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The following Q&A is between Hub CFO Jonathan Chevreau and Multi-Asset Portfolio Managers Ian Riach & Michael Greenberg of Franklin Templeton. (Franklin Templeton is a Hub sponsor.)
Jon Chevreau: The last few months have seen unprecedented volatility in the markets. How have your portfolios been impacted in this recent drawdown?
Mike Greenberg: Given the speed and severity of this downturn, our Portfolios from an absolute return perspective have been challenged like many others on the street. However, we do believe the current environment and positioning should allow strong returns going forward. We see a scenario similar to 2008 where balanced products suffered, but then rebounded very strongly. We can’t be sure of timing but feel same play book is a realistic expectation.
However, on a relative returns basis, our portfolios have performed better than some of our competitors. This is due to the more defensive positioning we took before the bear market started, where we reduced risk based on what we believed were stretched valuations in a late cycle. We had also reduced credit risk earlier, as we felt risk/reward was not favorable given the spreads. Especially in Canada given the threat of potential illiquidity with some assets. Despite not anticipating the crises, having a lot less credit exposure compared to some peers, worked out very well for us. Within our equity fund selection, we had previously moved more into our core funds, which have held up well in the downturn given their quality bias. We also increased allocations to some of the lower-beta funds/ETFs funded from more cyclical holdings that had more value and small cap bias.
Jon: What effect has this volatility had on your fixed-income allocations?
Mike: There are not many places to hide even in fixed income, as credit and spread products really sold off. Still, being more conservative and selective in our fixed income exposures prior to the downturn has helped us weather the storm quite well. We also feel we are well set up for some good opportunities in fixed income going forward.
We’ve been adding incrementally to credit funded from governments and we see better opportunities in credit but there is still some risk so we are not going ‘all in’ quite yet. We anticipate corporate earnings will crater and bankruptcies rise in the upcoming months. The longer the virus containment goes on, the larger the risk to the global economy, so we are being selective about picking our spots. Given the uncertainty we favour more active exposures in fixed income; even the fixed-income ETFs we hold in our portfolios are more active, and for us, that is important going forward as we are looking to capture some of the opportunities.
We are now a bit more positive on credit, especially in investment grade credit in the US given direct support from the Federal Reserve. Canada has seen some quantitative easing measures, but not direct corporate bond purchases like the US, so we still view this as a very illiquid market in Canada. So, we are bit more hesitant in that space, but we are also aware that there is a tendency to throw the baby out with bathwater, which again highlights why we like active credit management in this space.
Jon: Where do you think the Loonie is going?
Ian: I think the Loonie will continue to remain relatively weak compared to other currencies due to a number of challenges. The Canadian Dollar has been influenced by the economic backdrop of course but also energy prices. The influx of supply from Saudi Arabia and Russia combined with the forecasted decrease in demand due to Covid-19’s effect on the global economy has sent energy prices into a free fall. Canada is feeling it even worse than others. Just a few weeks ago when West Texas Intermediate oil was close to $50/bbls, our price benchmark Western Crude Select (WCS) was around $35 but recently we’ve seen it trade less than $5.00/barrel which is absolutely devastating for parts of our economy and our dollar.
Given the Loonie’s relationship to the oil price it is no surprise we have seen it drop and we feel it could stay weaker until we see some uplift in oil prices. Right now, we believe that current prices are not sustainable for anyone, Saudi Arabia included. They can likely produce a barrel of oil for somewhere around $10 – $11 per barrel, but really, they require oil prices to be around $60-$70 a barrel to balance their budget. Recently we have seen an OPEC deal that will attempt to curb supply to bring better balance to the market, but the demand hit will be large.
That is why we would not be surprised if we see a recovery in energy prices soon, and that will help the Canadian dollar somewhat, but the general economic backdrop of Canada will still keep our currency at low levels compared to the US dollar even in the recovery.
Jon: How will this downturn impact Canada’s commercial and residential real estate markets?
Ian: It will have an effect on both markets. On the commercial side, probably the hardest hit will be hospitality related properties like hotels, restaurants, coffee shops etc. Small office complexes with various service industries will also feel the lack of rent coming in and may face re-leasing problems if certain businesses can’t reopen or chose more remote working arrangements. Industrial properties will probably rebound quicker as the economy starts growing again as physical plants and storage are required for manufacturing and there could be pent up demand building right now.
On the residential side the effects may be shorter term in nature: people can’t decide to live “virtually,” they need a physical home. In the short-term buyers may be hesitant to make a move from rent-to-buy or “move up” due to uncertain employment situation. Sellers, unless they really need to move, say because of work, may be reluctant to accept offers that they feel are below “true value.”
Prices may dip in the short term as forced sellers may have to accept price concessions at least until there is more economic certainty. It also depends on what area of the country we talk about. Major urban centers like Toronto where supply had been limited before the downturn will likely see activity rebound more quickly than in areas like Calgary where the double whammy of the virus and the collapse of oil prices will affect that city more acutely.
How do you see Covid-19 affecting the economy and how would a recovery play out?
Ian: Obviously Covid-19 has already had a big impact on the economy and there remains many unknowns before we start to see a lasting recovery. We don’t know what letter in the alphabet the economic recovery will look like: a “V” or a “U” or “L” as the recovery is so dependent on the virus and the news on that front is still evolving day-to-day.
If we had to pick one now, I’d say we are looking at a “U”: the resolution of the virus will take longer and its impact lasts longer than expected, thus the rebound starts but with lower force and is more drawn out. In fact, it will probably look more like a “W” and we mean a true double “U” not a double “V” like we use conventionally when we write or type. Meaning we get a low and slow recovery, that will likely include fall backs. So it will likely look more like a sine wave than a letter.
Given this view we have been reluctant to aggressively add risk to the portfolio, although we have been adding on a measured basis as the outlook for equity returns over bond returns are much more attractive 12-18 months out. One positive note has been the significant policy responses from governments, which should help soften the blow.
What do you think about all this money printing by the Fed and other central banks?
Mike: The amount of money injected into both economies has been as unprecedented as the market shock itself.
On the monetary side, Central Banks have taken steps to shore up the plumbing of the financial system. Unlike 2008, where it was the system itself that failed causing a recession, this time it is the economic shock that is stressing the system. Central Banks have re-introduced old and various new programs to allow the financial system to function smoothly and provide a more liquid environment for whenever we get on the other side of the virus.
How about US and Canadian government support programs for employment and business?
Mike: The various support programs designed to help the financial system, businesses and individuals has also been unprecedented. On the fiscal side, Governments had been a bit slower and messier, but we are finally seeing some strong policy measures come through. Governments are looking to fund companies, small business and individuals to get them over the hump and try to protect jobs. For example, in the US we have a fiscal program worth $2 Trillion, and in Canada a program of $200 Billion with Finance Minister Bill Morneau saying there is “no cap.” This is very different than in the 1930s, where we actually had tighter policy, so we think these efforts will help prevent a drawn-out recession/depression.
Do you recommend a more conservative asset allocation for retirees or those approaching the “Retirement Risk Zone”? 60% fixed income, for example, for those 60 or older?
Ian: I would say retirees and every client should consult with their advisor: it’s tough for us to give specific advice as each individual’s circumstances are so different. Having said that, beyond preparing for immediate cash needs (which everyone should have in very conservative, liquid investments), this is not the time to sell equities. They may still benefit from holding a good proportion of assets in equities given our view that equity returns look more attractive compared to fixed income returns going forward. Markets will eventually rebound and selling low unless you really need the money will prevent clients from participating on the upside. It’s also worth noting that early upside returns tend to be higher than longer-term averages, so you want to participate in that.
What tactical asset allocation shifts are you making to deal with this volatility within Quotential and your other Multi-Asset portfolios?
Mike: We continue to balance our shorter-term concerns that had tempered our enthusiasm against the longer-term backdrop where equities have become cheaper and more attractive. Relative valuations between equities and government bonds are favorable. We also anticipate lower rates for longer and weak inflation, which also supports a tilt towards equities on a longer time horizon.
With that in mind, we have increased our equity exposure opportunistically during the recent volatility by reducing some of our fixed-income positions. This is largely due to the fact that current government bond yields are at historical lows.
We believe credit still carries more risk, but even there too, some valuations are more attractive, and we are starting to see some opportunities to selectively add back to credit market exposure.
Canadian equities and the CAD remain a concern for us, given the macro backdrop and the current environment for energy prices and thus we are maintaining an underweight position with our portfolios there.
In March, all asset classes seemed to fall together, as Correlations spiked to 1 ; are you finding any asset classes less directly correlated to stocks, such as gold or real estate?
Mike: In certain environments of panic selling we tend to see these correlation spikes occur. They tend not to last too long, so we don’t want to overreact to the short-term volatility. Continuing to maintain good diversification by asset class, region, factor and investment style still makes sense in this environment. Understanding which asset classes tend to experience spikes in correlation is also key. For example, we have stayed a bit more true on the fixed income side by having less credit, which tends to correlate more with equities and, and favour government bond exposure and cash. Generally, government bonds have maintained their personality of being a good hedge to equity risk outside these short periods where they move together.
From here credit has recent which increases expected returns going forward, as has equity. We’d expect yields to rise marginal in coming years building back a yield cushion to help government bonds continue to play that role of buffer to equity risk in balanced portfolios.
Other assets such as commodities, gold and certain foreign currencies have also been used as other means of having a more robust diversification when necessary.
Can you use puts or short sectors or specialty ETFs to dampen volatility?
Mike: A lot of shorting strategies will work obviously with severe market drawdowns but have quite a large bleed in normal times. It can cost a lot to use put options not only in explicit costs but also in lost opportunity costs in rising markets. It can be very expensive insurance and requires very good timing. I would say that using options in a total portfolio perspective is a great way to manage risk and indeed some of our underlying managers to use put options in both credit and equity to help manage risk.
I would also urge caution when using some of the more exotic ETFs. Many can provide a very different experience than expected. A few years ago, many investors were caught off guard when some of the ETFs than played in the volatility space lost 90% in one day. So, as a tool they can be useful if you know what you are getting so investors need to do their homework.
What regions, countries, and sectors are best positioned for recovery?
Ian: Generally we prefer to remain underweight Canada in favour of US equities. From a sector standpoint we would avoid deeper cyclical sectors for the time being to instead focus on quality companies that have strong balance sheets that can continue to pay (if not grow) their dividends. Obviously given the uncertainty around how long this global quarantine continues, we are staying away from transportation and travel-related companies: the auto and aircraft manufacturers, cruise lines, hotels etc.
Sectors that we would prefer are: Consumer Staples and Health Care. We prefer staples as people will still need food and other goods during this lockdown. The healthcare sector is attractive because we think there will be more spending and investment in this area going forward.
This virus has exposed the vulnerabilities of healthcare systems worldwide and we think there will be more investment on pharmaceutical and genome research as well as on diagnostic and treatment equipment.
Now some may say the government will just take all of that over, but we think the innovation will truly come and come faster from the corporate sector. We think areas in the Technology sector are good places to look. Again, this crisis has showed us how reliant we are on technology and telecommunications and well capitalized companies in this sector should perform well.
Now there will be a time to recommit to the Energy sector. It has been decimated, but for the foreseeable future the world will be reliant on fossil fuels and there will be a good entry point if you can take a mid-long term view.
Are you playing any themes that may benefit from the virus crisis, such as 5G wireless or the stay-at-home/work-at-home economy?
Ian: Many of us at Franklin Templeton have been working from home since this crisis began, so we are already seeing how quickly many businesses have had to transition to a work-at-home environment in the near-term. There are definitely trends in communications, retail and even fitness that have likely accelerated due to this crisis creating winners and losers in the economy. Our firm’s head office is in San Mateo, California in the heart of Silicon Valley and we have great access to some of the most innovative companies out there. The firm has also started various incubator initiatives to help fast track some early stage innovation that we hope ultimately to benefit our portfolios.
How are you handling possible inflation, given the rampant money printing and QE measures since the coronavirus crisis hit? Do you see a role for precious metals/gold, either via bullion or gold mining stocks like Barrick or Newmont? How about Real Return Bonds/TIPs?
Mike: There could be a risk that the massive amounts of stimulus eventually become inflationary, but given the hit to growth and likely slow recovery of the economy, we are still more concerned about deflation in the short-term. Textbooks suggest this stimulus should debase the USD and force yields much higher on longer-term treasury bonds, but so far that has not been the case. The piper may have to be paid at some point, but the question is when. We don’t see a ready replacement for US Treasuries or the US Dollar yet, so his should not be a Venezuela type scenario.
We have low conviction on how long the medical part of this all last and how long it will be before the economy can start to normalize again but do expect it to be slower. Policy efforts will help for now and will likely help keep the recession from moving into a depression. Risk assets have fallen a lot and the policy response has been forceful to stop-gap solvency risk in the system for a while which is very promising. We may see a role for TIPs if we believe inflation expectations will start to build but we prefer buying high quality equities as a hedge against inflation. Gold would be one interesting means of hedging potential inflation risk too but there are also concerns on runaway deficits, which could ultimately lead to currency debasement and higher interest rates are very hard to time.
Ian Riach, CFA, is Senior Vice President, Portfolio Manager with Franklin Templeton Multi-Asset Solutions. Ian joined Franklin Templeton Investments in 1999 and is a senior vice president and portfolio manager for Franklin Templeton Multi-Asset Solutions (FTMAS) and is a member of the FTMAS Investment Strategy & Research Committee. He has portfolio management responsibilities for all Canadian-based multi-asset products including the Franklin Quotential Portfolios, Private Wealth Pools, and Franklin LifeSmart Portfolios. He is also responsible for Institutional Balanced Portfolio Management. As the Chief Investment Officer of Fiduciary Trust Canada (part of Franklin Templeton Investments), Mr. Riach also oversees the investment management of Franklin Templeton’s private wealth business. With over 30 years in investment industry, Mr. Riach holds a Bachelor of Commerce degree from the University of Calgary and is a Chartered Financial Analyst (CFA) Charterholder.
Michael Greenberg, CFA, CAIA, is a vice president, portfolio manager for Franklin Templeton Multi-Asset Solutions and Fiduciary Trust Company of Canada. He is a member of the FTMAS Investment Strategy & Research Committee specializing in fixed income strategy and has co-portfolio management responsibilities for all Canada-based managed programs, including Franklin Quotential and Franklin LifeSmart. He also manages institutional mandates in North America and Asia. Mr. Greenberg joined Franklin Templeton Investments in 2006 and has 15 years of experience in the financial services industry. Prior to that, he was responsible for business development, product development and research for an alternative investment boutique Tricycle Asset Management in Toronto. He began his career at Fidelity Investments based in Toronto working with group retirement plans. Mr. Greenberg holds a bachelor of commerce degree from the University of Ottawa. He is a Chartered Financial Analyst (CFA) charterholder and a Chartered Alternative Investment Analyst (CAIA) charterholder.
