Episode 95: Investing, happily, ever after—is your portfolio set for a fairytale ending? (part 1)

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Kevin Headland:

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Macan Nia:

How would you describe that type of person? A type of person that buys a fable book for his son and then sees a list at the end and decides he has to have all of them? What type of person is that, Kev?

Kevin Headland:

I'd say a little bit of OCD, a little bit of competitiveness. It was a fun little game for me to try and find them all. They were also really good priced too, so I'm maybe a little frugal. Cost-effective?

Macan Nia:

Yeah. That's hilarious.

Kevin Headland:

Once upon time. Living happily ever after. Those are terms we associate with fairy tales. When we think of fairy tales, we think of them as stories for children that warn them of risks and teach them how to navigate the world. But investors can learn from these fables, too. From how to protect their investments during difficult times, to how to take advantage of opportunities when it makes sense. Fairy tales tend to end happily ever after and we believe this should be the same for investments. Let's look at today's investment landscape through an age-old lens. Listen on, this is Investments Unplugged.

Welcome back to Investments Unplugged. As always, I'm your co-host, Kevin Headland, Co-Chief Investment Strategist at Manulife Investment Management and with me is my other co-chief, Macan Nia. Welcome back, Macan.

Macan Nia:

Hey Kev, how's it going?

Kevin Headland:

It's going well, thanks. How are you doing?

Macan Nia:

Yeah, not too bad. For the first time I think in a decade, it was a good long weekend in terms of weather. That was a week ago, right. I think it was the first time I've ever seen good weather on the long weekend.

Kevin Headland:

It was really nice weather for me, too. It's been a while since it was that nice. So it was quite well-welcomed, shall we say, but hopefully that's what nice weather will continue. Now let's get right into this. We talked in the opening about talking about the landscape of investments through the lens of fairy tales. Now we selected four fairy tales to talk about our views on the economy, equities, fixed income, and what the Federal Reserve is going to be doing. And in this episode, call it episode one or episode A or part one of two, we're going to cover the first two: the economy and the equity markets.

So let's jump right in with the economy. The economy, the fairy tale we've chosen is Goldilocks and the Three Bears. Now many of you are familiar with Goldilocks and the Three Bears. Of course, this young girl gets lost in the woods, comes across a empty cabin and proceeds to go in and try the porridge. Finds some hot, some cold, and one just right. Tries the chairs out. Finds one's too hard, too soft, and one just right. And eventually, takes a nap in a bed she finds just perfect after trying two others that are hard and too soft.

Now, why this fairy tale for the economy? It's because the term often used in our industry is describing the economy as the Goldilocks economy. Not too hot, not too cold, just right. And right now, there's a lot of media attention to this narrative. For the US economy, it seems like it's just chugging along. Inflation is starting to slow, but the economy remains resilient and is going quite well. Now one of the things that we like to say also is that Goldilocks, of course, was a fairy tale and perhaps the notion of a Goldilocks economy is a fairy tale as well and eventually it comes to an end.

Now, one of the things we look at, of course, is the leading indicators for the economy and when we look at our slide of 15 indicators, we assign them whether they're leading, coincident, or lagging, as well as whether they are high-risk of recession, medium-risk of recession, or low-risk of recession, it's quite a hodgepodge, it's quite a mixed message, and I think that's why perhaps we're seeing this narrative of a just perfect, quote unquote, economy.

But we're starting to see these cracks in that economy, and one of those cracks that we think we're seeing is in the lagging column and that is the unemployment rate. Now, the unemployment rate in the US remains below 4% at 3.9%. This is being recorded on May 27th and we're getting the non-foreign payrolls soon for the month of May, and we'll see what happens there. But one of the reasons we say there's cracks is we look at the Sam rule. And the Sam rule is created or was created by Claudia Sam, a well-known economist, and what she said is when you see the three-month moving average for the US unemployment rate move 50 basis points or 0.5% from the most recent 12-month low of that same three-month moving average, that tends to signal a beginning of recession.

Right now we are at the 0.37 or 37 base points from the bottom, so we're not there at the 50 base point level yet, but we're getting close to it. And this is why we're starting to see not just about the number of the unemployment rate, but perhaps the direction and see whether we are getting a weaker economic environment than perhaps this perfect notion of a Goldilocks economy.

Macan Nia:

Yeah, Kevin, I think this is the narrative when it comes to the US economies. I think it was earlier today or maybe it was yesterday, but because the US economy is beginning to show cracks, you're seeing a rising share of... In the corporate bond market for example, there's basically reading agencies in terms of their downgrades are now exceeding their upgrades for the first time since the end of 2021. So these credit rating agencies can put any of these issuers on negative watch or negative outlook, basically meaning that they're more likely to be downgraded or they call them fallen angels, and that stood at, I think roughly 6% last week and that was almost, I think, 3% at the beginning of the year.

These are still relatively small numbers, Kev, so nothing alarming or close to that, but it's starting to... It's just another, it's a sign that the US economy is beginning to slow and there's some vulnerabilities that when they're not priced in, because everyone's expecting a soft landing, might create volatility moving forward. So I thought that was interesting that we're starting to see beginning of downgrades versus upgrades for the first time in a couple of years.

Kevin Headland:

Yeah, and it's really interesting as well, because you see it from the corporate level, but also you can also see it from the consumer level, and we're not quite seeing it fully in some of the retail sales data or again maybe some absolute employment numbers. But actually, the Federal Reserve Bank of New York came out with their economic well-being of US households for May of 2024. And right now, the overall financial well-being, 72% of adults doing at least okay financially was similar to the 73% in 2022, yet remained well below the recent high of 78% in 2021. So we're actually now at levels that we saw in April 2020 and actually lower than 2017.

So the important part also is you've seen this kind of change where things were improving, people felt better financially, especially coming out of COVID, some of the support mechanisms, the pent-up savings rates. Now you're starting to see that kind of come off the table and we're starting to see some of the impacts of perhaps this weaker economic data that we believe we're going to see filter through to some of the actual data. So it's kind of confirming that perhaps, again, seeing this Goldilocks economy and it's great and it's okay now. However, what's it going to be like six months from now? What about even a year from now? Can we see, where are the balance of risk, as we like to say, of the economy? Are we seeing improving economic data or are we actually seeing a decelerating economy? And we believe it's the latter.

Macan Nia:

Yeah and when we talk, Kev, with our broader macro team, there's that notion that the US consumer has been resilient, and they have been. But what's beginning to develop when we talk with the team is there's a disparity between consumers. So the higher class or the upper class, they continue to do well. They've really benefited from higher rates, they have all that disposable income, they're getting five plus percent on it. Whereas you're seeing in lower class and middle class that they're struggling a little bit more because they have a less margin of safety or buffer for the rising cost of living, whether it's food inflation, go through the list. So that's the US, is not too hot, not too cold, but we believe the balance of risks are if you leave your pudding or porridge out, that it's going to get colder.

And we think the balance of risk in the US situation is to the downside and some might argue the rest of the world is already, their porridge is already cooling. So here at home in Canada, a lot of the data suggests that Canada's ahead in terms of the end of the business cycle. You had retail sales numbers come out last week, they were pretty bad. I have a friend, anecdote, and I always love anecdotal evidence. I'm not going to go talk about the name, but they sell supplements. And he says, and typically he says his businesses somewhat recession-proof, right? Generally the individuals that consume at these places, they're recession-proof. And he's noticed a slowdown anecdotally, and I thought that was interesting.

You look at the rest of the world, Europe has been in a technical recession for several quarters. The data came out I think a couple of weeks ago, Kev, and it showed that they had growth of 0.3% in the first quarter versus the previous quarter and that was the first significant growth in six quarters. So yeah, it seems like they're coming out of the bottom, but again, not too hot, not too cold. It's not like they're operating gangbusters and the rest of Europe is slowing, Japan is slowing. So when you look at all these porridges across the world, they're generally already cooling and some that are a little bit late to the game like the US appears to show that there's cracks in the system.

Kevin Headland:

Macan, I think I'm going to get you to submit a list of terminology you want to use in these podcasts and I have to scratch them out for you and be your conscience first before you go ahead and just say them on a live podcast, but anyway.

Macan Nia:

Do I call them jugheads or just bodybuilders?

Kevin Headland:

No. People who go to the gym and work out and use vitamins and supplements, that's all. Anyway, going back to Canada, the Bank of Canada released, of course, the Financial Stability Report, and it was interesting to look at some of the data there.

Macan Nia:

Kev, describe what that is, because we always see the survey and what is the Financial Stability Survey?

Kevin Headland:

It's essentially what it is, the Bank of Canada creates a report about the stability of the financial system in Canada and looks at some of the weakness, of course, across the board, but mostly on the consumer level was something we're paying attention to right now. And one of the things they looked at is actually they looked at delinquencies on consumer debt, and what they do is they carve it amongst different cohorts. And what is interesting is they carve it right now amongst people with mortgages and those developed and actually look at credit card versus auto loans and mortgages. So revolving credit versus non-revolving credit.

And we've noticed is actually credit card delinquencies have increased. We're actually near the 2019, '20 slash peak and the move has been much higher since of course the bottom in mid-2021, call it. And the interesting is the move higher, the most delinquencies are those without a mortgage. So it's kind of interesting, and of course those who have mortgage are more likely renters, which also could be ascribed by the income levels, perhaps. But that's one way to look at it. But what's interesting to see is everyone or many people seem to point to the weakness in the Canadian economy due to higher interest costs on mortgages. But that's just one piece of it. There are other issues, perhaps, that are impacting the overall general economy that has nothing to do with mortgages or higher interest costs. As you said, it's the increased food prices and that perhaps wage growth has not kept up with the cost of necessities. So something to pay attention to. Of course, mortgages are coming due even over the next couple of years. If you have a variable rate mortgage that is coming to renewal in less than two years, of course you got it in early COVIDD period, that's going to be a material impact to the overall interest rates.

And again, one of the things I notice when I'm on the road speaking to financial advisors, again, there's a lot of belief that, "Oh, everything's fine. It's okay now." But what happens as you increase your mortgage? What happens to the propensity or the availability to consume and continue to grow your consumption, as the economy is a growth metric? You need to be able to grow your consumption patterns. And how can you continue to grow that consumption, especially in a discretionary perspective, if you're paying more for your needs, including higher interest costs for mortgages. So it's something to definitely watch out for. Nowhere near do we think it's going to be a deep recession, but just the balance of risks, we think that Goldilocks narrative of the economy, perhaps both US and Canada, is closer perhaps to an end than a beginning.

Macan Nia:

Yeah, it's interesting to think about that the Bank of Canada will likely be in an easing cycle by the time summer comes, but there'll still be restrictive policy being grandfathered in as people renew their mortgages that haven't done so in the past couple of years.

Kevin Headland:

For those that are interested, it's simple. Just Google Bank of Canada Financial Stability Report 2024. It's some great charts and some great data in there. So for those that are interested, I would recommend checking it out.

Macan Nia:

What percent of people do you think that download this will actually do that, Kev?

Kevin Headland:

Ever since I've looked into it, I thought it was really interesting. Maybe I'm just a big nerd.

Macan Nia:

Yeah, clearly.

Kevin Headland:

Which is what [inaudible 00:14:48] think, but anyway.

Macan Nia:

Well, I'm glad you take that part of the research, Kev, and save me from that agony. So let's transition, Kev, to the equity aspect of happily ever after. And we thought that the fable the Ant and the Grasshopper was a really good analogy or fable for an analogy to equity markets today. We've been presenting this for, I think we're close to a month now, right Kev, on the road and there's a couple of the fables that we have to remind or reintroduce to our readers, and this seems to be one of them, the Ant and the Grasshopper.

Basically, it's a classic fable. It contrasts diligent preparation of an ant for winter with the carefree attitude of a grasshopper. The ant spends the summer gathering food while the grasshopper sings and plays. Winter comes, the ant is prepared, but the grasshopper suffers due lack of food. And the story essentially is teaching the importance of hard work and foresight.

And we thought there were similarities between this fable and the current backdrop for equity investing. So we believe we're getting towards the end of an economic cycle. Global growth is likely to disappoint moving forward, and we draw comparisons between the winter in the fable and an economic slowdown in investing. At this point, like the ant, we have to work harder to prepare moving forward. And the reason investors or PNs have to work harder is moving forward, there's likely to be a disparity in company earnings.

So in our view, cyclical companies will continue to do, will do better. And we always get the question, we say, okay, investors that focus on quality factors at this point are likely to benefit. And people ask, "Okay, well what's quality?" So a couple of the factors we look at is ROIC, high return on invested capital, higher ROE, strong recurring cash flows, stable margins. And we think these companies are more likely to continue to beat on earnings. And in the past, in the most recent quarter, those companies that have beat on earnings, investors have rewarded them. And we'll talk about some of the tech names in a bit, Kev.

And another reason that we think we have to work harder moving forward is we've had a great past couple of years, Kev, in performance, and as a result, valuations are not as attractive. In many parts of the world, valuation on equity indices are near or above their long-term historical averages. Now, that doesn't mean there's not attractive opportunities out there, but we just have to work harder to uncover them today given where we are.

Kevin Headland:

I always love that working harder, because I think when I think about our portfolio managers, when valuations are really low, it's kind of that, I don't want to say easy, but markets move higher and a lot of it's not valuation. We saw that for pretty much the entire year last year. All the return was due to valuation. This year, again, much of the return is due to valuation, the bumpiness is due to the fact that valuation, as you said, is elevated, call it fair to full, on a general basis. But I think the key here is that when we work harder, we're trying to find opportunities. I don't want to say the easy money's been made, but really that active portfolio manager is working harder to find the opportunities.

And I think that's really aligns itself well with the notion of the ant. It's funny, you talk about this story about how not many people know the Ant and the Grasshopper and I tell a bit of a story about why or how I discovered it or how I reminded myself of it is when my son was younger, he's 11 now, almost 12, we came across some books in Dollarama to read to him at night and they're all the different fairy tales. And at the end of one of the stories, they had a list of all the available books of fairy tales they had available. So the type of person I am, I scoured all the Dollaramas in my neighborhood to try and find the entire collection.

Macan Nia:

How would you describe that type of person? A type of person that buys a fable for a book for his son and then sees a list at the end and decides he has to have all of them. What type of person is that, Kev.

Kevin Headland:

A little bit of OCD, a little bit of competitiveness. It was a fun little game for me to try and find them all. They were also really good priced, too, so I'm maybe a little frugal, cost-effective.

Macan Nia:

That's hilarious.

Kevin Headland:

But yeah, I came across some great fairy tales and some that are lesser known, but I thought this one worked really well because it really does talk about the hard-working ants and the notion that you need to work harder to find opportunities.

Macan Nia:

You would think when we look at the world today moving forward, quality, where's the opportunities when we look at international? Because one, I was looking at another thing today, so EM equities versus US equities from a relative valuation perspective, it's at a 50-year low. Minus one standard deviation. Last time it was at these levels was basically in 1970. It's now another question we get, is now the time for EM equities, international equities? I see you smirking. Why are you smirking?

Kevin Headland:

How many times have we said emerging markets, it's so cheap, we should buy it and price is only one aspect. And also I would question you and say that calculation, was it made on the S&P 500 market cap-weighted or equal-weighted?

Macan Nia:

Probably market cap-weighted, I'd have to guess.

Kevin Headland:

And that's one of the things I bring in a lot when I have discussed with advisors across Canada. And when we talk about these historical relative calculations, especially on price-earnings ratios, whether it's forward or trailing and saying, "Well, last time it was this, this happened. We're near those levels again." But the composition of the S&P 500 is so different today than it has been, I would argue, forever where roughly 30 plus percent, 30, 35% is technology. The top 10 names or top seven, Magnificent Seven, tend to be technology-like companies, growth companies. They tend to have higher price-earnings ratios anyways, because of growth companies, we have to take some of these historical data with a grain of salt, which I like to say. It's like, yes, it's important to analyze it, but let's also dig deep and look underneath the hood and just say not just the actual numbers.

Macan Nia:

And Kev, look no further than MSCI EM, right? China's composition of that, how much that has changed over even the past five years. At one point, early 40% of the entire index, and today I think it's been halved. So these indices change. They're breathing organisms, they're living organisms, they're an embodiment of their economies and economies adapt, they grow, companies fail. So it's constantly changing.

So to answer that, yeah, EM is very cheap relative to the US. We're always just very cautious in terms of a direct investment or a sleeve within an asset allocation to that part of the world. Get through the back door channels, hide it underneath these global companies. Because there's a lot of points to invest in that part of the world, but there's always points to invest in that part of the world. So we have found that doing it through the back channels, generally you can benefit from those dynamics, those positive dynamics, without really being exposed to the negative aspects of it.

Kevin Headland:

I think one of the aspects you're seeing also is this, on the asset allocation side, it used to be much more geographic allocation, right? You have your US allocation, your Canada allocation, your international or Europe allocation and your EM or Far East Asia allocation. And I think what you're noticing more and more, and you could argue perhaps we're in a deglobalization environment, but still, companies are still global in nature. And you don't have to, as you said, invest directly in those areas of the world to take advantage of some of the benefits that those areas of the world might be providing certain companies.

A global equity manager that's bringing hard to uncover the best opportunities wherever they may exist. And I think that's key right now. I mean, again, we're belaboring the point, but it just seems like a better opportunity. And the other thing is, I would say also, just to finish, my thought here is for advisors out there and for clients out there, it's to perhaps reset expectations. We don't think it's the time to hit the proverbial home runs and look to where the Blue Jays home run jacket that they just brought back recently despite the fact that you're still losing games. But the idea here is it's not time to try and swing for the fences. This is trying to play the Moneyball game, hit the singles and doubles and try and win over time and not just trying to swing for the fences.

Macan Nia:

Yeah, and interesting, so you were talking about those global companies. You look at the FTSE 100 in the UK, I think half that index, the revenues are driven from outside of the UK, so it just shows the nature of the global brands, the big names. And let's not talk about the Jays, because then I might just go off the left end or right end or both ends because they're extremely, extremely, extremely tough to watch.

But anyways, but I think when we look at the equities landscape today, like we were talking about in the global macro backdrop, we think we're getting towards the end of a cycle, when we bring that over to equities, that doesn't mean that there's not opportunities available in it, but you just have to work harder, like the ant. Uncover those opportunities given the earnings backdrop that is going to be end of a cycle, there are going to be winners and losers in that environment and backdrop. And with valuations, like we always say, valuation is a terrible predictor of one-year returns, but it's a very good predictor of medium-to-long-term. So valuations are, there's opportunities, but again, we have to work harder and we think very similar to the ant, investors willing to put in the work likely to benefit when that eventual winter or slowdown happens.

Kevin Headland:

And I think it's also important, as well, like the grasshopper. When everything looks great and it's nice and summer and warm, it's hard to see the winter or the slowdown or the choppy markets or weakness or however you want to describe it. It's hard to see that when things are so good, but I think it's important to make sure we take things into context and remember that all good things eventually come to an end. We don't know when. We think it's a great opportunity to invest, but invest intelligently and don't take too many unforeseen risks.

Perhaps that's a great way to end part one of our investing happily ever after, fairy tales of describing how we see the markets. I hope you enjoyed this type of thematic storylines for our viewers. Please stay tuned for part two where we're going to talk about fixed income and what we see with the Federal Reserve and the upcoming performance of markets when the Federal Reserve begins, ideally, their rate cut cycle.

So for once again, for Investors Unplugged, I am Kevin Headland and...

Macan Nia:

I'm Macan Nia.

Kevin Headland:

Thanks for listening. Take care.

Macan Nia:

Cheers.

Kevin Headland:

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