Hello, and welcome to The Download. I'm your host, Dave Richardson. This is a very, very special guest appearance that we have on today. You know what, Dagmara? We started at pretty much the same time together, and of course, my career has been not particularly successful. It's been a bust. We could talk about it but the listeners don't want to hear about that. And then you pretty much run everything now. Your career progression has just been phenomenal. What is everything you're responsible for now, Dagmara?

I even don't know how to start with you, Dave. You're fishing for compliments here. Okay, your career has been spectacular. And none of us has actually changed one bit in the 25 years or so that we've worked together.

That's right.

What I'm responsible for, you can think about it as all fixed-income products managed by GAM for the benefit of Canadian investors.

Wow, which is just incredible. If you think about the average investor in Canada, they would have a little bit more fixed income than equity—actually, a significant amount more fixed income than equity. So we talk a lot about stocks, but we really should talk a lot more about fixed income because of the importance that fixed income plays in people's portfolio.

Yeah. I can't blame investors over the last 20 years not focusing on fixed income so much, even though returns had been decent after the financial crisis, maybe, barring volatility of the past three or so years. But yields were low. Now, that has really changed. The environment has changed, and I think fixed income has become more interesting, earnings more of a rightful space in the portfolio because of recovering the income component. It's no longer just insurance and liquidity features that are attractive, but income component as well, especially when you look on income on a relative basis, valuations versus equities. There's a lot of features in fixed income that make it worthy of attention for portfolio construction.

Yeah. And stocks can be exciting and cryptocurrency, whatever the news fad is of every day. But fixed income is such an important part of the diversification that you need in your portfolio. As you say, where rates have moved, and we're going to get into this discussion, where yields are sitting right now, the income component, which for so many investors, particularly investors who listen to this podcast or investors like me who are veering towards retirement, that income component is really critical. And then before we go into what happened in 2024 and as we look forward to 2025, I think the other big thing for Canadian investors—and this does go back to the comment that we started working together 27 and a half years ago, 28 years ago—what a fixed-income portfolio looked for someone 28 years ago versus the fixed income portfolios that you're running today. I mean, it's night and day. It's a completely different world, right?

Absolutely. That's probably the reason why I'm still here, because I feel like I'm learning every day and every year. The fixed income world has changed dramatically in these 27 years. When state-of-the-art bond fund at that time would hold government bonds, perhaps sprinkling of provincial bonds, over the years, as the market has been evolving and developing, we have developed our capabilities and added full complement of specialists in credit, starting from investment grade through high yield, emerging markets, currencies, and more esoteric layers within these. So as a result, there is so much more a choice to build resilient income-producing portfolios for investors now than it was at the beginning of the century, let's say.

Yeah. And the other thing people need on this podcast, they need to see you as opposed to just hear you. So next time we'll get you on video because you also have evolved into having the best glasses of anyone that I've ever met. So the listeners aren't going to be able to see that, but we'll get to it next time. So Dagmara, as you look at 2024 and what happened through the year, was it what you expected? What was the year like from a fixed income investor perspective?

It's funny because if you looked at starting and ending point of 2024, you would say, oh, not much has happened, right? But it had been a very eventful year. It has been a decent year for bonds despite last quarter being negative, but the return for the bond fund in 2024 was 5%. Again, decent, not spectacular, very on point, because when we started 2024, yield on the bond fund was 4.4%. As you know, often in the long term, but not in any given year, yield is a good predictor of the return on your bond portfolio. It happened that it was very close this year, the yield at the beginning to actually experience, even though that journey, the path of travel through the year has been anything but steady. That applies also to higher intensity credit, within, for example, high-yield market. High-yield market delivered 7%. If you think about bond universe, delivering 5 to 7% is good, but not spectacular. But the divergence within that high-yield market has been huge. So-so returns on better portions of high-yield, double Bs and such. Triple Cs returned 18%. You had to actually reach towards much riskier credits in 2024 to get extraordinary returns. Whereas run-of-the-mill high yield, or even in emerging market, EM debt returned 6.5%. Higher quality EM, those that we would feel more comfortable with, between 1% and 2%, you had to go into countries with history of defaults to earn spectacular returns. Let me give you examples of such serial defaulters in 2024. Argentina, 103%. Ukraine, 63%, the country at war. Lebanon, 118%. Huge surprise, considering an ongoing conflict. Very uneven. You can't count on these to be repeated. At the broad diversified index level, nothing spectacular certainly can be considered surprising because equity returns were spectacular. People often think that if it was a great year for equities, it probably was a great year for high yield or emerging market debt. From that perspective, it was not. It was far from spectacular. It was coupon-type returns at the index level.

Although, from just those numbers you're saying, one of the things in equity markets was, if you wanted to maximize your return in equity markets over the past year, all you had to do is gobble up as much risk as you could take on. It sounds like the big winners in 2024 in fixed income as well, where if I take as much risk as possible: what country defaults regularly? I'll go there. That's where I get my returns.

Yes, unfortunately, that strategy doesn't work in the long term, or else it wouldn't be called the risky credit.

Correct. As we look to 2025, what are your expectations for what 2025 looks like? Is it going to be another good year for fixed-income investors?

For 2025, we expect a bit of boring. Boring or interesting path in 2024, but the return is decent. I think we expect coupon-type returns to make the story short for 2025. Let's start with where the yields are. We think that government yields are attractive. Why do I say that? Let's start from the components of government yields. Inflation has been coming down as expected. If you look at the beginning of '24, where the expectations were about where inflation will lead us towards the end of '24. What had been expected transpired. More important, even this morning, we had the release of US CPI, and the month-over-month number at the core level came surprisingly better at 0.2%. Market comes down. A little bit of a relief rally in yields and in equities. Importantly, that component that had been stubbornly high, options equivalent rent, started growing at a lesser pace. We have the best options equivalent reading since spring 2021 at 0.3%. That's encouraging. But even before, when we were somewhat waiting with baited breadth for the evidence of the following inflation, if you looked at longer term inflation expectations embedded in market prices, which are measured by something called five-year forward inflation expectations, they have been stable at 2.4% over the past four years. The episode of rising inflation and falling inflation, that tells me that the confidence in the Fed being able to follow through with their policy to achieve that 2% target inflation, that faith continues to be in the market. It has not been shaken. The market is pricing Fed successfully lowering inflation. The data is confirming that we're comfortable with this component. Now, when you assume that Fed inflation is coming down to 2%, real yields at 2.5% or so are historically very attractive. Real yields have moved up by 80 basis points since the first Fed cut in September 2024. Here I'm using, of course, the cornerstone of all pricing everywhere in fixed income, US 10-year treasury bonds. Real yields have moved up 80 basis points. Importantly, the market started paying attention to worrisome fiscal situation in US. And term premium, the compensation for uncertainty, often as a mental shortcut thought as compensation for fiscal uncertainty as well, term premium has gone up from negative 20 basis points at the beginning of '24 to positive 65. So it's that 80 basis points swing. Now okay, I'm compensated for the long-term inflation which is coming down on target. Real rates are historically attractive. Term premium has gone up. As a bond investor, I feel comfortable that government yields have moved high enough to make it appealing for us and likely to earn that coupon return in the upcoming year. Now, when we look at credit, it's a slightly different story. As you know, spreads are tight, valuations are expensive. The market, in many corners of credit is expecting the rosiest scenario possible. We're cautious there, and that's why this expectation of coupon-type return is with some bookends. On the one side, as you know, we do a lot of scenario analysis, right? We have to think, okay, what's the worst case for us. We listen to Eric Lascelles, we converse at risk meetings and weekly meetings with our fellow PMs in equity side as well, and we think, okay, worst case scenario from the economic perspective, a recession, even though the odds are low, we have to consider it. We would expect cuts from the Fed, maybe over 150 basis points over 12 months. Corporates would be hit. Depending on how much they are hit, their total return would be estimated between 7 and 10% over 12 months. That's the insurance part of the return distribution. Not high odds, but it's there. Then the scenario of Eric Lascelles, who recently has been referring to it as no landing. So 1995-96, no more cuts, more concerns about fiscal potentially, 10-year yields towards 5.5%. You have some capital loss offset by coupon and return around zero to 1%—let's say zero. That's the worst-case scenario from the returns perspective. These are the bookends with which we are looking at the portfolio returns, as I said, expecting something around a coupon-type 4 or 5 %.

Yeah. And that's your expectation once the Fed starts cutting. You look historically, once the Fed starts cutting and you go into a scenario where you don't have a recession, it is a coupon-rate of return 12-month period following that. If you have a recession, it's going to generate a little bit better returns. But if you don't have a recession, you get in around your coupon.

That's right. Boring is good in this case.

Yes. Well, I like boring. I think boring is sometimes underrated, especially when it comes to investing. Chugging along and getting a good solid coupon return when coupon is above 4%, that's not a bad life to be living in.

The market now is pricing the Fed cutting once by June. That's a change. At the beginning, yesterday, it was once by October. But as I said this morning, we had these better CPI numbers yesterday. Decent, very good, actually, PPI numbers. It's now one cut by June from the Fed and one and a half cuts by December. The Fed, of course, in the latest meeting in December, they assumed two cuts over 2025. The distance between the Fed and the market is not that far now. 14 out of 19 Fed members assumed two cuts, so that's an overwhelming majority. Interestingly, not one assumed a hike. In this case, I don't think it makes sense to be contrarian and say, nobody assumed hikes, so I assume hikes. I think this long-term stability of inflation expectations that I referred to earlier, the confidence in them being able to achieve that means to me that that's most likely a scenario that's right. I'm comfortable with these expectations. While Jay Powell in the following press conference said, we can't rule out a hike. You never can rule out the hike, right? There may something like a supply shock that would spike inflation. But the most likely scenario with high odds is that at most we have two cuts now in 2025. And until data changes that view, I think market pricing is right where it should be. No spectacular opportunities to fade it, but as we said, in terms of compensation for real rates and premium, it’s attractive.

That piece on inflation expectations, I use that in every presentation I do to investors, at least through this period. There was a long period where we didn't worry about inflation a whole lot at all. But since inflation has become a concern again, seeing what happens with inflation expectations and how inflation ultimately follows the path of inflation expectations, that it has stayed anchored post the blip. You had the big bounce after COVID. The fact that it came back down and settled and has not really moved since then does give you that confidence that we're ultimately headed in the right direction. Exactly when you get there, not 100% sure, but it gives you that confidence that you can look at the process we're going to follow around rates and the Fed and the Bank of Canada, etc. And from there, you can set out some base scenarios. And those scenarios last year were quite good. This year, a little more boring, but still good.

Yeah, yeah. Well, if we can avoid the excitement, that will be okay with me.

Okay with you. But there are some areas of the market that have some different types of opportunities, some plus, some minus. What are some of the other areas of the market that you're really looking at?

Well, as I mentioned earlier, we are a bit cautious about high yield, a bit cautious about emerging markets. You would have to reach towards these much less predictable areas of these universes for returns. As we always say, when we make an investment, especially in credit, we want to be compensated for the credit risk we're taking for the default probability. I always throw in: I want to be compensated for the risk of the unknown. In the 27 years, the unknowns do happen, and it's extremely difficult to forecast them. 2020, January comes to mind when for the same reasons, our allocation to high yield and EM had been extremely low, at a decade low, and we certainly didn't know that COVID or pandemic is coming. But that was the unknown. In this case, again, we believe that we are not compensated for the risk of the unknown in these higher-octane credits. But fortunately, within Canadian investment-grade universe, especially in shorter maturities, one to five years, we think the opportunity still is there. We felt this similarly at the beginning of 2024. If you remember, we were saying that in an expected environment in 2024, we didn't think that high yield has high odds of outperforming, and high yield returned 7%, and Canadian corporate investment rate returned 7% in 2024. It didn't disappoint, but it took significantly more risk. We think that Canadian investment grade, especially as I said, shorter maturities, it's not as good value as it was a year ago, but it's still decent. We continue to monitor consumer, corporate actions and accesses, the corporate health. We remain overweight in that sector, earning a little bit more than on government bet, about, let's say, 80 to 100 basis points more. And we feel comfortable with that positioning because historically, better opportunities arrive, driven by these unknown factors and that allows us to reload on riskier credits down the road, while in the meantime, we're happy with our expectations and holdings for 2025. There's a lot of unknowns, right? A lot of unknowns waiting for us this year.

No kidding. I think that the concept that I always talk to investors about when I talk about your philosophy in investing in fixed income, it makes so much sense to people the idea, just like in our day-to-day lives, I want to be compensated fairly for the risk that I'm taking. If there's a really hard job, and right now I'll get paid $20 an hour to do it, that doesn't seem like I'm being compensated fairly for that job. Now, I know at some point in the future, because other people are going to make that decision, they're going to pay me $50 an hour to do that same job. I would rather wait and take advantage of that $50 an hour and be compensated fairly for the work I'm doing. And this relates to that risk. When I'm taking more risk, I need to be paid for it because the chance that something unusual and leads to a negative return experience or a poor return experience is there. We need to recognize it. We've got to be rewarded for that. If it's not there, not there right now in some of the higher risk stuff, then I pass and wait for the opportunity because the opportunity will be there, right? That's the thing.

It always comes. You want asymmetric returns queued in your favor, not against you, right?

That's right. That's exactly right. So again, it just makes perfect sense. And so that's why it's that patience and that experience that you have and the team has over the years. Some new people in investing might go, oh, let's take that risk. We're okay with taking that risk. It's like, I'll wait because I know that at some point in the future that opportunity is going to be better, and that's when I'm going to take the opportunity there, not today when I'm not being rewarded for it.

That's exactly right. When I hear it's fair, I think like, fair doesn't get you extra returns. I'm just going to position myself cautiously here and be ready to invest at the time when it's, as I said, skewed asymmetrically in my favor.

So lots of risk out there. The geopolitical landscape. We have a new administration in the US. We've got a lot of new administrations all around the world with a lot of elections last year. We've got a few more elections coming, which could lead to some new administrations in other places, including Canada. Does that create any opportunities? Or again, is that one where you need to sit back and wait and see some of the big potential changes in policies that could occur before you want to wade out and extend yourself in any of those directions?

Unfortunately, I think that the uncertainty is only partially priced in the market. Let's just call it the two big unknowns. One had been obvious to us for the past six months or so, the new administration in the US, of course. Even though six months ago, we knew that the odds of that are higher, and two months ago, we knew that it's certainty the president-elect Trump who will take over. Until election day, in all analysis that I have seen, I have never seen anyone put Canada as one of the most exposed countries in terms of risk to the new administration. It was always the talk about friend-shoring, and we are on the right side of the neighbor in the south, so Canada is fine. You have to worry if you're China. Then soon after the election, we have this bombshell of an announcement of 25% tariffs on Canada and Mexico. From being a friend, we've become a foe, and a mooch and whatever else Canada is in the rhetoric coming from the new president. We have to, unfortunately, wait. Is it bluffing? Is it a negotiating tactic? You can't make that bet. I don't think it would be prudent to make that bet that we know what's going to come. Given this, we have to wait and see, try to neutralize the exposure where it might be explosive, where it's possible, because it's a very different scenario. Even if you have the 25% tariff's imposed for a month, it will cause huge dislocation in the market. Dislocation and volatility may bring opportunity. We'll assess that bet as it transpires, but we're not going to bet that we know what's going to happen. If anything, we make sure that our portfolio, again, using our scenario analysis, can stand with volatility and uncertainty and be in a position to take advantage of opportunities. That's the first big uncertainty. The second one, of course, is very new. California fires. L.A. fires. You and I have talked about L.A. and our affinity for it. I spent many, many Christmases there, and I've been extremely sad about what's happening there. L.A. has been hit. California is 14% of US economy. It's the size of UK economy. In the long term, people think about reconstruction and positive impact on growth. In the short term, you have dislocation, you have increased price pressures. Who knows what other consequences? But it's a disaster of such a scale that I think we have to also think about its impact on bond prices, on inflation, on growth in the shorter term, in the longer term. So these are the known unknowns. And of course, as always, we have unknown unknowns.

Yeah. Absolutely tragic. And yeah, I do often spend this time of year down in California. Now I've come to the Azores, which we're going to get you here, too, Dagmara. You'll learn to love this place as well. But when we talk about that and traveling and currency comes into play, and you also are leading the currency strategy at RBC Global Asset Management. The Canadian dollar has really been impacted by the election and a lot of the rhetoric post-election. So where do you see that coming into play?

Yeah, that certainly has had huge impact on currency market, on continued resilience of the dollar or strength of the dollar, actually. You think about cats having nine lives, this dollar bull market seems to have multiple lives, too. We've put our bearish US dollar outlook on pause after the November elections because of that overwhelming win of the Republicans, not only the office in the White House, but of course, both houses of Congress. The immediate impact on the market has been, of course, the expectation that the combination of policies, whether it is tariff, immigration, taxes, deregulation, will be inflationary. As a result, the market repriced interest rate expectations. Mid-September, there was more than 175 basis points of cuts priced into the US over the subsequent 12 months. Almost 2% of cuts from 5.50 to, let's say, 3.5%. Now we have, as I said earlier, one and a half cuts priced over the next 12 months. As the market priced out all these cuts in the US, that led to support the dollar. In terms of Canadian dollar, we had this very well-established range between 1.32 and 1.40. Canadian dollar was already on the border of extreme undervaluation, and the election results pushed it towards 1.40 or to 1.46. We're trading a 1.43 change today. Now the outlook looking forward is, again, one of these known unknown. How will the tariff story transpire? Because it will have impact on the trading partners of the US, Canada being a big one of those. If they are as bad as initial headlines suggest, that will lead to weakness of trading partners' currencies and strength of the US dollar. We have seen some analysis in terms of impact of tariff. If, let's say, 25% tariff were imposed on all Canadian exports immediately, that could lead to potentially as much as 10 to 15% of ever weakening of Canadian dollar. If this is an opening gambit and then it gets scaled back or if it's introduced gradually—again, this is not our forecast, but we have to analyze it to figure out how bad could it be, how much it would hurt—if it happened, this is an extraordinary opportunity to buy this really cheap Canadian dollar. But before you get there, you have to think about the pain that you're going to endure had it happened. Again, we can't make the bet here that we know how it will transpire. We also have the uncertainty of who's going to do the negotiation from the Canadian side. Canadian government is in a state of flux, and we have some potential candidates that are more skilled at it than others. From our perspective, that's why I said that we put this bearish US dollar outlook on hold because in the meantime, these events have supported US dollar. There is a small probability if the worst possible tariff scenarios were introduced and became a reality for strengthening the US dollar. But on the other hand, again, you look, okay, what is the options market pricing? The options market pricing in Canadian dollar is actually pricing lower volatility than historically, about 6 to 7% change over one year. That suggests the thing I mentioned about 2024. If you look at the beginning of 25 and the end of 25, you will look like not much has happened, but in the meantime, there was a lot of movement. That's one possibility. The other thing, of course, that we have recently learned is that Trump nominated Stephen Miran as the Chair of Council of Economic Advisors. One of his bodies of work in the economy is that tariffs may be actually good for US economy. That's one thing. There are some conditions there: for example, no reciprocal tariffs are implemented and the exporters lower their prices, absorbing it so the US citizens don't have to do it. But the other one, from the currency perspective, the other belief he is talking about is about the benefit of weaker US dollar and international intervention in currency market to weaken the dollar. Whether this is official intervention or policies that lead towards weakening of the currency, we need more details, more meat on that bone. But that had been the signal initially from his work. Since he is Trump's chosen chair of Council of Economic Advisors, we have to consider that as well. That strong currency is actually negative for US exporters, and the result of policy implemented is to be seen yet. Initially, it seems positive for the dollar, but I think that negative side is not appreciated by the market yet.

Yeah. What you see with currencies is they've got a natural way of reaching a new equilibrium. When you get out to extremes, forces come into play that start to pull the valuation back towards normal, not necessarily all the way back, but at least starting moving in a different direction. We're starting to get out to those extremes, right?

Because they move so much. When I started working in FX, I remember this salesman from one of the sell-side dealers, and he was joking: why do currencies move so much while they matter so little? But the reality is that currencies are the escape pressure valve. When you have these tariff implemented, it's not the wages, it's not the material costs that can adjust quickly. The currency is going to adjust to make these wages and the material costs more competitive. In their later course of action, then the business decisions come, taking advantage of the cheap currencies, capital moves and the factories can move, etc. But in the short term, it is the currency that will adjust because after all, this is the biggest, most liquid market in the world that's trading pretty much 24/7.

Well, Dagmara, that's a fascinating discussion. I'm going to wrap it up here. One of the reasons I'm going to wrap it up here is because for 2025, I've made a New Year's resolution. We're going to get you on the podcast more often. I hope you'll accept our invitations. So we're going to leave a couple of subjects still open for your next appearance, but a really interesting outlook on the year, although lots of interesting factors going on beneath the surface. Kind of boring in terms of how things actually play out. But that's good. Lots of entertainment out for us to watch in terms of news flow and different things happening. But in the end, pretty quiet within the fixed-income portfolio, which is a nice thing for so many people who rely on that fixed-income investment for insurance in their portfolio against equities and for income, which is why we buy fixed income. And we love buying your fixed income. Love having you on, Dagmara. Happy New Year and all the best to you and your family, and thanks for joining us.

Thank you very much. I'm looking forward to participating in more podcast this year with video and different glasses each time.

Oh, there you go. There's the teaser for people. Thanks, Dagmara. We'll see you soon.

All right. Thank you.