The Fear of Running Out of Money with John Wilson 2022 Update

November 2022

As we look toward a likely recession in 2023, the fear of running out of money in a bear market
is growing. How is Ninepoint’s John Wilson viewing the year ahead and how is he avoiding that
fear himself?

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Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

Michael Hainsworth:

It's been a challenging year for investors in both bonds and equities. Pretty much any asset class, with inflation at 40 year highs leading central banks worldwide to ratchet up the cost of borrowing at a pace most investors have never, ever seen. Many of us are reluctant to open the monthly portfolio statements. For many Canadians, their homes are an integral part of their plan. Selling that tax-free investment after raising the family is expected to pay for much of retirement. Economists are predicting home prices to fall as much as 30%. We don't know how high the central banks will raise interest rates, and there's much uncertainty about the depth of the coming recession. But according to Ninepoint's, John Wilson, the market has created a significant risk-reward proposition. John, thank you for joining us.

John Wilson:

Oh, thanks for having me, Michael.

Michael Hainsworth:

Does Canada get a deep and protracted recession in 2023? What's your call?

John Wilson:

Well, of course nothing certain and there, you know, the one good thing we have going for everybody is the economy has been incredibly strong, particularly the labour market has been very strong. So, you know, what you always worry about in a recession are obviously people losing their jobs and all the hardship that brings to families and to people's savings. So, at least we're starting from a very, very strong position in that sense, in that most people have jobs if they want them. In fact, a bigger problem has been finding people to work and personal balance sheets have been on the whole pretty solid with, of course, the one exception being that people are carrying large mortgages for homes, generally speaking. So, with that all said, we're going into what is going to be a much more challenging period. Obviously the cost of carrying those mortgages is going to go higher as people have to refinance and reset those mortgages. That doesn't happen all at once, right? If you have a five year mortgage, and you've got three more years left until it renews, you've got still some runway at a much better mortgage rate. But that all said, you know, the cost for businesses borrowing is going to go up meaningfully from where we've been for the last decade. And generally speaking, that pretty much always causes a recession and job losses. So, I guess the short answer to your question is yes, we do expect a recession. I think people have been a little impatient in as to when that's going to start. Our view is it's more likely to be the second half of next year. It takes a while for all of this to trickle through the economy. We're seeing some of the early signs of that slowdown both here and in the United States. But in terms of really being, you know, in a much more difficult spot economically and seeing joblessness really rise that's probably more the second half of the year. Is it going to be a really, really bad one? Hopefully not. You know, knock on wood, that will largely depend on what the central banks do. Whether and what inflation does that is incredibly uncertain. I don't think anyone who says they've got an answer to that is either not being truthful or is ignorant of what's really happening. So, we'll see. To date, inflation has been much stickier than anyone had hoped. And even though it looks like it may have peaked and that would be good news, it's still a long way above where central banks would like to see it, which is 2%. So, to the degree they stay with the rate hiking campaign which we think they will for a number of months and then hold at those higher rates for a number of months after that, that's really what's going to cause the pain.

Michael Hainsworth:

Yeah, I can imagine a lot of that has to do with the fact that we really don't know what the impact of any given interest rate increase is on an economy for anywhere from, you know 12 to 18 months down the road, which sort of brings us into that spring 2023 period of which you speak, what is your call on interest rates by the time we get to that point where we could very well find ourselves in a recession, as you suggest, in the second half of 2023 yet at the same time the Bank of Canada deciding that maybe we've we're done with rate increases? Is that your call, too?

John Wilson:

Yeah, I think they will be done with rate increases by that point. I think we'll be well above 4% and maybe even at 5% when they do that. And, you know, I guess where our view would differ from what has generally been floating out there if you look at what market expectations are for interest rates looking forward, people have, you know, that peak happening in the first half but then they have it, the rate starting to get cut again in '23 and then getting cut more in '24. And I think that's very premature. I think they're, you know, the real challenge that we're heading into is not just the interest rates have gone up a lot but that they're going to stay there for a while. And, you know, back to my earlier point about people refinancing, obviously the longer you stay at higher rate, the more people fall into that category when they need to refinance. So, and the more hardship that causes and the determining factor of, you know, just how long they hold there is going to be how long it takes inflation to come back down. And, you know, in as much as some goods inflation has come back down, service inflation has not, you know, we're going through this whole thing here in Ontario with CUPE looking to strike this coming next week and looking for a major wage increase. And you're seeing those sorts of demands across the spectrum in labour. People, you know, seeing inflation 8%, 9% and saying you know what, 2% wage increase isn't going to do it for me. I want 6, 7, 8, 9, 10%. And to the degree that takes hold that's what keeps inflation high.

Michael Hainsworth:

So, it sounds like what you're concerned about here is that we may see a pause on interest rate increases by the spring at the same time we have a recession in this country, but it may be a longer protracted recession because to your point not everybody's going to refinance their mortgage at the same time and they're going to be refinancing at higher costs, therefore, even less money is going to be in the economy.

John Wilson:

Yeah, that's not just people refinancing their homes. Obviously businesses will see a pinch as well. I mean, credit and access to credit and what you pay for credit is an important element of any business. And the more expensive that is, the less, you know, each opportunity's now got a higher bar before it's worthwhile doing and that causes less employment and all of those sorts of factors. So yeah, I just think they'll be, you know, the longer they hold it, the more pain they'll be in and the worse the recession will have to be, and that the ultimate determinate of that will be, you know, how long it takes inflation to come back down.

Michael Hainsworth:

Which sort of brings this to the ultimate point of this conversation, the fear of running out of money.

John Wilson:

Yeah, yeah and you know, I was thinking a lot about this over the last few days, preparing for this podcast and the fear of losing, running out of money. You and I have talked about this before when inflation wasn't a problem, right? We talked about it was already a problem and it was a problem for a different reason. It was a problem because interest rates were so low and you know, traditionally as people got older they moved their investments into more secure, less volatile income-oriented instruments like fixed income. And that tool really got taken away from them over the last decade. And so that caused a lot of problems for people when they, you know, started worrying about, well, you know, if I go into those types of instruments, am I going to run out of money? Now you've got a different problem, which is those types of instruments are now earning, you know, actually starting to be fairly attractive from our point of view, right? It's not, you know, in a high quality corporate bond, you could be getting, you know, five, six, 7%, that's pretty decent. The challenge is inflation, so that's decent, except if inflation's 8 or 9%, right? You're still getting a real terms, you're losing money. And so, you know, the variables have changed a little bit, you know, interest rates have gone up, that's good but unfortunately inflation's gone up more and that's bad. And so you still have this conundrum and people concerned about, will I run out of money? And it's a, it's a genuine concern. You know, I'm old enough to remember when I first started working, there was this thing called defined benefit pension plans where, you know, you were guaranteed a certain benefit for the rest of your life. And around the time I started working, actually all the companies started changing and making a defined contribution. And now it's up largely if you're in the private sector, it's up to you to save for your retirement and to invest properly and that puts a big burden on people. One, because they're not investment professionals for most people, and two, the environment is much tricker now than it was back then. And so, you know, when people think about generating in the cash flow they need to live their lives as they head towards retirement, you know, that comes really from two pieces, right? You can generate income or return on your capital from the capital that you've managed to save from your nest egg and if that's not enough, you have to actually start to eat into your capital. So, they're both connected and you know, if you were, Mike, I think you're going to live to a grand old age. Let's say you're 105, you can probably start eating into your capital, right? Like, I mean, as much as I would like for you to live much longer, you know, there's a finite period where we're all going to be here. But when you're 65, you know, realistically you don't want to be start eating into your capital because you are realistically going to be around 50 more years at least. And you need that capital to keep working for you. So, that's where this concern comes. People see, you know, see the timelines and everyone's living longer, knock on wood. We all stay healthy and continue to live a long time but they need to have that capital last for them and still generate enough cash to live the lives that they want. And that doesn't mean everybody needs to run around and buy a Ferrari, but, but people want to live, you know, in their homes or in a home that fits their needs and they would like to see their kids and maybe take a trip and you need to add all that up and figure out how much capital that's going to take and what's a realistic expectation of the return that can get you there.

Michael Hainsworth:

So, to your point about the difference between the last time we had this conversation more than I think it was two years or so ago to where we are today, there has been that pull back in the equity markets, and that is in part why we're seeing that rise in yields in the bond market, government and corporate bonds that race to safety. What does 2023 look like for you for fixed income when we keep having these sort of bear market rallies in equities?

John Wilson:

Well, so I would come at that maybe slightly differently. I think, you know, the equity market is down largely because the, you know the central banks have been raising interest rates right? And they've been raising interest rates because of inflation. And the unfortunate problem, which we warn people about with a 60/40 portfolio is one of the key benefits of a 60/40 portfolio over the last 30 years was that it diversified you, it's 60% in stocks and 40% in bonds. And historically when stocks went down, for whatever reason people moved to your point into safety and the value of your bonds went up and that helped offset your losses in your stocks. But when interest rates are zero, there's pretty much only one way for interest rates to go and that's higher, which is what we saw this past year. And by the way, for that last decade everyone kind of came to this conclusion that we weren't going to have inflation anymore. I don't know how many stories we all read about that. And suddenly inflation is back, suddenly, interest rates go higher, when interest rates go up, and this is hard for a lot of novice investors but the value of your bond goes down because your bond is tied to a lower interest rate and now everyone can get higher interest rates. So, now not only did you lose money in stocks but you lost money in your bonds and you, that diversification benefit that was really one of the core principles of having that split in your portfolio has disappeared. So, that's why it's been such a painful year for people in 2022 because they've lost money on both sides of the ledger. If you look into 2023, from our point of view, things have kind of reversed from where we were the last decade, last decade we were really worried about the bond piece of the portfolio. One, because when rates are at zero, it wasn't generating much income for you. And two, it presented a lot of risk for when, you know, one day the interest rates eventually rose which is what's happened this year. Now, as you look into 2023, fixed income actually got a better interest rate. If you're putting new money into fixed income you can get a, generally a fairly decent interest rate. Yes, rates are probably going to go a little bit higher, but we're almost there. And even if they hold them there for a while, you're going to generate that income. And at some point, you know, in a recession as it takes hold and inflation dies down they're going to start to lower interest rates and the value of bonds will go up. So, bonds looking much better. The problem to your point is now equities and you know, you've got a lot of things still to come at you on the equity side, right? You have more interest rate increases which generally lowers the multiple that you get on a stock or on a stock market. A recession will clearly lower earnings which means now I got a lower multiple and lower earnings. Higher interest rates, by the way, raise the cost of leverage for businesses, which again, lower earnings. So, all of those speak to a much more difficult period for equities. And the fact that we have these raging rallies, you know, 5% in a single day like we had a few Mondays ago those are very typical by the way of bear markets, not of a new bull market. That's not how you, if you're thinking you want to be back in the bull market, you do not want to see after, you know, six days of selling a 5% up day. That's not generally how you get there. So, you know, we don't think that bottoming process is over yet in the equity market. And I think more importantly maybe, people need to think, you know, and look at history, we've come out of a decade, call it 2002 to 2000, or sorry, 2010 to 2021 where equity returns were far above normal. And that was not maybe a surprise when the central banks are keeping rates at zero and doing, you know, quantitative easing, money printing, which boosted the value of all assets, houses, stocks, you know, lots of money chasing assets and those assets all went up a lot in price. And so you had 10 years where you earned abnormally high returns in equities, but people kind of forgotten that the 10 years before that, guess what, you almost, you didn't make any money from 2000 to 2010. You know, you basically, your return over that period was flat and, you know, the 10 years before that you had a great ten year run. And so, not that everything has to work in 10 year cycles but we're coming off of very high multiples into a much more difficult environment with much higher interest rates and much lower multiples in a recession. I just think equities are going to be far more challenged for a period of time. That doesn't mean you can't make money in equities but people shouldn't be looking at that area thinking they're going to make the kinds of returns they were making for the last 10 years because that's, in my opinion, just not going to happen.

Michael Hainsworth:

Your colleague, Mark Wisniewski, wrote to the Globe & Mail recently, you know, that he's seen "compelling opportunities". Where do you see the compelling opportunity?

John Wilson:

So, we talk a lot about this with our clients. You know, everybody has an, I call it an investment destination they want to reach and people get very focused on the destination. And in our view, that's obviously incredibly important. But what's equally important is the journey you need to take to get to your destination. And that's a function of the kind of portfolio you build. You know, I can show you the most amazing investment destination with your capital, you know, three times your money in five years. But if it's a line that goes up and then way down almost to zero and then up and then down and you're just never going to make it, you'll lose your nerve, you'll likely buy high and sell low. That's generally the history of what investors do in those types of environments. And you'll realise a return far below your destination. If on the other hand, I can give you not maybe as high a return, but a much gentler ride, you'll stay with it and actually in the end realise much higher return than you would've otherwise. And you know, in this current environment given what interest rates have done, we don't even think it's necessarily, it's necessary to give up on how much return you're ultimately going to get at your destination. We just think there's an opportunity right now to allocate to non-correlated strategies, what we call alternatives in a way that still gets you to your destination but does it in a much gentler fashion. And that we think is not only going to increase the success rate of people getting to their destination but make the ride a lot more enjoyable and less stressful.

Michael Hainsworth:

So, dig a little deeper into that for us. If the yield on many high quality corporate bonds now exceeds the dividend yield of their stocks, how are you going about deciding what qualifies as an investment?

John Wilson:

Well, you know, everybody has different needs and wants and, you know, at different stages in their life and different risk tolerances. And so, you know, we work with advisors who, you know, are experts at gauging that with their clients and helping their clients understand what they need and want and what they can really tolerate. Our role in that process is to put as many choices in front of the advisor and the client that they can choose from, all of which they can build portfolio allocations that help them get, achieve those goals. So, you know, our focus when interest rates are here is, you know, can we give you strategies that generate an attractive return for you that are not correlated to your core allocations to stocks and bonds, but still generate a nice return? And because they're not correlated, it's going to smooth that ride for you. So, instead of being just 60/40, maybe you're 50/20/30 or 50%, 40% stocks, you know, 40% bonds and 20% alternatives. And those alternatives can have all kinds of different flavours and there's lots of reasons why people pick different ones. Sometimes they pick different ones because they're familiar with them sometimes because, you know, they've had experience with them. So there's all kinds of reasons why you can end up with the allocation that people end up. But our, you know, where we think the world is going here for the next number of years is there's less movement away from the 40% allocation of fixed income for all of the reasons that Mark laid out. And you'll see people lower their allocation to equities like they did by the way, in 2000, that was the last time, you know, there was a big allocation globally to alternatives was in the early 2000's when stocks had a really rough period through 2000. And that was a smart thing for particularly institutional investors to do because they managed to diversify their risk into things that weren't as relying on equity returns.

Michael Hainsworth:

One of the things that he did point out in that Globe piece was that regardless of whether we get a hard or a soft landing for the economy, fixed income has already priced in most of the uncertainty?

John Wilson:

Yeah, I think that's largely true. I mean, credit spreads are wider. They're sort of implying that there'll be some level of defaults that's way above anything that we're at right now, and so yeah, to a degree they've discounted a lot of the bad news already which makes it an appealing investment right now, as you head into 2023. Equities on the other hand I would argue have not, right? Earnings estimates for next year have started to come down but they're still above this year by a pretty significant margin. And we think they have to go below where earnings are for this year, that plus a multiple that remains pretty robust on historical standards, certainly at or above average. And, you know, the equity market is, that doesn't mean you can't make money in stocks, by the way. There's, not everything goes down. I mean, Eric Nuttall's done a fantastic job with energy and that's a whole different kettle of fish because of the energy supply shortage globally. But, generally speaking, in terms of indexes, you know, equities just haven't reflected a potential recession whereas fixed income has.

Michael Hainsworth:

If there was one takeaway for the listener in your mind, what would it be?

John Wilson:

The key takeaway is that portfolio construction is the single most important thing you're going to do. And there's a temptation to tinker and, you know, trade around things and you know, but if you're not an investment professional and even investment professionals, actually the more professional people are, the less they do that, they set, you know, they have their strategy, they set their allocations and they let them work. And the key factor in setting a good portfolio allocation is understanding how much risk you have and how correlated the things you've chosen are to each other. Everyone understands, don't, you know the saying, "Don't put all your eggs in one basket," but if you have your eggs in five baskets, but all the baskets fall at the same time then you haven't really achieved anything. So we think, you know, the key takeaway is build a portfolio that has an allocation to uncorrelated assets in addition to your stocks and bonds. You're probably going to want to have less stocks and allocate to those other types of strategies. To Mark's point, you can go to a good bond manager and Mark's a fantastic bond manager and earn really attractive returns right now. And that's probably the kind of allocation you're going to have for the next decade. And, by the way, in Canada, that's what our most sophisticated pension plans do, right? They have over, they actually have 50% of their allocation to those types of uncorrelated investments and it's the Canadian retail investor that is underallocated to those types of strategies, not only compared to CPP and Teachers and all these big pension plans, but also just generally to other developed markets, places like the United States and Europe where they have used these strategies more often.

Michael Hainsworth:

John, thank you for your time and insight.

John Wilson:

Yeah, thanks Michael.

 

Listen on Google Podcasts
Listen on Google Podcasts
Listen on Spotify

 

Part of Ninepoint’s Alt Thinking Podcast Series. Available at Google, Apple, and Spotify Podcasts.

 

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