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Mark Brisley
Managing Director and Head of Dynamic Funds

Myles Zyblock
Chief Investment Strategist

Mark Brisley: You're listening to On The Money with Dynamic Funds, the podcast series that delivers access, insights, and perspective from some of the industry's most respected active managers and thought leaders. From market commentaries and economic analysis to personal finance, investing and beyond, On the Money covers it all because when it comes to your money, we're on it.

Welcome to another edition of On The Money with Dynamic Funds. I'm your host, Mark Brisley. To kick off our 2023 podcast series, we continue with our now three-year tradition of having Myles Zyblock, our Chief Investment Strategist here at Dynamic Funds join us for his perspectives on the year past and the year ahead with respect to global markets, global economies and the influences on both.

Myles is highly regarded and followed for his investment insights that blend the tools of finance and psychology in order to capture major inflection points in financial markets. He provides top-down strategic investment ideas and inputs for portfolio managers and analysts here at Dynamic. His investment views are shared broadly via his regularly written research reports and regular appearances on Canadian and US financial media programs. Myles and I are going to frame the conversation today around an outlook for 2023, but with consideration given to the shocks felt in 2022 in markets, economics, and geopolitics.

We look back on a year dominated by headlines starting with the letter I, inflation and interest rates, and now the ponderance of recession inevitability. Given central banks' continued fight against inflation to bring overheating economies under control, uncertainty around economic conditions and the measures being taken to address them along with a seemingly wide acceptance of muted global growth in 2023, the question seems obvious, is it time for caution or optimism or both, and where will the opportunities be for investors? Myles, as always, it's great to have you with us today.

Myles Zyblock: Thank you, Mark. It's always been an enjoyable time. I can't believe we've been doing this for three years. Time does fly.

Mark: It certainly does. Listen, I just saw that the editors of Collins Dictionary have declared 'Permacrisis', their word of the year for 2022, which is defined as an extended period of instability and/or insecurity. I guess it's all in personal perspective as to whether that seems realistic or not, but let's start with what drove markets in a really difficult 2022.

Myles: Perhaps the more appropriate question might be what drove almost all markets down in 2022, global equities experienced a downturn with the S&P 500 and the global equity benchmark both off by about 20% as the calendar closed. There was also nowhere to hide in bonds outside of, let's call them the very shortest duration instruments, say somewhere inside of three-month T-bills, it's unusual for stocks and bonds to struggle and by so much together, cryptocurrencies were a disaster.

While alternative assets didn't decline nearly as much as bonds or fixed income, they experienced a down year as well. The big exceptions to this whole story were global energy stocks, they were up 28% last year and some agricultural commodity prices like orange juice, which was up 46%, corn was up 14%. Generally speaking, however, this past year can be really described as a year of return scarcity, and it was a year driven by a trifecta of first high starting valuations across the asset classes, maybe also unexpectedly strong consumer price inflation and finally, a pronounced global monetary tightening cycle.

Expensive alone isn't usually enough to shut down asset price performance, but expensive with a negative catalyst often proves to be problematic for investors. We had already talked about inflation, the rate cycle, and then you had Russia's attack on the Ukraine and the subsequent energy crisis that took over Europe. There was worries again about the global economy and corporate cashflow growth as the year progressed. I think the calendar closed with China abandoning its zero COVID policy. That's a step which generated initially, at least, it's generated a surge in viral infections, and it does leave us with additional questions about the health of the economic cycle.

Mark: I guess we all thought maybe we'd break for the holiday season and come back to a year much different than 2022 but what are we facing? Is this going to be more of the same in the coming year?

Myles: I don't think so. Last year's concerns were largely focused on how to manage rising inflation and interest rate risk across the world. Global inflation had touched its highest level in about 40 years. There were over 400 interest rate increases from Central Bank and just put this number in perspective, that averages to about a little better than one per day in the global economy. This coming year is likely to be focused on how that very aggressive monetary policy tightening cycle is being absorbed by the macroeconomy.

Inflation, while elevated, it's started to moderate, and I expect that to continue. Commodity prices have started to decline, global freight rates are dropping, supply lines are operating, let's call it closer to normal, and the destocking of excess business inventories in, some industries, at least, will probably lead to more price discounting in the months ahead.

At the same time, the interest rate and inflation shock is a lingering headwind for end market demand. Housing and other interest rates, sensitive or let's call it big-ticket spending categories are rolling over. New orders for the manufacturing industry have started to slow and, in the US, the all-important services industry is showing signs of stress. Perhaps part of the reason for this is because wages, after adjusting those wages for inflation, are still having a difficult time gaining ground so what we call the real wage growth is still negative in the US. Service sector wages drive the American economy.

This leaves us with an inherent tension that's likely to linger for a while longer. Many policymakers within the central banks, like in Europe, the Federal Reserve, and other major central banks, believe that they must tighten policy settings further to get inflation closer to their 2% target. The inflation rate globally is running closer to 9% today than 2% but the macro economy is turning down, and this is a concern for financial markets and investors. Moderating inflation is good, but a deep economic downturn is not good.

I guess it, ultimately, becomes a question about whether central banks are making a policy mistake. Have they already raised rates by enough or maybe have they raised them by too much? It was something like 60 years ago when Milton Friedman, if you don't know this gentleman, he was a Nobel Prize-winning economist, Dr. Friedman shed important light on the recurring predicament faced by central banks.

He said, "The reason for the propensity of the central banks to overreact seems clear. It's the failure of monetary authorities to allow for the delay between their actions and the subsequent effect on the economy. They tend to determine their action by today's conditions, but their action is going to affect," and again, this is a quote here, "It's going to affect economy only 6 or 9 or 12 or 15 months later." A gentleman who won a Nobel Prize in economics has the range from 6 to 15 months, so that's something to keep in mind that last year's rate tightening cycle is still working its way through. Obviously, the full tension that we've seen as a result of this policy tightening is yet to be resolved.

Mark: You talked about inflation. The impact on inflation is real and we know it's felt, and for many people on this podcast, I'm sure feeling the same way when it comes to just the household balance sheet. There are many commentaries out there though that say that central banks will likely be forced to pivot and signal cutting interest rates sometime next year, which could maybe be the beginning of a sustained recovery. Do you think that's likely or do certain things have to happen, in your opinion, before we see that?

Myles: Right now, for example, the Federal Reserve is concerned about wage inflation and wage inflation, even though it's not keeping up with price inflation, it's elevated in the eyes of the central bank. What they want to see is those wage gains start to moderate. The only real way to have that happen, at least historically speaking, is you've had to force employment demand lower. That means pushing the unemployment rate higher. As people do get laid off in those sorts of situations, their bargaining power at the income or the wage table lessons, and it puts downward pressure on inflation.

I think one of the things that the Fed has been stressing is they need to see wage inflation down because wage inflation drives what they call services price inflation, and that's one of the biggest components of the consumer price index. Wages need to come down, which means unemployment needs to go up, and we haven't seen that. In fact, most recently, the US unemployment rate tied its lowest level, not only in the cycle but almost in history, so we really haven't seen that yet.

Again, we've seen some stresses beginning and in some areas like the housing market, the Fed knows that's likely to happen and they're okay with that. What they really want to see before changing their tune probably is a little less pressure on the wage supply. Now the European Central Bank is facing a little different problem. They just have astronomically high inflation, so it makes the inflation rates we're seen in America look puny.

Part of that is, obviously, translated through their prior energy price shock. They don't have a lot they're looking at right now other than to say that they need to see inflation get down towards their target, so they're not even giving us a hint yet of the conditions that they're looking at outside of inflation itself before they really stop the tightening cycle.

Mark: Given all of that and how you've framed it so far, do you see opportunity ahead and where?

Myles: The easiest investment story at this stage is with respect to bonds and in particular high-quality bonds. After one of the worst years for bonds in history with the global fixed income benchmark index is down about 25%, there seems to be some opportunity developing, whether it's a soft or hard economic landing, the bond market is likely to be a winner. That might sound a little upside down but let me explain.

Global economic growth is slowing. We can all argue about how much it will slow, some people think a recession, some people think a soft landing, point is it's slowing, and that is good for bond market performance. Inflation is also peaking, again, by how much it slows is anybody's guess, but at the margin, lower inflation is usually supportive for bond prices. With inflation and economic growth rolling over, I think more and more central banks, the Fed, and maybe the Bank of Canada, are likely to stop raising interest rates at some point in 2023.

Within about three months of Central Bank's putting on the brakes on their tightening cycle, what I've noticed is that bond yields usually start to drift lower, so we're getting to that zone. Again, peak inflation, peak economic growth, and peak policy rates, place bonds in a more favorable light entering into 2023. I failed to mention that the proportion of global equities that have high dividend yields, or that have dividend yields greater than the bond yield has dropped rapidly over the past year from about 90% of equity market constituents now down to 35%. What that's telling me is that bonds are becoming a more competitive asset class again finally.

The outlook for let's say riskier asset classes, like equities, and commodities, I think that probably depends a lot more on the depth of the economic slowdown and economic recession, accompanied, usually by declining corporate earnings might open the door to further price declines, corporate earnings growth is still positive, so we haven't even moved there yet. A soft economic landing, or even, let's call it, a very mild recession, probably sets the stage for rally.

I continue to think based on the incoming data that the downside risks for these riskier assets do remain a little bit more of a dominant feature in the first half of this year. We're still holding on to a defensive equity posture. This includes a bias towards dependable balance sheets from a style perspective, dividend growth from a style perspective, maybe from a sector perspective, this is like healthcare and consumer staples. The big change, I think, is this.

Well, the narratives or stories stole the show over the past couple of years and we saw that in things like the meme stocks, which are just the darlings of social media or recently issued IPOs, or many of the non-earning tech companies, those were the monster performers, they stole the show, they had great stories attached to them, but they've been put to rest. I believe that companies which exhibit dependable fundamentals are likely to represent leadership in this next chapter of the equity market cycle.

Mark: Probably a little confusing to the retail investor where they see a business that's seemingly doing quite well, but from a stock price perspective, it's dropping, or it seems to be underperforming relative to how it's doing as a business in terms of revenue. That's, in a lot of cases, especially in the discretionary area, the inability of that company to pass on the higher expenses to the consumer. That I think confuses people, is this still a good business?  But to your point, balance sheets are good, management is good, how you reconcile that as an investor?
Myles: We know that financial market prices they reflect companies, but they aren't companies. When you look through time, you see that financial market prices are much more volatile, typically, than the actual fundamentals of the business. Why is that the case? Well, it's the case for a lot of reasons but a couple could be human psychology, or it could be changes in how we discount future earnings. The whole point is that when you have stressful markets, good and bad stocks tend to go down. That's just typical what happens in bear markets.

If you're a long-term investor, and you understand that this business still remains rock solid, these are times when you actually want to buy more exposure to those companies, not less. What you have to do is, let's call them the lower quality companies, those with more stressed balance sheets, those with broken business models. Look, in a bull market, people love riding those just like they love riding the good companies. In tougher markets, and when we usually come out of the back into tougher markets, the prior winners tend not to win.

Most of the prior winners, I'm talking big winners, were low-quality companies, and part of that is reflection, like I said, about sentiment, about the transformative nature of social media and how that's affected stock prices. It's not just chat rooms anymore, we're talking about Twitter and all that sort of thing, and that really gets stories going. You have to keep that in mind and not to be discouraged that even though you own a great company, today it is going down, over time, solid companies, good balance sheet, quality fundamentals tend to win the day, so you just have to be patient. Thinking about markets is the long game, it's not a sprint.

Mark: I want to shift for a second over to a discussion about currency and particularly the Canadian dollar as we are a company domiciled here in Canada. How do you see the Canadian dollar performing in this environment?

Myles: I think the Canadian dollar is in a bit of a box. It's performance over the past year, in the middle against most currencies, which includes the Yen, the Euro, the Aussie dollar, et cetera. It's middling perform good relative to half of them didn't perform so well against the other half. I'm about to sound right now like an armchair analyst a little bit, on the one hand, on the other hand kind of thing.

After a year and a half of being quite negative on the Canadian dollar, I'm tempering that view just a little bit. I'm still negative, but I guess a little more towards a balance view than an outright table-pounding negative guy on the Canadian dollar. We have China exiting its zero COVID policy, which undoubtedly is causing some near-term stress given the rising caseloads. I think we could see Chinese demand in activity pick up sometime later this year once they get through this challenging period. Not like what we saw in most of the rest of the world after their COVID restrictions were eased.

A better China might generate a source of underappreciated demand for industrial commodities, which then translates usually into a higher value for the Canadian dollar. Our currency is still a commodity currency. Now here's where the armchair analyst enters again. On the other hand, the health of the Canadian housing market worries me a lot. The rapid increase in boring rates that we're seeing, these have been met by all-time highs in household balance, sheet leverage, and expensive house prices.

It suggests that important risks for the Canadian economy remain in place. I'm still cautious, maybe not outright negative because, we've seen the dollar weakened, but I'm a little cautious on the Canadian dollar, but perhaps maybe just a little less so than a year ago. Today's value against the US dollar, when I looked more recently on the screen was about 74 and a half cents.
I think the outlook is balanced between say, 78 cents on the high side on a decent China recovery and maybe on the low side of 72 cents, for the global economy gets a little weaker than we think. The outside scenario for the Canadian dollar where we're facing a much deeper downturn in Canadian housing, I wouldn't be surprised at that point to see it at 68 cents. It's not the base case at this stage, but something we're definitely keeping our eye on.

Mark: One of the other things coming out of the pandemic was consumers had stockpiled cash. Is there risk that some of that is now being depleted because of higher cost of things? Does that concern you about the household balance sheet as well?

Myles: As we know inflation robs our purchasing power. You go out and buy a loaf of bread or a carton of milk and you're paying a lot more money, you have a lot less for other places now, obviously, on top of that we're adding higher interest costs to a lot of homeowners and inflation and interest rates are working in the same direction. They're stealing our available cash flow.

Yes, that is something that is, obviously, having an impact and you can see that, through that, some of the more discretionary items on retail shelves aren't flying off the shelf like they once were. Things have slowed down. The necessities are going to be the necessities. We need bread, we need milk. Some of the gadgets and the fun things that we were purchasing just have to be put on hold for now. We are seeing in effect with higher inflation, higher interest rates on consumer behavior for sure.

Mark: What will surprise you in 2023? Or what could we be in for surprise-wise that we're not thinking about?

Myles: Well, by definition a surprise is something you don't see. To take this very simply, the analyst community themselves are bracing for, let's call it global economic stagnation over the next year. For example, the economist believe, if you look on consensus analysts’ estimates for growth, they believe that US GDP growth is going to be 0.3% in 2023. Stagnation almost zero, right? Eurozone -0.1%, very close to zero. Again, Canada, half a percent, well, I guess we're going to be the leader, but that's still pretty close to 0%. The UK's, I guess let's call it a little bit of the outlier, -0.9%, but none of these, really are big booms or busts at least that's what the analyst communities views as what's going on.

A period of stagnation. The surprise scenarios, to me, are either a deep recession or no stagnation, what actually some economists refer to as a soft landing. Something like 2.5%. Both of those are scenarios that are still in play, don't have enough information in hand to rule out either scenario. The implications of a deeper-than-expected or surprisingly deep recession seem obvious to me. I mean high quality across the board in your portfolio, you got to hold high quality.

The implications of a soft landing also seem a little bit obvious. Everything rallies, even low-quality assets to some degree. I'm not saying you chase those. Declining inflation, peak central bank policy rates, and ongoing earnings growth I think would be fantastic news for most assets. How do I come out on all of this is, as you could probably tell from my comments, I'm encouraging a bit of a defensive portfolio, postural, albeit a little less defensive than a few months ago.

I think there will be time and it will be upcoming. I'm not talking three years from today, it's going to be a lot sooner than that, where it'll be important to adopt a bit more of an aggressive posture. It could even be sometime later in 2023 just not yet. The big position for me since the fourth quarter of last year has been to favor the high-quality bonds and have said it again, I think that's an opportunity. We should think about balancing that with high-quality defensive equity exposure while continuing to hold a full allocation to alternative investments including things precious metals.

I should be clear, just because I say I am favoring high-quality bonds, it doesn't mean that I should own no high-yield credit in a portfolio. It's the same thing after saying I favor value doesn't mean I should own no growth. My opinions that I've been discussing on this podcast, they reflect what I call marginal tilts in an overall well-diversified portfolio. It protects, at least historically speaking, it is protected our financial trajectory the best.

I guess the question to ask yourself is whether you're in a sprint or a marathon, my near 30 years in this business teaches me that investing is more about the long game. Once you understand this, investment solutions become more obvious regardless of the immediate economic scenario on the road ahead. Again, just to reiterate, that's to ensure that your portfolio is diversified across a wide range of higher-quality assets.

Mark: To close this discussion off, Myles, I know you personally as an investor embrace an approach that uses active management. Can you just talk though a little bit about why in this environment do you hold that belief that an actively managed portfolio approach is probably more beneficial than relying on index-like returns? Does that also lend itself to the thinking that, look, there's a lot of great businesses on sale right now that an active manager can find you?

Myles: This is the whole point. Active management has several benefits in particularly in stressful environments. When the good is being thrown out with the bad, active managers who go stock by stock they can really differentiate what's being put on sale and maybe what deserves to be punished. This sets us up. My colleagues today, what they're doing day in and day out is setting us up really well for the next upmarket cycle. They're looking through the weeds and seeing what has been unduly punished and I think that that is a very attractive thing.

Now, at the same time, just keep in mind that if you're buying a particular ETFs an indexed ETF, again I'm not against the idea. You should know what you're buying and for example, for the TSX, you're buying a market capitalization-weighted index or basket of stocks that is heavily exposed to energy and financials. In the US, if you're buying the S&P ETF, you're buying a market capitalization-weighted index that's heavily exposed to technology consumer discretionary. The point I'm trying to make here is that there are points and cycles, times and cycles when certain of these industries or groups of stocks fall out of favor, and active managers can adjust accordingly.

No matter what, if you own the TSX, ETF you're exposing yourself to a lot of energy, no matter if it's a good time or a bad time for energy. That's one of the differentiating factors. Also, the ability for active managers to use other tools in the toolkit to adjust the risk exposure via things called options. Or they can even hold a little more cash to protect and buffer some of the downside. There's lots of things that I think are very beneficial for investors when they're thinking about active management.

Mark: That's great perspective, Myles, thank you for your insights today and I look forward to having you back mid-year to see what has changed. On behalf of Myles and myself and all of us here at Dynamic, Happy New Year to all of our listeners. We'll talk again soon.

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You've been listening to another edition of On the Money With Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor or visit our website @dynamic.ca. Thanks for joining us.

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