Market cycles tend to follow a pattern where bullish phases grind slowly upward and bearish phases tend to be abrupt, painful and relatively short. There is also an "in-between" period where volatility and uncertainty dominate. Geoff Wilson, who is responsible for asset-allocation strategies across many multi-asset class mandates within Toronto-based TD Asset Management Inc. (TDAM), argues that we're in the latter phase of the cycle, as markets struggle to confirm their direction.
A key reason for this scenario is the changing direction of interest rates in the U.S. "As soon as you do this, the market needs to digest the change," says Wilson, managing director at TDAM. "If you are dropping rates, the market tends to move very quickly, getting ahead of you because the environment needs stimulus. In this environment, though, the U.S. Federal Reserve is looking to remove stimulus -- but wants to do it at a slow and measured pace. This is much harder to predict. In my view, this has created a large part of the volatility we are seeing."
Tactical asset allocation is one of the tools that Wilson implements, as he heads a group of analysts and portfolio managers that oversee about $61 billion in assets. About $22 billion is held in TD's Managed Assets Program that encompasses 13 fund-of-funds portfolios.
Determining whether the Federal Reserve will back off or be more aggressive has everyone guessing. But given that nominal GDP growth is about 2% a year, Wilson is cautious and expects that the Federal Reserve will raise interest rates only about 50 basis points (bps) a year, as opposed to some who predict annual moves of 100 to 150 bps.
"This is an environment where you don't necessarily benefit by setting an asset mix and leaving it," says Wilson, a 26-year industry veteran who began in TD Bank's treasury department in 1990 and moved to TDAM in 1996. "From a tactical-asset-allocation perspective, a good equity analyst will see where the relative opportunities are -- because they are not trending to the extent they once were. On the equity side, we're asking, 'Can companies grow their earnings, and how quickly will they do so?' This is definitely a trickier environment."
The most important aspect of TAA is having a broad framework to work with, says Wilson. That means understanding long-term trends, which help to identify when markets are moving to extreme levels. "That's when the tactical trades kick in and you are able to add or reduce risk," says Wilson. As a starting point, Wilson and his team focus on the United States, because of its dominance in the global economy and its highly diversified stock market. From there, they study other markets.
According to the TDAM team's analysis, the upper range of the benchmark S&P 500 Index is around 2150 points, which is not far from its current 2100 level. Moreover, the team is factoring in the possibility of changes in tax policy after this fall's U.S. presidential election. "If they increase taxes, then some companies may not be able to grow as quickly," Wilson says. "It will likely have an impact on their multiples."
Overall, Wilson expects equity returns of 5% to 7% a year. However, that depends on productivity growth, which lately has been lower than in the past. "We have to see if this is a cyclical trend or a secular one, because a lot of companies, rather than investing in the future, have borrowed money to buy back their stock," says Wilson, adding that he studies changes in the U.S. Purchasing Managers Index to determine the strength of the economy. "That's been one of the drivers of earnings growth."
On the fixed-income side, conditions are equally challenging as ultra-low bond yields have turned negative when inflation is taken into account. "From an investor's perspective, that's very punitive," says Wilson. "What can you do in the equity market to offset that? To the extent that you can capture some of the cash-flow yield, or dividend yield, that's a better alternative. The real challenge is managing the risk."
How do these views translate into portfolio changes? Take, for instance, the $8.7-billion TD Managed Income Portfolio and the $5.5-billion TD Managed Income & Moderate Growth Portfolio. Both utilize the same group of TD funds, such as TD Canadian Bond and TD Income Opportunities Pool. Where they differ is the equity exposure.
TD Managed Income Portfolio has a benchmark of 70% fixed income and 30% equities. TD Managed Income & Moderate Growth Portfolio has a neutral mix of 55% fixed income and 45% equities. These are only starting points, however. Depending on investment inflows or outflows, and market activity, the portfolios may be tweaked every six weeks or so. "If the market is moving around quite a bit, we may make significant changes weekly," Wilson says.
A recent instance of TAA occurred in early April when Federal Reserve chair Janet Yellen made dovish comments that resulted in a positive reaction by equity markets. Accordingly, the team reduced the equity exposure on the basis that the market had run its course. Conversely, whenever equity markets come off, the team tends to raise the equity exposure. "In these kinds of markets," says Wilson, "we're looking for opportunities to make those changes."
