With North American central banks on the brink of an interest rate hike cycle, investors are concerned about inflationary pressures, the future of the global economy, and their portfolios.

On a new TDAM Talks podcast, Ingrid Macintosh, VP, TD Wealth and Head of Sales Enablement, Communications and Digital Strategy, TD Asset Management (TDAM), welcomes special guest Robert Pemberton, Managing Director and Head of Fixed Income, TDAM, as they discuss the pace of rising rates, what global growth will look like in 2022, and opportunities for fixed income investors across the yield curve.

Highlights include:

• With the Bank of Canada and U.S. Federal Reserve signaling interest rate increases, what is the inflation outlook? (1:00)
• How far and fast will the central banks go, and what is the expected end point for rate hikes? (8:00)
• What does this mean for fixed income investors? (5:30)
• Will global growth remain positive amid the continuing pandemic and a surge in consumer prices?
• How will higher rates affect borrowers over the short- and long-term? (17:00)

Please visit the TDAM Insights for more podcasts, and send us an email at td.tdamtalks@td.com to provide feedback or recommend future topics.

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Transcript

NARRATOR: TD Asset Management welcomes you to this week's podcast.

As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management.

INGRID MACINTOSH: As we wind down January, we've seen central banks in North America continue to pause on raising rates.

My name is Ingrid Macintosh, host of TDAM Talks. And joining me this week, one of our favourite guests, Rob Pemberton, Head of Fixed Income here at TD Asset Management.

Together, we are going to talk about the current estate of the markets, central bank activities, inflation and rates.

Rob, welcome to the podcast.

ROB PEMBERTON: Great to be back and happy new year, everyone.

INGRID MACINTOSH: Happy new year to you too.

So, as I said, at the time of recording this, we've just come through the week where both the Bank of Canada and the Fed have both paused on rates, or not started to raise rates.

There are so many factors here.

Can we talk a little bit about what this is signaling to us and what this means for the outlook for inflation?

ROB PEMBERTON: Well, I think broadly speaking that the Bank of Canada did what it said it was going to do. It had indicated that it would wait until the conditions were appropriate to raise rates, and those conditions being the output gap closed, employment conditions being met. And clearly in both the statement and in the press conference afterwards, clear that that's the case.

Our expectations are now that the Bank of Canada will have its first-rate hike on the meeting in March, which would be 25 basis points and really start a longer prolonged hiking cycle. Right now, the market is pricing in five hikes for the Bank of Canada in the year. And we believe that might be a little aggressive given everything that the bank has indicated so far. But clearly front-end short-term interest rates are going to rise throughout 2022.

The Federal Reserve also met this week and indicated that they are likely to raise rates in March. And with that, we're really seeing a couple of things playing out.

Central banks recognizing that Omicron, it still provides some uncertainty. So, the pandemic purgatory persists, and that has implications to economic growth.

And I think the central banks also recognize that there might be a point of perception that could be misconstrued if they raised rates while economies were under various stages of lockdown. So, certainly as we wait till for March, my expectations are that we won't be in that position. And the central banks will absolutely begin to raise interest rates.

Interesting to note--

INGRID MACINTOSH: I'm going to--

ROB PEMBERTON: Sorry, yeah, go ahead.

INGRID MACINTOSH: I was going to say I'll click on your remark with respect to four rate hikes this year and maybe some more in '23.

Because I know we hear in the press, and the press loves to talk about rate hikes. So, our perception that four in '22 might be more reasonable and likely at a quarter point at a time.

It feels a little bit more conservative than some of the news cycle would suggest to us. Is that how I'm hearing it?

And, also, you've said this to me before too, that the Bank of Canada really is much more concerned with the state of the economy and the population versus the estate of financial markets. And that's how they're really going to set their tone.

ROB PEMBERTON: And the answer to both of those is yes. So, with respect to interest rate hikes, we're taking a more cautious view or conservative view to rate hikes going forward versus what the markets have priced in. And we've heard from Governor Macklem that he doesn't believe that interest rates can rise as far as they had in the past. So if that's the case, then a five or six rate hike in 2022 seems to me that it would probably use up most of the, quote unquote, "arrows in the quiver." And the Bank of Canada is unlikely to proceed at that pace, at least at this stage, given our views. For the Federal Reserve-- and sorry, back to your comment on the economy, that's the clear focus for the Bank of Canada.

As a reminder, the Bank of Canada's mandate is price stability.

INGRID MACINTOSH: Exactly.

ROB PEMBERTON: The Federal Reserve's mandate is price stability and full employment. So, when looking at it through that lens, price stability breeds full employment in the Bank of Canada's view, and as such is looking to anchor inflationary expectations. Just as a reminder to listeners, rate hikes in and of themselves will not solve supply chain bottlenecks. So, this is more about anchoring inflation expectations rather than changing the supply demand dynamics of things, at least in the way that the central banks are going to try and manage this.

INGRID MACINTOSH: So that dialogue is a bit about speed and pace, maybe a little bit of a terminal destination, like how far do we think ultimately though the Bank of Canada, for example, might go?

From a hike from 25 basis point today, where might it end, do you think?

ROB PEMBERTON: All right. Well, again if we go to market pricing, the market's pricing 2 and 1/2% as where the Bank of Canada gets to. And that's over the long term. And they're looking to about 2% for the Fed with respect to where the terminal rate is on that rate hiking cycle.

Interesting to note, though, if I take Governor Macklem's comments that interest rates are unlikely to be able to rise as far as they have in more recent hiking cycles, the last time we got to 1 and 3/4%, 2%. So, to me, that indicates that there's likely going to be some challenges in pushing too hard on the brake pedal with interest rate hikes. And, if we look at the yield curve 2 years to 10 years, the yield differential between those, we're starting to see that really compress. So, the spread between the two of them decrease. And, as that gets smaller and smaller, that yield differential, there's a higher probability that the economies are going to feel stress. And looking at it through that lens, I think the central banks have to be careful and monitor the shape of the yield curves as they're raising rates as well.

INGRID MACINTOSH: So, as we're sort of pivoting our conversation from the impact on the economy to the impact on markets and specifically fixed income markets, as we know, a meaningful portion of our clients' portfolios are invested in fixed income. And, as we go through this journey, what does this mean for fixed income investors?

ROB PEMBERTON: Well, what I really look at is one of the comments you made earlier in and around the terminal rate or where do central banks get to. And what does that imply to investors? Well, to us, if the overnight rate is going to go to 2%, or 2.5% depending on which market you're looking at, what does that mean longer term? And, certainly we perceive that there's going to be volatility at the front end of the yield curve as interest rates adjust to the first hiking cycle in quite some time. But the longer end of the yield curve, 10 years, 30 years, continues to be very well anchored. And while we do see modest increase in interest rates in that part of the yield curve, we don't see the same type of moves happening that we witnessed from the lows in August of 2020.

So, to me, we're really going to see some adjustments in the front end of the yield curve. And from an investing perspective, we've been able to take advantage of that in terms of positioning within the portfolios in order to preserve and protect clients' capital. And I think as well as we continue to see the discussions and movements on interest rates from central banks, that we will also see more opportunity. And in an environment where we're going to see greater volatility, the opportunity to take advantage of dislocations in the marketplace really argues for active management in a market where just accepting what the market gives you could be very, very challenging for clients' portfolios.

INGRID MACINTOSH: And interesting what you called it with respect to the shape of the yield curve because as it pertains to investors' portfolios, our gut is that as rates start to rise, we have these negative returns. But what I'm hearing from you is the market's already priced in.

The fixed income portfolios have been feeling this over the last 12 to 18 months already. So, part of that journey has already occurred. I'm going to pivot the conversation a little bit back away from the curve back to the economy. And we're sitting here.

We were super excited coming through the end of 2021 that we were coming to the end of the pandemic, and then Omicron came upon us.

Restrictions are back in place.

We've got labor shortages.

We got dislocations again.

From your perspective, what does global growth look like in 2022?

ROB PEMBERTON: It certainly looks slower than it did in 2021. And I think, for a number of reasons, not the least of which are some that you mentioned. Once again, while we may be done with the pandemic, the pandemic isn't done with us.

INGRID MACINTOSH: Not done with us, exactly.

ROB PEMBERTON: So that continues to provide challenges with respect to supply chains, transportation, all issues that really impact energy costs, food costs, and plus or minus durable goods costs, which really impacts the consumer overall. So that's going to remain a challenge as we go into 2022.

The amount of fiscal stimulus has basically been reduced to virtually nothing compared to where it was in 2020 and early 2021, as the programs designed to support individuals have run their course. And with monetary conditions about to begin that tightening cycle, both of those provide a headwind to growth as we move forward. So, that's another that we would add to that. And then in that context of prices and impacts of prices, with energy continuing to remain elevated, certainly for the average consumer, the cost of fuel and home heating and whatnot is impactful and really acts as a tax on their spending power. So, there are a number of things converging here that I believe will dampen growth.

Growth will still be positive.

By no means are we slipping into a recession of any sort.

Growth will be positive.

It just won't be as positive or robust as it was in 2021. And I think that that's going to play out throughout the course of this year and into early next year as we likely revert more towards trend.

INGRID MACINTOSH: Yeah. So still going forward, but a bit of a bumpier ride and at a slower velocity than we had in 2021. So, we've talked about rates. We've talked about the economy.

We talked about the curve.

We've talked about fixed income the growth outlook. Maybe we can tie it all together with a view from the Wealth Asset Allocation Committee.

Given the scenario continue to be underweight fixed income in this environment given the limited upside, what does this mean for investors? What is the wealth asset allocation thinking about allocations in fixed income absolutely and then more specifically within the fixed income continuum?

ROB PEMBERTON: Well, so high level, we do believe the growth is still going to be strong, just not as strong, and as such have continued to hold our positioning with a modest risk overweight, that meaning modestly overweight equities, modestly underweight fixed income in the current context.

Within equities, we prefer Canadian equities overall. And we're taking a more neutral stance with respect to US equities in the current environment given what we see going forward. And within multi-asset portfolios, continue to really like the alternatives and real assets and infrastructure which continue to provide good diversification and a certain amount of inflation hedge in here.

Within fixed income, we continue to be overweight credit. As listeners will be aware, earnings remain very strong.

Free cash flows remain very strong, very supportive of the corporate credit market. So, we maintain an overweight position there.

We are underweight our sovereign exposures.

We don't believe that sovereign debt will provide a real return to investors given where inflation is and what's going to happen with central bank rate increases, particularly at the front end of the yield curve.

And in the inflation protection space, RRBs, tips, given what's happened with interest rates and real yield-- so the difference between inflation-linked bonds and nominal bonds-- we're not seeing the opportunity as being as robust as it once was and have reduced our positioning in inflation-linked bonds from overweight to neutral. So that kind of speaks to some of the nuances inside the fixed income world. And as well, we continue to maintain a modest underweight in duration within the portfolios given the rising interest rate environment that we expect in order to, again to protect clients' capital in this environment. So, if 2019, 2020 were really about building capital for clients, we really view 2021 and 2022 as preserving clients' capital, providing a sleep-well factor, and providing that diversification when we see some of the volatility rear up in and around what's going on in the equity markets. So that's kind of a high-level view of what we're thinking about. Need to dig into it if you've got other questions.

INGRID MACINTOSH: Yeah, I was just going to say, it's consistent with what you and the TD Asset Management fixed income team have always focused on, is making sure that we've got that incremental yield day in day out in the portfolio. And never has it been more important than in periods where you need to cushion that price impact that could occur from the upward direction of interest rates.

It's systematically how you've always done things. And it's ever so important now more than ever. I do want to turn a question. When people think about rates rising, we're talking about investment portfolios. While it's painful to go through the journey ultimately, savers who have been quite frankly penalized for quite some time will certainly have a benefit going forward. On the other end of the continuum, we've had a juiced punchbowl for borrowing for the last number of years. And lots of people have potentially stretched themselves in their mortgage investments.

What does this mean if you're a borrower, and how should you think about the outlook for the next few years?

ROB PEMBERTON: Well, immediately, I don't think it's going to negatively impact borrowers. It will take some time for interest rate hikes to work their way through the system. And for particularly for people with mortgages, when's the next time your mortgage resets and what are the implications there? So realistically, probably two to three years out, we'll have more resets impacting this outcome. So, investors should be aware. Borrowers should be aware and be thinking about what they want to do in the interim.

When I think about that mortgage side of things from a broad risk perspective to the economy, I tend to be more focused on the employment picture than I do on the immediate interest rate picture.

Employment is going to be able to drive the support that we need to see consistency in the housing market. So, the mortgage side of things, I perceive right now that borrowers are going to be able to work their way through this and have time to adjust to the changes before their next resets. If they've got a five-year fixed, when's the next time they actually have to go into the bank and reset what their mortgage rate is?

Be prepared to see higher rate, but I don't think that in the immediate period that we're going to see a negative outcome on that front.

INGRID MACINTOSH: That has been a trip around the world with interest rates from every perspective.

Rob, thank you so much, as always, for your insights.

To our listeners, you can find our recently published WAAC Perspectives on the TD Asset Management website along with more of our latest thought leadership and commentary around all subjects. Also, if you want to receive the latest expertise and updates, you can follow us on Twitter at TDAM_Canada and on LinkedIn at TD Asset Management.

Rob, Thank you again.

Have a great day.

Happy new year.

And to our listeners, we'll see you soon.

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