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RBC GAM’s Chief Investment Officer, Dan Chornous joins Dave for an in-depth conversation about the current economic and market trends facing investors today. Dan also shares his thoughts on inflation expectations, and provides insight into where investors can look to find opportunities around the world. [21 minutes, 04 seconds] (Recorded May 13, 2021)


Hello and welcome to The Download. I'm your host, Dave Richardson, and we have a really special guest today. We’d love to get him on more. If Eric Lascelles is the hardest working economist in Canada, the hardest working chief investment officer in Canada has to be the chief investment officer at RBC Global Asset Management, Dan Chornous, The Boss. Dan, how are you doing?

Thanks very much for having me, Dave.

You probably don't like the “Boss” reference because you're not much of a Springsteen guy. You're more Rolling Stones. Or do you like Springsteen too?

Big Boss fan as well. I’m just a rock and roll fan, but you're right about the Rolling Stones. If there was a list, that would be it.

Yes, and I know we could talk rock and roll for hours, but people come to this podcast to hear about investment matters. We've had lots of your team on over the last few weeks talking about what's going on in markets, what our overall view is. So it's great to have the top of the house on to give your view. It's always interesting [to get] your thoughts on where we're at. And when you're looking at markets, you look at everything that's going on around us. What are you thinking about these days Dan?

First I'm thinking a lot about it. You mentioned having my partners on your call over the last several weeks. I spent a lot of time with my partners. For 20 odd years now, four times a year, we've all met, all the senior investors, to discuss the outlook for the economy. We did that over the last two weeks. And so, it was a great time to hear the expressions of view. While our views are always evolving, I think our central tendency is still the same. We think that we're fairly early in an economic recovery. Interest rates are in the rise, but a lot of the acute risk that we saw for further rises has been dampened. Always room for a little higher yield, but much of the damage is already done. For the stock market, our concern has to do purely with valuations. Is the market a bit ahead of itself? Possibly. And we've been trimming our positions a bit as a result of that. But we don't think that ultimately the current cycle won't be validated by the very strong earnings that were coming through and that the market ultimately will have further to rise. So we continue to have overweights in equities, as we have for a very long time now.

Yes, as you say, taking a little bit off the table recently. It looks like it's been a fairly good call so far, just on valuations. So where are you seeing equity valuations in aggregate globally? Are there any particular pockets of concern that you're keying in on in terms of high valuations?

Well, it's a fascinating area to look at right now. If we look globally at our equilibrium models, if we aggregate the degree of over- or undervaluation, the world is about 17% above what we would consider fair value. So that's not outstandingly expensive, but it's a bit expensive. But it's mostly pocketed in the United States. Especially the United States, on trailing earnings, 30 times earnings. Canada, 25 times earnings. Emerging markets (EM), 25 times earnings. Europe and the United Kingdom and Asia, 20 times earnings. And you know, that 20 times earnings number is a very reasonable number when you have such low rates of inflation and strong growth in the future. So, it might be that the U.S. is a bit ahead of itself, but then the earnings that are coming through are much stronger than were expected. So, if it's a bit ahead of itself, that's one thing, but it's not a lot ahead of itself. We originally entered the year in 2022— which we're very soon going to be looking into for earnings— looking for 190, maybe 200. We see estimates now as high as 250 dollars for S&P earnings in 2022. And these numbers are still rising strongly. On a year-on-year basis, we're up something like 50% in the first quarter. And of course, these are hugely skewed numbers. We're going to get very strong nominal growth in GDP. We're going to know something like as much as 9% nominal GDP growth. Few of us have ever lived through 9% GDP growth. That's going to drive 10% margins on the S&P and result in something like somewhere between 25 and 30% earnings growth out over the next eighteen months. So, yes, the U.S. market is a little ahead of itself. It's the biggest market. It draws everything to make you look a little more expensive, which is not all that true. I think what the market is experiencing now is the old «buy on mystery, sell on history. Now that the earnings have been reported, it's explosive, it takes a rest. But I think there will be much more earnings coming forward in the future.

And just for people listening, the math on that 250 dollars of earnings for the S&P, if I put a 20 multiple on that, then I'm at 5000 for the S&P 500. Correct?

Exactly. And then, some might be uncomfortable with the 20 multiple. And I think they should grow comfortable with that, though. With time, when you have second low inflation and interest rates and a growing economy, and you don't have a lot of other choices to invest your assets and get more than a single-digit return, I think liquid equities will trade at a higher multiple than we've grown used to. So, in our math, the absolute neutral point, the fair value number for equities is close to 19 right now. Moving the multiple then up to 20 or 21, something like that, that's not that hard of a push. You add something like 200 to 250 in earnings, and that's why the market's been so strong.

Yes, and as you say, unprecedented growth in our lifetimes, really. I was in China a few years back and they were growing at 9% and I saw what that felt like. It makes things interesting, but it also raises the spectre of inflation. And you've heard a lot of that. Just in the general news, not just in the financial news, it's gotten out into the general public around rising prices. People are seeing it at the grocery store, when they go to buy lumber or things for their garden, for that matter. And so, we just saw an inflation report out of the U.S. that saw some pretty significant numbers. Particularly significant when this number was last this high back in 2008 or in 1981. Where do you think we are with respect to inflation? What's happening right now? Why do those numbers look so big and where do you think we’ll end up?

And it's another great and timely question. Eric Lascelles and his team have done some excellent work in this area. It’s very important to our view, because if we get inflation wrong, much of the rest of this is wrong. One of the reasons why valuations are so high is because inflation is expected to stay low. If that's not right, you're going to get a little more pricing power in corporations and maybe even a little more earnings growth. More importantly, the value of those earnings falls as your discount rate falls or rises. So we need to be very sure of our forecasts in this area. Yesterday's PPI numbers, yesterday’s CPIs were kind of a gut check for all of us. We expected that inflation would rise, perhaps not quite as much as it has, but almost as much as it has in the latest releases, partially because of base effects. The comparisons are just so low because after all, the economy has effectively shut a year ago. And then you have the supply side problems where commodity prices are rising. You mentioned lumber, for example. We've had this shut down in gas supply in the United States with the pipeline. There are some short-term and even intermediate longer-term pressures on resource pricing. There's a huge amount of liquidity in the economy that's being gradually unleashed. That's driving purchasing decisions. That will actually create shortage that also drives them. But then if you look at the slack that remains in the economy and some of the intermediate term factors are actually working the other way, and certainly longer-term factors are. You know, we're an aging population globally. Nominal GDP growth rates have been falling for many years. They're going to continue to fall. That itself is dampening on inflation. We pull all those things together. In the short term, inflation could rise for another couple of months, three months, perhaps. In intermediate and longer term, it will start to flatten out and move back towards or below 2% because the important longer-term forces are greater than those in the short term. What we need to watch though: is reported inflation inflation expectations? We all believe that central bankers have the ability to control inflation and do lot more about it now than they did when I was in university and we had the last big spike of uncontrolled inflation. As long as we can look to things like the TIPS market, the return bond market, see that surveys of inflation are still anchored around maybe 2.5%, where they are now, that's fine. People say this is transitory, but if people all believe that inflation is actually out of control, it'll show up in those market-based expectation numbers first. And it will become a problem. It's not there.

Yeah, I use the analogy— it's a little easier on video than it is on an audio podcast— my hair is really long. (You can see, the listeners can’t). And it's only long because of the pandemic and we're locked down. I can't go to a barber and get a haircut. But also, if you look at my hair, it's not even really that long. It's long compared to the way it normally is, which is pretty short. And that's kind of inflation. The minute things return back to normal and you get through the upset of the pandemic, my hair will just go back to where it was, the same. Unless I start to think about my hair differently and go, maybe long hair is the way things are going to be. And that's around expectations and inflation expectations. So, I can tell you, just to reassure everyone, I'm getting a haircut. So Dan, you won't have to worry about my professional look as part of the firm. But I think people have heard enough about my hair on this podcast.

I'm just glad you have a choice.

Yes, well, you know, Dan, there's a reason why we do audio here. So, Dan, are there any other parts of the world that you think are a particularly good opportunity for investors right now?

We've been rotating our exposure gradually away from US markets. We’re slightly underweight US markets. And we have good exposure in Canada; we've been benefiting from the recovery in resource prices and certainly recovery in the Canadian dollar, which is associated with that. Europe looks cheap to us. The United Kingdom looks cheap. Asia looks attractive. And even emerging markets, which have moved so strongly over the last twelve months, are still not overvalued, much closer to equilibrium than certainly the US market. All that said, again, we're not particularly concerned about the US market over the intermediate term, again a little ahead of itself. One of the things we see happening in that market spills to all other markets. We've seen a big transition of leadership. For the first part of this bull market, it was all ITs and companies that benefited from work from home. Other names have caught up. The gap in performance is no longer that large. It's fairly similar across the market, all of a sudden. The market is been led by value, not growth. That tends to be a precursor of a long economic cycle. All these things suggest good things in the future. But as you say, there are always better or worse values out there. And right now, we think that outside of the United States represents better value than within the United States.

And Dan, as fast as we've seen, out of the bottom of the pandemic last March, a real significant bounce back. I think we would admit that it surprised us how strongly markets have come back and the levels that we've got markets at which we talked about. Does that set us up as we continue to move through the cycle, that we may have seen the best of the cycle in terms of raw returns and that we should maybe temper our overall expectations down in the different asset classes for the future?

That's certainly true for every cycle and maybe especially for this cycle. As the market moves out of the very depressed low, there's a quick catch back where companies begin to reprice in the core level of earnings. And then as you advance into the next stage of the cycle, we realize that earnings will actually grow through the cycle, so stock prices are then driven not by PE expansion, which is looking forward, but by actual earnings growth. And typical earnings growth averages 6 or 7% a year for most markets. You move from explosive gains to more sustainable gains. And I think we're probably approaching the next leg of the market being much more like that. I think essentially you should look for something like low single digit returns in fixed income and mid-single digits, maybe high-single digit returns, out of equities on a go forward basis.

Yes, and very important, whenever I raise that point, when we talk about future returns being reduced, we're not necessarily saying negative or we're not being negative. We're saying that instead of getting as we've seen an 80% bounce back over the last twelve months, we're now talking about going into 5 to 7% kind of returns as you move forward in equity markets. Positive returns, but much more modest and as you say, driven by earnings as opposed to more optimism about the future.

And I think importantly, significantly higher returns as much as in the single-digit area in stocks, significantly above those that we'd expect out of bonds. And as a result of that, we've continued to run an overweight in equities and a mild underweight in bonds.

And Dan, something that we talked about, I think, the last time you were on: the strategic asset allocation move that you made last year looking forward for a balanced portfolio. For example, you took 5% out of what was in fixed income— your benchmark weighting at 5%— and moved it to equity. So, your equity weighting went up 5%; that's sort of your benchmark. And then, in the more tactical asset allocations, the short term, you've actually gone the other way. But overall, you really view the right structure for portfolios to be tilted more towards equity for the foreseeable future?

We read a fascinating paper across investment platform and shared it over the last four or five years. It was originally written by the Bank of England in 2016, and followed up by the Fed, on the real rate of interest around the world. It showed that over the prior 40 years— essentially since I entered the business— when you had a high real rate of interest, 6, 7, 8%; that’s after inflation interest rates in the United States and Europe. Independent of whether you're in a country with a strong central bank or a weak central bank, high inflation or low inflation, rising or falling democracy, democratic system or totalitarian system, your relative interest fell from about 6% to something like 0% or below, over the following 40 years. So all of that monetary explanations that were provided were essentially wrong because it happened everywhere. When they disaggregated the reasons— it's one of the most amazing economic articles I've ever read— it showed that of all the things that move the real rate of interest around, it is demographic related. So, as the developed world became wealthier, its family size fell, and as the emerging world emerged, the same thing happened. The nominal GDP growth therefore started to fall. Nominal GDP growth is highly associated with real rates of interest. So when you forecast these things— and these are really easy forecasts because demographics move slowly and we're well informed on them—, basically you might get back up to 0 or 1%, but you're not getting the 6% we came from. Real rates of interest are the base rate of return for asset prices. So, you add to that an inflation premium— maybe it's 2%— add to that a term premium to get to what a 10-year bond yield should be, about 3.5% bond yield. So we almost made 2% a few weeks ago. Where might we go over the cycle ahead? 2 to 3%, maybe not even. And so that's what you expect your rate of return would be on a bond over the future. Call it 3%, and then add a 300 or 350 basis point risk premium for stocks, and you're talking about 6.5 or 7% returns for stocks. So, think of this: a 60/40 balanced fund has earned you somewhere between 8 and 11%, whether you’re on a ten, twenty or thirty-year time horizon. We're carrying around in our mind, I’ll make 8% on my balanced fund. That's probably what we have in our savings estimates for our retirement plans. But you take 40% of a 3% return on bonds and 60% of a 7% or 6.5% return on stocks, you end up with 5% being your terminal return target, not 8 or 9%. So you need to shift things around. Number one, maybe you can extend your time horizon. Most of us actually can, in our long-term savings plans. Buy a little more equities. Count on time to get you back on side. It has always worked in the past. Move out of the sovereign bond market into credit. Within credit, maybe a little bit of high yield can help. We're not talking about replacing your government of Canada bonds with some Argentinian long bonds. We're saying that maybe there's room for a little more risk in that credit portfolio. Then there's this great white spot that exists between the former role of sovereign bonds— which was to provide you with cash flow and to attenuate risk in equities— and your equity portfolio, which is the adventure that gives you the higher returns. You need to find things to fill that space, things that mimic the prior role of sovereign bonds. We think private markets do that. We believe in adding real estate allocations too, which we've done in our own balance for portfolios. We think that some absolute return product that doesn't give out too much of the upside but buys you downside protection is quite useful in that area. We've been building out those areas of our portfolio as well. I think the key thing is, though, whether you do exactly or might be interested in what we did, you need to do something about focusing on what long-term returns are going to be and reflect that either in your expected savings programs or in what you're investing in to achieve the old goals.

Yes, and that's why I thought it was so important to get you on today and to run a little longer than we normally do, to make sure all the nuance around that point is clarified for people, because it really is the right time to be looking at something. As we're moving out of this pandemic, we're in a different world and there are things you can do to take control and position your portfolio for success in any kind of market. This is one, again, that you've got to pay a little bit attention to, as you've been doing at RBC Global Asset Management. So, Dan, thank you very much for your time, as always. It's always great to see you, even if it's just by video. Hopefully we'll be able to get you on again soon.

Well, we're all looking forward to getting back to our old lives, that's for sure, Dave. Take care of yourself and I hope everybody on the call is well. Bye Dave.



Recorded: May 13, 2021

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