ongoing uncertainties like the U.S. election, geopolitical tensons in the Middle East and Ukraine, and whether central banks will be successful in their quest to navigate a soft landing. We have been very pleased with the results we have delivered for clients this year and we are often reminded that past performance is not indicative of future results. We will continue to be opportunistic and adjust the risk and return profile of your portfolio as market conditions change.

We are excited to announce a few planned webinars over the coming months.

• Market Update Webinar: Evan Howard interviews Jim Bantis on asset allocation, and Adam Moody discusses international equities with Murdo MacLean from Walter Scott & Partners
• Year-End Planning Webinar: Jonathan Paul moderates a session with Mark Chan and Jag Gandhi from RBC Family Office Services on tax and calendar year-end planning considerations
• Elder Care Webinar: Bruce Leboff hosts a discussion with Leanne Kaufman of Royal Trust and Audrey Miller of Elder Caring Inc. to discuss elder care issues

We will email the registration information for each of these events as they come up. We appreciate your continued confidence and support.