Hello and welcome to The Download. I'm your host, Dave Richardson. Always special when we have our old friend — actually, sorry, I'm not supposed to say it that way — our good friend, Sarah Riopelle, with us. Sarah is the queen of asset allocation, and we always like to check in with her on where she thinks we should have our portfolios positioned and the reasons why. Sarah, great to see you.

Thanks for having me. You can say old. It's okay. I'm not that sensitive.

No, you're also not that old. I'm old. You're not.

We do it a long time, so we can say old friend from an experience perspective.

I guess if you look at it from a friendship perspective, if you're friends for 25 years, that would make it an old friendship, I will say.

Exactly. Let's go with that.

Good long history of quality time. So, Sarah, just before we signed on, I said, how are you doing? And you said, you're living the dream. What are you doing? How's it working?

I don’t know. Spending all my time looking after client assets and traveling around to the offices to see the teams and then spending time at home enjoying the summer here in Toronto. So, there's lots going on.

Yeah, lots of heat there.

Yeah. With the humidity, we're 40 degrees this week, so not sure I'm enjoying that thoroughly, but it's better than snow and cold, right?

Or maybe 15 degrees in bright and sunny and beautiful here in Whistler. But you keep living your dream. I'll live mine. Let's get the asset mix. In some form or another, on every episode of this podcast for the last two and a half years, we’ve talked about inflation. It still is the big thing that's driving a lot of thinking around investing and thinking of central banks and governments. And what's the latest there? And is anything else emerging that's going to take over as a risk outside of inflation?

I'd like to be able to tell you we don't need to talk about inflation or central banks anymore, but they're for sure still the key topic of discussion. Inflation has been a bit more stubborn in recent months, but there's a variety of metrics continuing to indicate that it's moving in the right direction, which is good. What are some of those metrics? Increases in the money supply, used car prices, residential rates. These are all the things that drove the surge in inflation during the pandemic. And all of these are starting to cool quite significantly, as well as several other indicators which are pointing towards inflation becoming less of a story going forward. So we have growing confidence that these inflation pressures are likely to continue to subside, and that's going to mean that there's less of a need for this highly restrictive monetary policy that we've had in place for the last 12 plus months. Some central banks have already started to cut rates. We had the Bank of Canada go over the last couple of weeks. European Central Bank reduced their policy rates in the first week of June. Our current view is the Fed will begin their rate cutting cycle sometime in the fall. So far, the US economy has held up reasonably well. The jobs market still appears to be healthy. Our base case scenario was that the US economy will experience a soft landing and avoid recession, that inflation will continue to fall gradually toward that 2% target that's so important, and that central banks will start to deliver that modest easing that we talked about. But outside of inflation and central banks, there are a wide range of potential outcomes around our base case. The US election is top of mind. Geopolitical tensions continue to be something that we have to monitor very closely. Then some questions around Chinese economic growth as well. So while inflation central bank moves are key and top of mind, we are still monitoring a number of other risks around the outlook as well.

I'm going to get Eric Lascelles on in the not-too-distant future, maybe even the next week, to talk about China. I don't think we spent enough time talking about the Chinese economy — and the Indian economy for that matter — with Eric. But we'll get him on to go into a little bit more depth on that, because that's been a topic that we've touched on over the years of the podcast, but we probably haven't spent enough time on recently. Now, with all that, we've got central banks. Some have already started lowering rates. We're waiting on the Fed. The Swiss Central Bank, I believe — I was watching in the background as I was falling asleep last night — cut rates for a second time overnight. We've got the ECB cut. But those are the rates that are set by central banks. Longer end of the curve. We've already seen yields come down a bit, and they've been coming down a bit more recently. Does that change your outlook in any way, or is that what you expected to happen?

Well, bond yields, especially in the US, continue to be focused on what the central banks are doing. In the US, with what the Fed is doing. Will they shift from tighter to looser monetary conditions? And that means rate hikes versus rate cuts. That's going to have important implications on the bond market. The change in yields so far this year have happened as markets have adjusted to those changing expectations around the timing and the magnitude of rate cuts. Our view is that prospective returns for fixed income markets still remain pretty robust. The risk of substantially higher yields from here, we believe, is quite minimal as long as inflation continues to fall as we expect. This means that bond investors are likely going to keep their coupon and potentially benefit from some capital gains should yields decline from their current levels. So that would be especially true if the economy stumbles and prompts a bid for safe haven assets. So that's something that we're keeping an eye on as well. We expect fixed income markets to deliver mid to high single-digit gains over the next 12 months. And so that's a pretty good outlook for the fixed income market coming off of an outlook from several years ago where we were expecting negative returns out of the bond market for quite some time. This is a nice shift in prospective returns for the bond markets. One important point that I wanted to make — and I'm taking that from my perspective as managing asset allocation and managing multi-asset portfolios — is the role that we think the bonds can play in a multi-asset portfolio, given in our current outlook. Now that yields have moved to higher levels and we're not seeing that valuation risk that had existed prior to 2022, we believe that bonds are in a much better position to act as a dependable ballast in a multi-asset portfolio in the face of equity market volatility. And so that's one of the key reasons for holding a mixture of both stocks and bonds in a diversified portfolio. I think it's an important strategy for investors so that bonds can provide that balance and provide that more stable investment experience over time in the face of equity market volatility. And we're much more comfortable with the current scenario where bonds can step in and act as that ballast in the face of any potential equity market volatility.

Yeah. And let's go to stocks first, but I do want to circle back around that idea in terms of where you've been positioned, and that really plays into a lot of the reason why you're positioned the way you are because of the role that bonds can play in this current circumstance. But on the other side, we keep seeing stocks hit all-time highs seemingly every day, especially in the US and this group of technology stocks that just continues to power forward. Is this something that can continue? Do you expect it to continue? Can it continue on this pace?

Yeah. So stocks continue that march upward to record levels. As it's been the case for some time, the biggest gains, as you said, are highly concentrated in that small group of US mega technology stocks that are benefiting from those trends in artificial intelligence and machine learning. We call them the Mag Seven. I'm still calling them the Mag Seven. I know there's different terms for them because it became the Mag Eight at one point, and then it became the Mag Six at one point. Anyway, so let's go with the Magnificent Seven just for simplicity. They've delivered a return of about 25% since the beginning of the year, which has lifted the overall US market to a return of just over 10% over that the same period. If you look at the equal weighted S&P 500 — so that helps to understand what the average stock in the US market is doing — it’s only up about 5% so far this year. So when you take out the impact of those big technology stocks, the overall market is not doing as well as would otherwise be implied. The strong returns have pushed valuations for the overall market to pretty high levels, close to one standard deviation above our estimate of fair values. So valuations in the US market are quite robust and quite stretched. You've probably heard the term US exceptionalism. This references the fact that the US economy and the US market have been held up surprisingly well relative to many other markets around the world. When you look at those other equity markets, they've not enjoyed the same gains. And what that means is, in many cases, those markets are much more reasonably valued versus the US market. Our global composite of equity markets is situated right around fair value. When you carve out the US market and look everything else, we're actually about 15% below fair value. So lots of good value in markets outside of the US, with Europe, Canada, the UK, and emerging markets showing quite good value from a valuation perspective. So as a result, we believe that global equity markets could offer attractive returns should the economy and corporate profit growth remain positive, as we expect it will. So some valuation risk and concern around the US market, specifically, but a lot better value in markets outside of the US.

Yeah, and I think sometimes people get locked in on those major indices and seeing them at all-time highs and miss what you really need to be looking at. That's an indication of momentum, but then you need to look at valuation. In the US, particularly if we include those stocks that have been rallying, we have a relatively expensive market. But again, as you point out — and when I'm out talking to investors and we highlight some of the models that we have that show valuation — that stock markets are actually fairly attractively valued, even after the moves that we've seen. So you wrap it up and you have been sitting in, for a while now, what you'd call a neutral position. To keep it simple, if you had a balanced portfolio, you would be at the target level of stocks, target level of bonds, target level of cash. Sometimes you would be overweight stocks, sometimes you would be overweight bonds. But here you are, you're boom, right on that neutral weight. So again, going back to the discussion about bonds, why are we sitting there? Is there a reason behind it? And what is the next move that allows you to make a change?

So I think I've hopefully demonstrated over the last couple of minutes that there's a wide range of potential outcomes for the economy and markets. And we recognize that there's an improved outlook for bonds and the potential for stocks outside of the US to show good returns. But then there's also the fact that valuations within the US, or the large-cap US market, are quite demanding. You have to balance all of that against each other. You also have to remember that to move the asset mix, we have to sell something to buy something. It's a relative trade. It's not just like we like stocks, let's buy them. We have to actually fund that from somewhere. That means selling stocks to buy bonds or vice versa. We look at the prospective returns for these asset classes. They're all very close to each other. Taking a bet on one against the other is not necessarily the best option. While our view is that stocks still offer superior return potential to bonds over the long term, there is some near-term risk after the latest rally, especially in the US. One thing that we look at is a concept called the equity risk premium. The equity risk premium is the extra return that you can get over bonds when you invest in stocks. It's the compensation that you get for taking on the additional risk of owning stocks over bonds. Right now, the premium is effectively zero. You're effectively not really earning any extra return to take on the risk of equities. We're not ready to add to stocks at the expense of bonds just yet because you're not being paid that extra compensation for owning the risk of equities. We would consider increasing our exposure to stocks should the equity risk premium widen, or if we saw a broadening in the equity market rally beyond just those mega-cap technology stocks and those themes around artificial intelligence that we've talked about already. On the flip side, we aren't ready to sell stocks either to buy bonds because of the improving outlook for the economy and for earnings. That's reflected in our shift in probabilities of a recession. 12 months ago, we had a higher probability of recession. We now have a higher probability of a soft landing. And so that shifting view has led us to not be ready to sell stocks just yet either. So for all of these reasons, we're sitting on a neutral position in the asset mix for now. We are certainly always looking for opportunities to adjust the asset mix to take advantage of those opportunities on behalf of our clients. What would our next move be? Honestly, Dave, I don't have a crystal ball to give you a lens into whether or not would we be buying stocks from here? Would we be buying bonds from here? It's all going to depend on the opportunities as they present themselves.

Yeah, and it's an interesting case as we bounce out of the down cycle in COVID, then the bounce out, and then the fall back down combined with inflation and higher interest rates. And then where that leaves you. As you say, it leaves you in a position of a lot of uncertainty. And we talked with all the various guests about it. I mean, let's face it, there's always uncertainty. You never know exactly what's going to happen. But there are periods where there are more possible outcomes with much wider ranges. And so that neutral allows you — and you still got plenty of stocks — if things end up being a little bit better than you expected, well, your bonds are still okay and you get your benefit out of stocks. But in the event that something goes the other way, then your bonds are there to protect you on the stock side. So until you see a little bit more clarity on where we're going longer term, it just seems like the prudent call.

Right. And if you're going to earn mid-single digit returns from all three asset classes, then you have to be very careful about taking a bet on one over the other. And if there's a potential for higher returns at stocks, don't bet against stocks just yet in favor of bonds. Anyway, so as you said, a wide range of potential outcomes, so you’d prefer to sit at a neutral position and wait for an opportunity to present itself.

Well, a very comfortable position, being neutral, sitting on maybe a lovely chair on a patio in the beautiful Canadian summer. A relaxing position for an asset manager to be in.

There you go. That sounds like a nice way to spend my evening.

Well, there you go. Well, let's give you the summer off, Sarah. Thanks for checking in with us here on what was an early summer, by the way. And we'll catch up with you as we get into the September period when everyone comes back from their summer vacations and markets tend to pick up in activity levels.

Great. Thank you so much.