What worries me the most are the risks we don't see, says SVP

When Ian Riach, Franklin Templeton Investment’s Solutions’ senior vice president and a portfolio manager in Canada, looks ahead, he’s cautiously optimistic, but can also see some risks.

“I think what worries me the most are the risks that we don’t see,” he told a Franklin Templeton Global Investment Outlook webinar yesterday as it looked at capital market expectations for 2022 and beyond. “With valuations being high, we may be vulnerable to a larger pullback if something unforeseen arises.”

Riach cited the recent market volatility sparked by Omicron, but also said Canadians’ high debt load is a risk. Its consumers are carrying higher debt loads in a highly priced housing market. “This could make us vulnerable to a policy mistake if the Bank of Canada raises rates too much too early,” said Riach.

He said the volatility provides opportunities, especially for active management. Franklin Templeton, with $185 billion of assets under management, focuses on high-quality companies that trade at reasonable valuations. “We actually think these types of companies are going to lead the next phase of the market,” he said. “They can provide some protection from downsides risk should we get a larger pullback.”

William Yun, Franklin Templeton’s Executive Vice President and head of advisory and wealth strategies in New York, said the risks include COVID variants that could cause more economic shutdowns and the chance of higher, or sustained, inflation rate that could cause a more rapid tapering and unsettle the markets.

Long-term returns

Yun said, looking ahead seven to ten years, “we think that global growth and inflation will both be around 3% over this extended period – and that’s generally a good backdrop for risk assets.” He expects increased volatility in various asset classes as interest rates could rise in many economies. “We expect equities to outperform fixed income and non US equities to outperform US equities,” he said.

Raich said Canada has slightly higher expected returns, due to lower valuations, but it comes with some higher volatility. While he said valuation is not a good short-term timing tool, “lower valuations tend to indicate higher return potential over the longer-term.”

Anticipated inflation

Yun said U.S. inflation, now at a 30-year high of 6%, is beyond transitory with supply and demand challenges and higher energy costs. He expects high inflation for two to three quarters before the supply and demand imbalance equalizes.

“As we go through 2022, we expect the inflation numbers that we’re seeing today to come down to 5%, probably by the mid part of the year and closer to 3% toward the end of the year, where we expect it to settle for the longer-term,” he said

Riach said Canada’s biggest risks are wage pressure and higher energy prices. While there is higher wage growth in the lower end of the economy, wage growth is tapering off at the higher end. Boomers are retiring or leaving the workforce, which could keep wage growth lower for higher earners and keep a lid on wage push inflation. Once they’re past the next three quarters, the demographics could be deflationary, and globalization could also help to keep inflation in check.

Interest rates

Even though there has been some recent concern about Omicron, Yun said they don’t expect interest rates to increase much for the short or long-term.  The futures market is not expecting the Bank of Canada to move before next March or April, and then it could only have two or three hikes in 2022.

”We don’t think that the Bank of Canada is going to want to get too far ahead of the Fed in terms of short-term rates as that could affect our exchange rate, which could have a negative effect on exports,” he said. “The Bank of Canada also remains an active player in the bond market, even though it’s pulling back a bit on its quantitative easing program. It can still influence rates longer term, and we don’t think it’s going to want rates to rise too fast or it could impact the recovery.”

Active management

Yun said the environment is still attractive for risk assets. 2020 saw a shift to an earnings-driven market versus a liquidity-driven market. “That’s generally a healthier sign for equities overall,” he said, noting they’re seeing double-digit returns in many developed markets, particularly in the U.S. They expect earnings will continue to be very attractive, but steadier after 2021’s strong rebound, and here will be high single digits into 2022.

While the real returns in yields for equities are still minimal, equities are an attractive asset class in the near-term and the consumer is strong in many quarters, with over a trillion dollars of savings, so there’s pent-up demand. Inventory will also be replenished, which will contribute to growth, and there are still share buybacks in the market, which are all positives. While there’s a risk that profit margins could decline, he said, “we think we’re still relatively positive on equities overall.”

Riach said Canada is seeing a healthy earnings growth – particularly in resources and financials. Energy companies have benefitted from higher oil and natural gas prices for the last few months, and the banks, particularly, have benefitted from the steepening of the yield curve as they borrow at low short-term rates.

While he said Canadian consumers may not be as financially healthy as their American counterparts since their households are carrying higher debt levels, employment is improving, “so that could support some more spending growth, which would help the consumer sectors and broaden out any rally.”