Episode 23: What’s the possibility of a full-blown recession?

Narrator: WP Talk. The Wealth Professional podcast.

James: Hello everyone. And welcome to the latest edition of WP Talk. I'm your host, James Burton, managing editor of Wealth Professional Canada. For this episode, I'm delighted to welcome Andrew Buntain, VP and institutional portfolio Manager of Franklin Bissett Investment Management, to discuss some of the hottest topics in investing right now. We delve into quantitative tightening, consequential slowdown of growth and the possibility of a full blown recession in 2023. We also discuss what this means for fixed income markets and how Franklin, besides Canadian Core Plus strategy, is positioned to navigate these realities. Andrew starts by tackling arguably the biggest issue of the day, and that's inflation. Okay. Andrew So let's start with arguably the hottest topic of the past 12 months, and that's inflation, of course. Now it seems to be on a downward trajectory. Do you think the worst of it is behind us?

Andrew: Oh, well, James, we'd like to think so, but it's remaining fairly elevated after CPI in Canada here peaked out appeared to peak out in June at 8.1%. It's still hovering around seven. And in the US we had a CPI print just this morning as this is being recorded and the November figure was 7.1% year over year, which is down from 7.7 in October. So yeah, you're right, it's on a downward trajectory, but it's still in that elevated aspect of things where far from the Fed or the Bank of Canada's target of 2% inflation and stable prices to go with that. And I think inflation is the Bank of Canada's primary concern. That's basically why they've been on a very aggressive rate tightening cycle going back to March. And we now find ourselves at 425 on the overnight rate and potential for further increases potentially. And as we get into 23 and I think the last missive we heard from Governor Macklem was that things are now data dependent and they are going to want to see how effective their implementing of the policy has been in getting those inflation numbers down. So it does appear on a downward trajectory is the worst behind us. We'll know more as we move through the end of this year and into next. But it is still hovering at levels that are of significant concern for monetary authorities.

James: Now, before we get into what might happen with the central banks moving forward, I was just curious to ask you, you know, back when they started the rate hiking cycle and the word transitory was used. I'm just curious to kind of ask you about your interpretation of that back then and then kind of perhaps looking looking back now in hindsight as to the language that was used back then?

Andrew: Yeah, well, it seems as though the word transitory eventually gave way to the word persistent, and that gave way to the word entrenched. And there's a lot of difference in going from transitory to entrenched. I think in calendar 21, the Fed and the Bank of Canada were basically inactive and the bond market in Canada lost two and one half percent that year because market forces were taking rates higher by virtue of putting selling pressure on bonds in anticipation of rate hikes, which eventually began here in March. So, yeah, I think the the monetary authorities were potentially a little late in terms of bringing on a tightening policy, but they've had to be very aggressive here in 22, and that has had significant fallout for the bond market in terms of total return. So that's why policy going forward in these next few quarters is going to be very important for shaping the term structure.

James: Yeah, absolutely. So so what about then 2023 in the central banks? Like you said, they've been they've been aggressive this year. What's your expectation on further rate hikes or otherwise from the Bank of Canada and the Federal Reserve? Do you think they're content with inflation slowing down or will they sort of stay steadfast in really bringing inflation down to target?

Andrew: Well, it doesn't seem as though Governor Macklem is very content with inflation. I think he's just recently he was quoted as saying the greater risk is in tightening too little. And if that's his attitude, then there's evidence that he is still very focused on inflation. It's still a very significant concern, understandably. We do expect the Fed to raise rates through spring and then potentially hold as they wait to see more of their effectiveness or efficacy of their rate hikes. The Bank of Canada, don't forget, has not paused and there's no pivot in the near term in our view. So if the idea of raising rates too little is the greatest risk, then I think that tells us a lot that inflation is still front and center in their minds and there is potential for more in the way of rate hikes, maybe smaller, maybe less frequent, but very focused on on that.

James: So with that in mind, Andrew, where do you see the opportunities in the fixed income markets? And maybe this is a good time to bring in your core plus strategy. Maybe you could help us understand how that strategy is positioned to capitalize on these opportunities.

Andrew: Right. Well, James, we we have the core plus bond fund here at Franklin Bissett, which is a 7030 split between between core Canadian and us. And the reason we have a US fixed income component is there are certain things in Canada that are there aren't available or don't trade very well that we want to fill in valuable subsets of the fixed income markets that in many ways behave differently during periods of rising rates or strain or stress in the bond market. And I'm referring specifically to high yield bonds and of course, bank bank loans or floating rate notes as you would know them. There isn't a lot really in Canada to work with. And the US high yield is so much deeper and broader as a market than here at home and more liquid, which is also important. So we fill in those gaps and what I'm getting at is that we are very big believers in diversification. We make a point of diversifying with some asset classes and fixed income that have low or negative correlations with one another. And that was very helpful. For example, in 21 when we had high yield and bank loans do quite well in that year, which was a losing year. Total return for the Canadian bond market. So the ability to go off benchmark and find things that that help increase the diversification of the portfolio is is of importance to us. It didn't work out so well in 22 because nothing was spared in the selloff that we saw. But longer term, we do think there is benefit in diversifying other opportunities. We remain overweight corporates. We do believe that the research that we do fundamentally on the corporates adds value and will likely be a very important aspect of what we're able to do in the coming year because security selection will be very key. We're very selective at the moment. We do like the triple B bucket because there's a wide range of triple B's in Canada. There's not so good triple B and there's pretty good triple B and a lot of range in between. And astute analysts and researchers can can make a difference in that. But overall, we've been reducing our credit exposure on the corporates and implementing credit hedges and so on, because there's been some widening over the course of the year. But a selective approach among corporates we think will be an important element of the performance in 23 curve wise we're overweight, the long end of the curve in the US, we think there's a yield advantage, a significant opportunity in terms of the yield advantage there. I think we're about 348 on the US 30 year at the moment versus 282 on the Canada. So we're of the view that the long end of the US curve looks attractive at the moment. So those are a few things that that we think are are helpful in how the core plus strategy can can add value how it's done historically and going forward.

James: Yeah. Just as an aside, Andrew, is we've always had many years of historical low interest rates. Does this sort of change of environment, this kind of new era, for want of a better phrase, its fixed income investing kind of interesting again?

Andrew: That's a great question. I think, Yeah. I mean, in the eighties, nineties and 2000s, you had a secular downtrend of interest rates. It was pretty hard to lose money in bonds outside of 1994 and 1999. You laddered your maturities rates were good, There was lots of inventory in the cupboard and and it was a cure for insomnia. And now since the great financial crisis you're right. That phrase lower for longer really entered our lexicon because rates basically went sideways since 2008 and a couple of healthy dollops of volatility in 2013 and 2018. And and of course most recently in 21 and likely here in calendar 22. So yeah, that lower for longer phraseology which kind of morphed into the transitory when inflation came into the picture and then moved along a continuum there. So I think that active management in bonds makes a lot of sense in that lower for longer environment where yield is hard to come by and you do have to watch for volatility. That's where an active manager, I think can really add value and in the passive strategies are not advisable in that lower for longer environment or what we've seen so far this year. So it's yeah, that we've moved, we're still are technically in a low rate environment when you take the long view the decades long view. But rates have come up very significantly and money's not free anymore and it's going to be harder to eke out gains in the bond market against a backdrop of likely continued volatility.

James: Yeah. You've alluded to it in that answer there. But what headwinds will the fixed income investor face as this year closes out? And then obviously we move into next year? And in addition, does the core plus strategy have fortifications in place to handle these challenges?

Andrew: Yeah, I think all the biggest uncertainty are headwind facing fixed income investors is a overcoming the shock of what they just endured in the course of this year. I don't think anybody really would have bought bonds or a bond fund with the expectation of an 11 or 12% downturn over the course of the year. So there's been a lot of shock that people have had to process and some have retreated to the refuge of GICs and the perceived safety of GICs, which the principal is safe. But if you're getting 5% on a GIC and inflation is running at seven, you're getting a negative real return and that's damaging purchasing power. If you do that long enough, it makes it very hard to keep retirement incomes going and pension payments and so on and so forth. So yeah, that that headwind I think is around the uncertainty of rate policy and and inflation. But it's really it's kind of new ground for a lot of investors who aren't accustomed to these kind of downturns. Now, having said that, James, it's fair to say that in calendar 19 and calendar 20, some of those same investors were enjoying unusually high total returns in the bond market. We're talking, you know, six, seven, 8% in what was then still a lower for longer interest rate environment. Most of those calendar year gains in 19 and 20 were from price appreciation and not necessarily from a contribution to coupon or yield in a low rate environment. So if you have a total return expectation of bonds, Canadian bonds for longer term of, say, 4%, then you know, if you were getting eight and nine, you were kind of borrowing performance from the future there for a while. And and the market has claimed a good portion of that back here this year. That's kind of a facile way of looking at it. But context is really important. So headwinds, yeah, the uncertainty around rate policy and inflation, I think is still on top of people's minds. And there is potential for more price volatility in bonds because there are there's policy and then there's market forces and it's a market like any other market. If more sellers and buyers come come to market that day, then you get downward moving prices. We try to look at volatility opportunistically to take advantage of it, but it frightens a lot of other people away and the perceived safety of cash.

James: Interesting. Let's hone in a bit on corporate earnings, Andrew. You know, they've weakened. Yeah. So what does that do for your outlook on the corporate bond market in Canada, in the US? And what does that mean for your core plus strategy as well?

Andrew: Well, on the on the positive side, there's been slightly lower issuance this year as corporates were issuing a lot in calendar 20 with the onset of the pandemic. And then I think we I think we're at about 97 billion in issuance overall in Canada to the end of November, which is lower than I think 112 this time last year. So there's less issuance and if there's less paper out there and still a good amount of demand, then that can support prices in a broad sense. But you're right, James, corporate margins are under pressure. We've gone from a year where there's been multiple compression on the on the equities, and I think that's going to turn into margin compression. And a lot of corporations, people sometimes remember corporate issuers are trying to execute on their business models in an inflationary environment, and they're facing higher input costs and raw materials costs, of course, and labor costs which have gone higher, especially among the lower skilled segment of the workforce. So these are things that corporate managers are going to have to contemplate. And it leads us to my comment earlier about being very selective, about about individual issuer risk. And there are some companies that are set up to navigate through periods of recession with more durable cash flows and resiliency and consumer staples names and pipelines, utilities, those sorts of things typically have a resilience. We don't say recession proof anymore. We say recession, recession resistant or recession resilient. Key words there. And that's been what's driving some of the thinking. What I said before about we've been sort of reducing corporate exposure and really being selective about quality and and getting the numbers right so that we've got the right kinds of corporate paper in our portfolio. When we look at high yield, for example, in the US, most of our tendency there is as much as we've been upgrading credit quality in Canada, we've when we when we look at high yield, we're really at the high end of that double B bucket, like just on the verge of being converted or rated back upward into investment grade. You know, companies like Ford or Occidental or others like that would be sort of in that range. So even when we're playing in the in the high yield space, we're really trying to focus on the uppermost of the quality that we can find because that's one of the things that can help you in a period of strain or stress in the bond market, especially among  corporates is that credit quality? It's very key for us at the moment.

James: Yeah. Okay. Some great insight there, Andrew. Now, I want to move on to the question that I'm sure you've never been asked before, but with what the markets are telling us right now, are we heading into a full blown recession? Andrew, is this the R question?

Andrew: The R. Question. Well, I guess the short answer is yes. When we look at all the indicators, they seem to be pointing that way. Consumer spending and sentiment and all those sorts of things that we can that we can look at. But the inverted yield curve is is often the most significant indicator of recession. And the yield curve and on both sides of the border is not just slightly inverted or modestly inverted, it's very significantly inverted, which portends a potential for deeper recession potentially. Now, in Canada, we have significantly more exposure at the consumer level than our American counterparts in residential real estate. And the higher interest rate structures are starting to cause problems for people, for example, with variable rate mortgages. And we're not calling for a kind of subprime meltdown or lots of foreclosures or anything like that. But if you've got a half million dollar variable rate mortgage at the moment and your monthly payment, for example, went up by 700 bucks a month with these trigger rate letters, then if my math is right, that's almost $9,000 for an after tax dollars for a Canadian family. And I don't know how many Canadian households there are that have a spare nine large lying around unused, and that now has to be put to a higher mortgage payment for nothing in return. And if they do have that money lying around, it was probably earmarked for a new pool or kitchen or some other type of big spend. And that won't be happening now. So as the consumer spending starts to falter, then the economic slowdown starts to come in in these companies that are facing margin compression and they've over inventoried and they've over hired are going to have to start liquidating inventory at lower prices and potentially start laying people off. And that can have a compounding effect on on an economic slowdown or a recession. So having said all that, though, James, I think the the recession that we anticipate here is has never been more anticipated nor more welcome in Canadian capital market history. I think that this is something that everybody sort of sees on the horizon, and our view is less sanguine, I think, certainly than our central bank and perhaps many of our peers, because we do envision that there is a potential for a deeper and longer recession. The silver lining of that here in Canada is that it should prompt a more forceful policy response in terms of rate cuts. And that's an encouraging thought. If you're a bond investor, if we go back through the times where we had, you know, rate hikes in 1994, six of them from the Bank of Canada, 1995, they started to cut rates in 95 was a great year for bond investors. The same rang true in 99 with the inflationary effects of the technology boom and then the next year the rates got cut again. In 2000 was a great year for bond investors. The difference this time around is we're looking at two years back to back now. Well, likely by the end of this year of negative total returns. And I can only draw from that that at some point in the next year or beyond that, there will be some kind of policy response made more forceful here in Canada for the reasons I mentioned. And that can set up for a very nice set of returns in the bond market. That's just investors need to be patient through the current period of uncertainty and volatility. So that's the basic view on on recession is and it may not surprise you, but I think where we may differ from others is that we are trying to be more realistic. We're not calling for a shallow or a short recession. The consumer is going to likely endure some pain as we go through the rest of calendar 23 before we see rate cuts start to happen.

James: Yeah, interesting that's a great answer, Andrew. Illuminating there on what might lie ahead, whether or not a recession. And so I guess maybe the question there is the severity of it how severe it's going to be. How do you think investors should navigate this volatile market with with uncertainties driven by multiple factors? You mentioned the slowing growth. There's geopolitical issues, the war in Ukraine, for example, lockdowns and lockdown protests in China. How should investors sort of approach that?

Andrew: Yeah, well, that's a list of reasons that investors have to be to be nervous, you know, with slowing growth and investors are not feeling as flush as they once were perhaps. And when the consumer is starting to feel the pinch, that sort of runs through into their views on on investing as well, especially after what they've just endured. I mean, we have been in terms of what an investor can do to navigate this volatile market. The bond investors had to do two things that they've never really had to do before, at least in this generation. One is to consider tax loss, selling their bonds or their bond fund, getting selling their security, and then buying it back 31 days later to maintain the exposure. The trick, of course, there is that when you go to cash, you've got to come back from cash. There's a tendency to want to stay in cash and and out of fear. But then you don't get any upside if and as and when the bond market recovers in years to come. But tax loss selling in bond funds is now part of the experience of a of a bond investor. And the other is is dollar cost averaging. I think investors who had been trained we've all been trained to dollar cost average equities and take advantage of the volatility and the price swings with a monthly purchase amount or a quarterly staggering of investment or even weekly regular purchases if you can. The more volatile the underlying, the more frequent you want the purchases to be to capture that volatility. And certainly in the equity market that's been a triumph of the dollar cost averaging is when you look at how the TSX has performed. But I think in in looking at bond funds, there's nothing wrong with an investor who has $1,000,000 just doing a quarter million today, three months from now, put it layering in another quarter million, three months from then and so on for the course of the year, because 23 is likely to be another year where there's pockets of volatility, there's more coupon available. So that's helpful. It supports the total return. Yields are better. I think the yield average yield on a corporate saw recently was something like 5.2, 5.3. So that's pretty good support for a total return. But there are likely to be periods of volatility and for some of the reasons you mentioned about China and the Russia-Ukraine war, the market is very announcement driven, nervous and jittery and is subject to periods of volatility. And our approach is as active managers in terms of how the core plus strategy plays a role in that is we try to be opportunistic around volatility, we try to take advantage of it and approach it with a clinical and professional sense and try to keep the emotions out of it, because that is what a professional investor of course is supposed to do. So we will be opportunistic is the best word I think I can use to describe our approach to calendar 23 and what it may have in store for us, because we do expect a few more twists and turns in the road ahead. Whatever form those take, we will be prepared to take advantage of them. 

James: It's a final question then Andrew. Thanks so much for those insights as well. You know, our audience, our listeners, our advisors. I wondered if you had sort of a final thought for advisors in terms of how they should approach the fixed income market as we head for the turn of the year and how they can how they can serve their clients best? 

Andrew: Well, the first thing that comes to mind, James, is that on this side of the proverbial table when we're working with advisors and trying to provide them with updates and support is I always remind my colleagues at Franklin that we need to have empathy for advisors. Advisors are on the front lines and they didn't anticipate an 11 or 12% downturn in the bond funds they're using or even if they're using bond ladders. So it's very important that we provide support and regular updates so that they can have productive conversations with their clients, ideally to have them remain invested for the fuller cycle. We do anticipate a time in the future when bond prices should perform very nicely. And the real risk is that if somebody sold their bonds or their bond fund today and locked in that 11% loss, went to a GIC and they're getting a -2% real return after inflation. And they've locked that money up for, I don't know how many years. And then if there's a significant recovery in the bond market, which will probably happen faster than people think because bond market anticipates, it's not like you get through the end of a recession and then the rate cuts happen and then the bond market takes off the bond market like we saw last year in anticipation of of rate hikes from the Fed and the Bank of Canada started to lose ground. I think the bond market starts to anticipate that early and if people are sitting in GICs, they could they could miss out on some of the early signs of recovery in the bond market. And that's something that I think would be very hard to explain to an investor if we locked in the loss. We got into a GIC. We're losing purchasing power and then the bond market recovers and we're not there. That's a that's a much tougher conversation to have. But the empathy that we have is right now facing clients who are saying, put me in a GIC or I'm moving elsewhere. And that's really difficult for advisors. And we have to acknowledge that and we have to support them on that. 

James: Andrew It's been great chatting to really enjoyed our time together. Thanks so much for joining us on WP Talk.

Andrew: Thank you very much James.

James: Thank you for joining us for this episode of WP talk and a huge thank you to. Andrew for sharing his insights. For more WP talk episodes, go to wealthprofessional.ca click on the resources tab and select WP Talk. The site also includes all the latest news and views from the industry. And if you haven't already, feel free to sign up to our daily newsletter. I'm James Burton. Until next time.

Narrator: To learn more about Franklin Bissett's core plus bond strategy. Visit franklintempleton.ca/coreplus, see how fund managers combine Canadian core bonds with non-core fixed income opportunities to seek superior risk adjusted returns and a consistent income stream. That's franklintempleton.ca/coreplus.