RBC Global Asset Management’s Chief Economist tells WP about some possible portfolio adjustments for the current landscape
In this first part of a special two-part interview, Eric Lascelles, Chief Economist for RBC Global Asset Management, talks about the current market environment and what represents a good play right now.
WP: There has been a lot of talk about bloated valuations and muted future returns recently – what’s your view on the current market environment?
Eric Lascelles: Very few investment categories can be said to be cheap when compared to the historical norm. Bonds yields are much lower than usual and stock valuations are somewhat higher than their historical norm. Similar, credit spreads are quite narrow.
Unavoidably, this points to reduced returns in the future. The yearly double-digit gains in the equity market dating back to the financial market were only partially a function of a growing economy, and much more powerfully the result of valuations rising from exceedingly cheap levels to slightly expensive readings. Going forward, equity returns will need to lock back into the underlying pace of profit growth plus the dividend yield, with the risk they might even have to give back a sliver of the valuation gains from prior years. This suggests single-digit rather than double-digit gains. Fixed income returns also look set to be more limited in the future, as capital losses from rising interest rates erode part of the coupon paid out by bonds.
All of that said, we continue to think that equity markets are the more attractively (or perhaps it should be less unattractively) priced of the two. The risk premium paid for holding stocks is substantially larger than normal, meaning that stocks should outperform bonds by a larger than normal amount, on average. Although interest rates may rise somewhat, we believe a normal bond yield is substantially lower than it was a decade or two ago. Not only does this limit the scope for coupon clipping from a bond investor's perspective, but it also means that equity price-earnings ratios can be higher than before (since they are akin to the inverse of a bond yield). This is to say, equity valuations are higher than historical norms, but not necessarily inappropriate in a low yield world.
WP: Do you think the current business cycle still has some way to run?
EL: Our business cycle work argues that North America has arrived at a late stage of the business cycle. This is distinct from the end of the cycle, and there could well be a few years left to run. But a variety of metrics confirm that the cycle is aging, and that it is now in a fairly advanced state. Examples include low unemployment rates, minimal output gaps, narrow credit spreads and slipping profit margins. However, there is little precision in such analysis. The second best guess about the business cycle is that it may have a little longer left to run than this assessment -- a few variables suggest more of a mid-cycle interpretation, including the state of the U.S. housing market.
WP: Should investors be preparing for a recession? If so, what represents a sensible defensive play?
EL: Given the late stage of the business cycle, we believe the risk of a recession is higher than usual. It is perhaps a 25% risk for the U.S. over the next year and a little higher for Canada. As such, it would be unwise to position completely for a recession. Nevertheless, it is an environment that argues for somewhat less investment risk taking. To illustrate, we have reduced our equity allocation steadily over the past year, taking it from a moderate overweight to a modest overweight. To be clear, we still own more stocks than a neutral position would suggest -- and therefore fewer bonds -- but this valuation, and growth-motivated overweight, is being scaled back due to the state of the business cycle. Other appropriate adjustments include rejigging credit allocations, de-emphasizing high yield and emerging-market bonds, in favour of safer investment grade securities.
From an equity sector perspective, this might argue for starting to shift toward more defensive sectors like utilities and telecom, but we have not done this in a major way since such sectors are often bond-like in their behaviour, and the current environment of rising interest rates is not a kind one those sectors.
WP: There has been a lot of talk about bloated valuations and muted future returns recently – what’s your view on the current market environment?
Eric Lascelles: Very few investment categories can be said to be cheap when compared to the historical norm. Bonds yields are much lower than usual and stock valuations are somewhat higher than their historical norm. Similar, credit spreads are quite narrow.
Unavoidably, this points to reduced returns in the future. The yearly double-digit gains in the equity market dating back to the financial market were only partially a function of a growing economy, and much more powerfully the result of valuations rising from exceedingly cheap levels to slightly expensive readings. Going forward, equity returns will need to lock back into the underlying pace of profit growth plus the dividend yield, with the risk they might even have to give back a sliver of the valuation gains from prior years. This suggests single-digit rather than double-digit gains. Fixed income returns also look set to be more limited in the future, as capital losses from rising interest rates erode part of the coupon paid out by bonds.
All of that said, we continue to think that equity markets are the more attractively (or perhaps it should be less unattractively) priced of the two. The risk premium paid for holding stocks is substantially larger than normal, meaning that stocks should outperform bonds by a larger than normal amount, on average. Although interest rates may rise somewhat, we believe a normal bond yield is substantially lower than it was a decade or two ago. Not only does this limit the scope for coupon clipping from a bond investor's perspective, but it also means that equity price-earnings ratios can be higher than before (since they are akin to the inverse of a bond yield). This is to say, equity valuations are higher than historical norms, but not necessarily inappropriate in a low yield world.
WP: Do you think the current business cycle still has some way to run?
EL: Our business cycle work argues that North America has arrived at a late stage of the business cycle. This is distinct from the end of the cycle, and there could well be a few years left to run. But a variety of metrics confirm that the cycle is aging, and that it is now in a fairly advanced state. Examples include low unemployment rates, minimal output gaps, narrow credit spreads and slipping profit margins. However, there is little precision in such analysis. The second best guess about the business cycle is that it may have a little longer left to run than this assessment -- a few variables suggest more of a mid-cycle interpretation, including the state of the U.S. housing market.
WP: Should investors be preparing for a recession? If so, what represents a sensible defensive play?
EL: Given the late stage of the business cycle, we believe the risk of a recession is higher than usual. It is perhaps a 25% risk for the U.S. over the next year and a little higher for Canada. As such, it would be unwise to position completely for a recession. Nevertheless, it is an environment that argues for somewhat less investment risk taking. To illustrate, we have reduced our equity allocation steadily over the past year, taking it from a moderate overweight to a modest overweight. To be clear, we still own more stocks than a neutral position would suggest -- and therefore fewer bonds -- but this valuation, and growth-motivated overweight, is being scaled back due to the state of the business cycle. Other appropriate adjustments include rejigging credit allocations, de-emphasizing high yield and emerging-market bonds, in favour of safer investment grade securities.
From an equity sector perspective, this might argue for starting to shift toward more defensive sectors like utilities and telecom, but we have not done this in a major way since such sectors are often bond-like in their behaviour, and the current environment of rising interest rates is not a kind one those sectors.
