An Update from the iAGAM Asset Allocation Team

We feel comfortable that the current economic environment is supportive for bond markets. And so accordingly, we've shifted our tactical stance going from underweight earlier this year to slightly overweight as of now.

What’s your comfort level with equity market valuations?

So first off, when we're talking about valuations, it's really important to be precise about the metric that we're using. Now, one of the most common metrics that's used in the financial press is the forward price to earnings or PE ratio. And if you use this metric, well then the S&P is trading right now at roughly 20 to 21 times forward earnings. Which is not only higher than the long-term average over time if you look at 1900 to present, but also more expensive than most other equity markets around the world. However, a relative high forward price earnings by itself is not cause for concern because one, it's only one of many inputs that determines asset prices. And two, it by itself is a relatively crude measure of valuation that does not fully reflect what's going on under the surface. Because what's happened in the U.S. over the last couple of decades is that the S&P 500 has become significantly more weighted in the higher PE sectors. Think here about technology, the AI darlings, the consumer discretionary sectors.

And all of this has happened at the expense of the more traditional value sectors, the defensive names such as utilities that tend to naturally trade at lower multiples. And it's worth noting that this change in weighting towards the mega-cap tech names and the associated structural changes in the PE ratio, that's not a new phenomenon. In fact, if you study the stock market history going back to say the late 1880s, and we have, you'll find that consistent innovation and creative destruction have consistently driven similar changes in market leadership over time. So what does this mean for our portfolios? Well, our current view is that while U.S. equity valuations are a bit high and that does bring a little bit of risk, there can be good reason for this given the sectoral shift. And this is not alone a sufficient condition to be cautious on the asset class or to have a precursor for equity underperformance.

And so from a top-down perspective, what we're doing in our portfolios is to combine our deep analysis, our historical analysis of the drivers of valuations, the things that we just talked about, with many other quantitative and macroeconomic inputs to form a holistic view on the asset class. And I'd say that at this point based on our comprehensive analysis, we're generally constructive on equities.

What are your expectations for interest rates?

Over time, we've generally become more comfortable with the idea that central banks at the very least and their monetary policies that they're following, are no longer a headwind to equity and bond returns. That's our base case, because remember that back in 2022 we were facing significant inflationary pressures coming from both the supply and the demand side of the economy. And there was real concern that inflation would quickly spiral out of control. That's actually why you saw simultaneous declines in equity and bond markets a couple of years ago. However, over the past couple of years, inflation pressures have not only subsided on the supply side but demand-driven inflation is also more in check.

In other words, central banks are much closer to achieving the so-called Goldilocks scenario, the soft landing, which is that they have been more or less successful in bringing inflation down without inducing a severe recession. And to us, this is critically important because now if growth falters, if economic growth disappoints, central banks actually have room to cut rates to support the economy. When previously they wouldn't have been able to do so with as much ease because there was that persistently high inflation that they had to worry about, that's less of a concern now. All of which is to say that we feel comfortable that the current economic environment is supportive for bond markets. And so accordingly, we've shifted our tactical stance going from underweight earlier this year to slightly overweight as of now.

Which asset classes are you currently overweight and underweight?

Currently, we are constructive on equities, though we're being careful and picking our spots in terms of size and regional exposure. Specifically we find a good value in U.S. large caps, but we're underweight the small caps a little bit as we see better earnings in the large companies given their pricing power, given the AI themes that are happening and just given the general moat that large companies have built around themselves. Now, on the fixed income side, we're also overweight specifically in Canadian bonds as we see more room for rate cuts in Canada than in the rest of the world. Given that the Canadian economy has seemingly slowed down a bit more than other countries in response to the rate hikes that were done last year and the year before. And then finally, in the commodities complex we continue to maintain our bullish view on gold. We've had this trade for most of the year. And we've had this trade because emerging market central banks in response to geopolitical tensions have allocated more towards the yellow metal.

In addition, we're seeing an environment of peak real rates which is generally an environment in which gold tends to do well. And then finally, gold is also a good diversifier from a portfolio perspective. So I would say generally constructive on equities, constructive on fixed income particularly in Canada, and then also long specific commodities such as gold. Now, one thing that being long all these things means, is that by definition we're underweight cash. Cash was a good asset to have in 2022 relative to other things. But as things normalize, as inflation gets down to reasonable levels, as the environment gets supportive for risk assets, we think it's time to get out of cash and deploy into other more risky asset classes. And that's what we're doing in the portfolios.

Can you update us on the iAGAM Asset Allocation Team?

Asset allocation is an area we continue to invest heavily in at iAGAM, primarily because of how important the long- and short-term asset mix is for long-term wealth creation and for the retirement accounts of our clients. And because investment excellence starts with exceptional talent, we continue to add to our already solid team with new talent from some of the best asset allocators across Canada. Our most recent hire is our new head of research, Alex Bellefleur. Now Alex is a seasoned investment professional. He's got 17 years of experience as an asset allocator, both on the retail and the institutional side. Now, what Alex brings is a unique ability to link insights that are derived from deep data-driven macroeconomic research to the strategic and tactical decisions in retail portfolios. And as our new head of research, Alex will not only accelerate the development of new asset allocation capabilities, but he will also take a prominent role, a client-facing role in communicating with advisors and clients on a day-to-day basis.

And so I'm excited to have Alex on the team. I'm excited to continue growing the team, investing in the team, and to bring the best of institutional investing to our retail portfolios.

Recorded on August 26, 2024. For definitions of technical terms, please visit iaclarington.com/glossary and speak with your investment advisor.

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