FidelityConnects: The Fed decision and asset allocation with David Wolf

[00:04:47] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. We're just a couple of days away from rate decision day. Both the Fed, we've got the Bank of Canada holding press conferences through this week. Last week's inflation and employment report suggests a green light for rate cuts across the board but questions surrounding how current political sentiment is shaping long term Fed independence still remain. How might the markets react if rate cuts do resume on both sides of the border, and looking further down the line, will a change in Fed personnel result in a shift on how monetary policy is fundamentally conducted? Joining us here today to discuss how these key economic and market factors are contributing to asset allocation decision-making is portfolio manager and member of Fidelity's Global Asset Allocation Group, David Wolf. Welcome. Great to see you, David. Thanks for joining us here.

[00:05:37] David Wolf: My pleasure.

[00:05:38] Pamela Ritchie: It's the beginning of an important week.

[00:05:40] David Wolf: It is.

[00:05:40] Pamela Ritchie: We will invite everyone to send their questions in for David, we'll put those to you. Let's start with the two decisions that need to be made in our country and across the border, which is more the central bank to the world. It's all in the bag at this point, is it not?

[00:05:55] David Wolf: I don't know about in the bag. The Fed is going to cut rates, Bank of Canada is going to cut rates. Let's talk about the Fed first which is the more important decision for markets not just in the U.S. but in Canada and elsewhere, which pains me a little bit to say as a former Bank of Canada official but it's true. I don't think there's any question that the Fed's going to cut rates. The market discounting right now is for a 25 basis point cut, and that's pretty firm. There's a little bit of suspicion that we might get 50 but 25 is the ... one of the very interesting things, and I'm sure we'll talk about this extensively, is why the Fed is cutting.  There's this standard approach which is to say the labour market is weakened so job growth has kind of trailed off into almost nothing, we've had a big down revision to payrolls, unemployment rate is up a little. By the usual growth inflation matching that to the level of interest rates you would be cutting. But then you have what's quite new and challenging, shall we say, for many folks including us, is we might call it political overlay which is we know that the administration is wanting to put heavy pressure on the Fed to be easing policy, and that's everything from Trump tweeting about Powell., the newest Fed governor is Steve Miran who actually used to...

[00:07:21] Pamela Ritchie: Looks like he'll be sitting there to make the decision within...

[00:07:24] David Wolf: It's unprecedented to have a member of the administration also as a member of the Fed, at least in modern times.

[00:07:31] Pamela Ritchie: On loan, we've heard, I don't know if that's correct.

[00:07:34] David Wolf: Ostensibly. Trying to fire Lisa Cook, that pressure is clearly there. For the decision Wednesday, and I want to talk about kind of the longer term implications of this as well, but for the decision Wednesday if you're the Fed you kind of have two ways that you can go. You can either indulge the pressure and say, okay, maybe you go 50, maybe you sound very dovish and you kind of accommodate or appease that pressure that's coming from the administration. You can go the other way and you can say, well, the most important thing for us as a central bank is our credibility so we have to be seen as resisting these calls for lower rates which still means that you probably cut 25 basis points but you sound very different. There is some uncertainty surrounding the decision on Wednesday.

[00:08:23] Pamela Ritchie: Again, we'll sort of go further into this but for your purposes, for the way you look at the markets, for the way you make decisions, this rate cut is a cut that, as you say, sort of looks like it'll probably happen. It is going to be very important to how it is positioned for further because it'll talk about how more rate cuts, should they come, will be made. Is that right?

[00:08:42] David Wolf: Yes and no. That's how people will take it Wednesday afternoon and that's how the market will trade maybe Thursday. The really important piece is if you look out over the next year or two, three years, how are the decisions being made, who is making them and how do you balance this rate policy that's appropriate for the economy with the rate policy that the administration wants. The two can be very different things. Maybe to illustrate in terms of how we would think about these things, particularly from a fixed income point of view, usually the way that we're thinking about our bond allocations in the funds, and I'm simplifying here, basically, say you project out the economy, what's happening with growth, implications for inflation, what does that mean for short term interest rates, i.e. the decisions that the Fed is making, and then you cascade that, what does that mean for longer term rates, the slope of the curve, credit spreads, and you can build a fixed income approach from there.

[00:09:40] That's still relevant but it's not clear how relevant that is because the other method of thinking that you have to take now is, okay, what is the probability that the administration is going to effectively be able to capture the Fed, and how long does that take? How far below appropriate are rates going to be driven? How much is the longer end of the bond market going to very unhappy that rates are lower than they should be so bringing in inflation risks. And then how likely is the combination of the Fed and the Treasury because a captured Fed is working together with the Treasury, how likely are they to come in and do something like yield curve control, or try to bring down long term interest rates in the interest of mitigating the cost of the budget. All of these things are things that a year ago you wouldn't have to think of  but that's arguably more important than the basic economic stuff. It's something we have to think about. I'm interested in what happens Wednesday but not that interested in. What we're interested in is if you look out a year, two years, three years, what is the Fed doing, why is it doing it and how do we not only make money out of that in the funds but really protect ourselves in the funds.

[00:10:59] Pamela Ritchie: Well, to what extent and what type of comment or direction could be signalled on Wednesday that would make you change an allocation, not tomorrow or in three days, to Treasuries, to be involved in the U.S. market that is maybe changing the way that they make their own decisions within the structure of the Fed.

[00:11:22] David Wolf: Maybe two comments there. The first comment is I don't think there's anything they could do or say on Wednesday that would make me want to change anything, because it may not be the same people six weeks later who are making those decisions. They may change their minds.

[00:11:35] Pamela Ritchie: But even that.

[00:11:37] David Wolf: Well, exactly, which gets to the broader point which is everything that's happening in terms of this political overlay to the Fed, questions about independence, questions about the way monetary policy is made, et cetera, is unsettling if you are a bond investor, if you're effectively funding the U.S. government by buying Treasuries. One of the things that we've done in terms of how do we play that is we don't. We take our ball and go home. What that means is we've sold out basically all of our U.S. Treasury holdings in the funds for which I'm responsible because there are a lot of other places that we can put fixed income money where we don't have these concerns about the of policy and the implications in terms of instability in the macroeconomy.

[00:12:23] Canada is one and we can talk about that, but even something like the German bund market. It's not great but it's actually the highest you've been able to get in over a decade. It's in a currency, the euro, that you think is going up rather than going down. You have a very entrenched fiscal framework. They're going to be borrowing more money for their defence but their debt level's lower et cetera. There are lots of places that we can own fixed income that are not exposed directly to these questions that are going on in the United States. Maybe the final comment on this is if we're doing this you can bet there are a lot of other asset allocators around the world who are doing this. That in and of itself is the kind of thing that's going to push down the value of the U.S. currency and U.S. Treasuries and push up the value of some of these other markets.

[00:13:18] Pamela Ritchie: That is absolutely fascinating that the bond portfolio could actually change a little bit, and is changing.

[00:13:24] David Wolf: It has, we've done that.

[00:13:24] Pamela Ritchie: It has already. Tell us a little about the Canadian opportunity. This seems like a moment. It looks like Tiff Macklem will also be in a position where he has to cut. We've seen growth slowing in this country. We know that that's sort of baked into markets as well. What sort of concern are you looking for from the Bank of Canada governor when he speaks?

[00:13:47] David Wolf: Well, first of all, to step back and look at Canada from a policy perspective versus in the U.S., there are a lot of things about Canada and the U.S. that are really sharp contrast at this stage but one of them is just how the central bank is making decisions. We just talked about the Fed and there's the economic piece and there's the political piece. In Canada, basically, the last thing that you worry right now is the political piece because the Prime Minister is the former governor and my former boss, Mark Carney, who if anyone knows the value over the long term of central bank independence it's Mark. So you don't worry about political interference you're just looking at the economics.

[00:14:24] Pamela Ritchie: So it's not in the equation for that, for the way we're looking at things.

[00:14:27] David Wolf: So what are you worried about? You're looking at the quote, unquote, ordinary economic stuff. Where is the economy at? Where is inflation at? The fact of the matter is the economy has been soft, seems to have gotten a little bit softer. We have the unemployment rate a little above 7%, it troughed out below five a couple of years ago. You have the housing market is pretty much at a standstill everywhere. You had GDP print negative in the second quarter. We got some data...

[00:15:01] Pamela Ritchie: Are we in a recession?

[00:15:02] David Wolf: Well, we got some data...

[00:15:04] Pamela Ritchie: We could be.

[00:15:04] David Wolf: I think we've been close to recession, and do you want to call it or not  for a year and a half. The numbers are slightly positive, slightly negative but I think we've effectively been close to recession, if not in recession, for a couple of years. It really doesn't matter whether you call it that or not, that's been the effect of it. In that context and with the data having weakened off a little bit further it's fairly easy for the Bank of Canada to say, okay, we need slightly looser policies. So they'll do that on Wednesday. It's a lot less interesting than the U.S. decision but for someone like me I like not interesting.

[00:15:39] Pamela Ritchie: Not interesting is good, yeah, boring is good in this sort of area. Tell us a bit about where we get down to. If we get to down to 2% interest rate there's not a whole lot of room to cut after that if we're in a position of, I don't know, some version of a crisis, right? 

[00:15:58] David Wolf: That's fine.

[00:15:58] Pamela Ritchie: It is fine?

[00:15:58] David Wolf: That's totally fine. The market...

[00:15:59] Pamela Ritchie: It took a long time to get up off very low interest rates.

[00:16:02] David Wolf: Yeah, I mean, so current rate is 2 3/4%, the neutral rate, as the bank would define it, is pretty close to that 2 3/4%, if you cut to 2% which is roughly what markets are discounting right now by this time next year so that's slightly loose. If the economy falls out of bed, if you have a crisis, whatever, you go further. We got, obviously, all the way down to almost zero. I don't think that's likely in virtually any state of the world but you've got plenty of room. I don't think that lower bound is at all on the bank's mind at this stage.

[00:16:36] Pamela Ritchie: Okay, well, let's broadly speak about what that possibly could stimulate or at least catch the economy a little bit but also taking a look at what appears to be an ambitious plan for build-out, government led, over the course of the next few years. More interested in sort of how you see the environment for investing in Canada. You've mentioned in recent notes that you're sort of pivoting the ship back towards Canada, you're less negative on it, certainly. I think you're actually neutral on Canada at this point.

[00:17:08] David Wolf: For the first time in a very long time.

[00:17:11] Pamela Ritchie: You've always said you can afford to be very, very patient with certain types of investment. What does that mean today?

[00:17:17] David Wolf: There are a bunch of different things in there and I'll unpack some of them and then we can go there. First, with respect to monetary policy in Canada, again boring, not that interesting. What's a lot more interesting, as you alluded to, is this ambitious agenda, particularly at the federal level in terms of getting the economy going, getting productivity growth restarted in this country. We're looking a lot more at fiscal policy, not just how much borrowing the government does but what that money is being spent on in terms of expanding infrastructure, et cetera, ultimately, the economy's capacity to produce which is what drives those productivity gains and longer term growth.

[00:18:02] Now, the Prime Minister as I know personally very well is a force and if anyone can get through the red tape, bureaucracy, entrenched interests, et cetera, to get some of these bigger projects done, it's him. We'll see if even he can manage it because there's a lot of headwinds that way but we'll see. Our move back into Canada is going to depend very much on the success, particularly at the federal level, in terms of laying the foundation for that better economic growth over a longer period of time.

[00:18:37] Pamela Ritchie: It sounds like, I don't know if it's a couple years out but there's going to be some spending, there's been lots of announcements lately, that is going to happen right now and is government funded entirely and it's close to shovels ready type projects. They're happening now. Over the course of what it sounds like a couple of years there's a major projects office as you well know. That is the kind of stuff you'll be watching to see how that unfolds 'cause they are sort of there meant to get rid of red tape, frankly, and get things moving. That's part of what they're doing there. Is that process something that you're watching extremely carefully?

[00:19:08] David Wolf: Absolutely. It's not something where we're going to make a different decision today, tomorrow, next week in terms of how that goes. We'll see over time. One of the important points you mentioned about patience, one of questions I've gotten asked quite a bit in recent months is why are you moving back to Canada with your investments? Canadian economy may be in recession. The U.S. seems to be doing great. U.S. market has been on fire. What are you doing? The answer to that, again, is the sort of forward-looking and long term approach that we tend to take. Canada's current struggles were very visible many months ago.

[00:19:43] Pamela Ritchie: Like the mortgage '25, '26.

[00:19:45] David Wolf: Yeah, the resets on rates, the headwinds from tariffs which were very clear in the second quarter in terms of a big drop in exports, reduced immigration. Regardless of how one feels about that those people spend, they work and that's a contribution to the economy that's not there anymore. So you expected this to be weak. It was discounted by the market, amply so in our view. We're looking out a year, two, three, five, ten to say how are things going to evolve going forward. One of the things our colleague, Mark Schmehl, likes to say is one of the times that you have the best investments is when things are really bad but they're getting a little better. I think that's one way to think about Canada where things economically are, clearly, not very good now but there is a path to them getting better over time, potentially, much better, potentially, a little better, we'll have to see.

[00:20:43] What it means for us is, again, we've been underweight Canadian assets, underweight the Canadian dollar a very long time because the trend had been negative. Now things actually are not very good but the trend is flatter to even slightly positive so we want to bring money back into Canada. Again, we're not dramatically overweight, that will take some time and evidence that things are going in the right direction, but it's been sensible from our point of view in the context of some improvement in the outlook coupled with the deterioration in those U.S. conditions to move money back into Canada.

[00:21:22] Pamela Ritchie: It's really, really interesting. Tell us just a little bit about your outlook for the currency discussion. You mentioned with Europe and taking a look at from a fixed income perspective and bond perspective that you like being exposed to a currency that might well be going up, the euro itself, the U.S. currency and, really, the Canadian currency because you had quite a call on the Canadian dollar for a long time, and it was a bit dismal there for quite a long time. Where does it go from here?

[00:21:49] David Wolf: One kind of big brush stroke way to think about how we've managed the currency is I came to Fidelity in 2013, Canadian dollar was close to parity, we sold it, a lot of it, and we bought it all back at 70-ish cents. That's been a real win for our investors. Where do we go from here? We're around 73 cents or so right now. I think the bigger story here is not Canada but the U.S. itself. We have a strong view, both our group in Canada and our broader global group, that the U.S. dollar is coming from an overvalued position and is likely to trend downward. That's against everything so euro, yen, sterling, Swiss franc, and Canadian dollar. We've been trying to, not only as I mentioned earlier in the conversation, get out of U.S. Treasuries but get out of U.S. dollar assets, generally speaking. Now, that doesn't necessarily include U.S. companies, many of whom are thriving right now and we have those holdings, but generally speaking broad brush we want to be reducing our U.S. dollar exposure.

[00:22:53] Now, why do we want to be doing that? It doesn't have much to do with what we were talking about in terms of the Fed decisions. It has a lot more to do with that political overlay. One of the ways to talk about our view in the U.S. is we think that there should be a higher risk premium associated with U.S. assets because it's a riskier place. Things could work out great, things could work terribly, and you're not being paid to take those risks right now. If Treasury rates were 150 basis points higher, if the U.S. dollar were 20% lower, if the U.S. broad market, so not the AI plays but the tail of it, was 5 P points cheaper we would still be involved in the U.S. in greater size. But it's not, and if it gets there we'll move money back into the U.S. but it's fundamentally risky.

[00:23:47] It also, if I may for a moment, it gets into what is the administration trying to do. I think one of the things the administration in the U.S. is trying to do is actually produce a weaker U.S. dollar, even though they won't come out and say that.

[00:24:05] Pamela Ritchie: Through inflation?

[00:24:06] David Wolf: Not so much through inflation but take the following premise. You have a huge debt pile in the U.S. and that's mostly on the government balance sheet. U.S. government is highly indebted. How do you get out of debt? Well, there are three ways historically how a government gets out of that. One is you default your way out which you never have to do if you're the sovereign issuer in your own currency.

[00:24:27] Pamela Ritchie: So that's not an option, really.

[00:24:29] David Wolf: You can grow your way out which always sounds good, never really works. Or you can inflate your way out, to your earlier point. Now, part of that inflation is just domestic CPI, goods and services, prices go up but a big part of inflation when you have a lot of foreign debt, the way that the U.S. does, is depreciate your currency. You're basically giving dollars back to the people that lent them to you, dollars that are cheaper than the ones they gave you.

[00:24:55] Pamela Ritchie: That are worth less.

[00:24:55] David Wolf: That are worth less, exactly. In a sense you're kind of stiffing your creditors which is consistent. I'll just...

[00:25:09] Pamela Ritchie: As an investor you don't want that.

[00:25:12] David Wolf: I don't want that so we don't have that. As I mentioned, we still have plenty of U.S. company holdings, U.S. dollar holdings. One of my primary jobs as a multi-asset investor is to make sure that we're diversified and not owning anything in the largest economy and market in the world would not be diversified. We have plenty U.S. holdings, don't misunderstand that, but in terms of our active process, where do we want to be tilting, for many years it was into the U.S. and out of Canada. Now it's more out of the U.S. and into a lot of other countries, including Canada.

[00:25:49] Pamela Ritchie: That is fascinating. We're going to swing back to that. There are a number of questions that are linked to today's headlines because there are a lot of headlines actually coming out today. One of them is, it looks like an increasing trade discussion between China and the U.S., just park that for a second. This question is, any thoughts on the U.S. pushing, and this is just a social media post from the President right now, it's not necessarily policy pushing but...

[00:26:11] David Wolf: Is there a difference?

[00:26:13] Pamela Ritchie: That is for you to answer. U.S. pushing for semi-annual reporting rather than quarterly reporting. I mean, actually, President Trump did push for this when he was first in office, didn't actually go anywhere. Maybe just give us some context for why that would be good or very bad.

[00:26:30] David Wolf: Semi-annual reporting of economic data or of companies?

[00:26:34] Pamela Ritchie: No, companies. He's pushing for it to be not quarterly and to just be every six months.

[00:26:39] David Wolf: Maybe we would fit that into the broader conversation including the economic data because we know that he was not happy with the BLS and replaced the head of the BLs. That's caused questions, understandably, from everyone as to the quality of those data going on ahead. I mean, the big picture, what I would say, not just that social media post, we'll see if that's policy or regulatory changes or not, et cetera, but if in a modern, high functioning financial market the currency is information. To get the highest valuations that you can out of a company, out of whatever, you need to have the best, most reliable, most transparent information that you could get. Things like, well, we're just not going to tell you, we're going to tell you half as often how we're doing, or maybe you can't believe these payroll numbers, that all goes in the other direction. That's what happens...

[00:27:40] Pamela Ritchie: There's a transparency question there.

[00:27:41] David Wolf: Well, I mean, investors want, and deserve, and we are investors, the best information we can get on which to make decisions. That seems to be going in the wrong direction, frankly, in the United States. Again, it's wrapped up in this concern about a risk premium that, you know, let's take the extreme. If we never had any information about anything how excited would we be to invest in something? Not that excited. So that risk premium needs to be there.

[00:28:09] Pamela Ritchie: You go to that no data, no problem, right?

[00:28:13] David Wolf: Maybe for others, and you know what, if there are other investors that are content in having zero information and are going to pay up for securities we'll sell them to them, no problem.

[00:28:25] Pamela Ritchie: Let's talk just a little bit about the idea of patience because I want to come back to this and fundamentally see if I can get you to say anything about how you are thinking about investing in Canada. We have some clarity on some big projects, as we mentioned before, government funded. But moving ahead, what's of interest to those investors in this country that have pockets big enough to make real investments in, essentially, infrastructure in a new country where the fiscal taps are going to be turned on. Germany is also doing this, Europe is also during this, what is of interest?

[00:29:00] David Wolf: Well, there's plenty of interest. It's one of the things that the Prime Minister has, and I think will continue to say, if we really get some of these big projects going the returns to the private investors who will be involved alongside public money could be very large. The returns to the economy, which is ultimately why you do it, could be very large. All of that, though, will take a long period of time. Let's take the example of, among the major projects, I think one of them I saw is expanding the port in Churchill which seemed, and getting the rail line up there properly, et cetera, which seems like a great idea. There are two ways that that's going to stimulate the Canadian economy. One, building it  because that's a lot of building and that's a lot of capex and a lot of jobs and a lot of money going in, et cetera, and two, once you have that available, particularly in a world where the Arctic is more, shall we say, economically viable, that could be a real boost in terms of the strength of the economy, certainly in northern Ontario, northern Manitoba, et cetera, but more broadly for Canada, that could be a really big deal. But that takes a long time to manifest itself.

[00:30:06] I'm sure many folks will wait to see kind of the whites of the eyes of stuff actually put in place, actually earning a return to investors, to the economy et cetera, and that's fine. Again, the way that we're set up with a very long term approach is if we wait for the whites of the eyes we will have missed a lot of the value. We would much rather be involved in a project like that and, frankly, in an economy as a whole when, as I mentioned earlier to quote Mark, things are bad but they're starting to get better.

[00:30:43] Pamela Ritchie: Okay, that's fascinating. There's a number of questions coming in. Let's go to this one. It has to do with the Bank of Canada, ultimately, the Bank of Canada lowering rates, the impact longer term on fixed mortgage rates. We are in the midst of these years, as you mentioned, '25, '26 of the mortgage reset. How do you answer that?

[00:31:03] David Wolf: So lower Bank of Canada interest rates other things equal, and I'll use the economist term, tend to mean lower fixed rates, and that can be three year, five year, beyond five year, et cetera. The other big influence, maybe two big influences, though, are one, what's happening in terms of fiscal policy, spending and bond issuance. If you think about it, even if Bank of Canada rates are at 2% if the government is borrowing a lot and issuing a lot of 5-year bonds those rates in the 5-year space could actually move up if lower, shorter term interest rates are moving down. The other issue is there tends to be something of a tether between Canadian 5-year yields and U.S. 5-year yields so if the U.S. market gets very unhappy with politically compromised inflationary policy and U.S. rates start to go up that's going to tend to tug Canadian rates up.

[00:31:54] Pamela Ritchie: Okay, so that's an example of where something that goes on in the U.S. and it drags Canada along with it.

[00:31:59] David Wolf: There will be things like that and we can't avoid it and we would like to, we don't get to make the world that we live in, et cetera.

[00:32:05] Pamela Ritchie: You just get to invest in it.

[00:32:07] David Wolf: Well, but to the core question of what happens to fixed rate mortgages the answer is it depends. Generally, the more the bank is cutting the better it will be in terms of bringing down those longer term mortgage rates.

[00:32:20] Pamela Ritchie: As we walk through this kind of fascinating week, central bank policy, of course, being written, new decisions being made and so on, what would you leave with investors as sort of what you're making sure you look very closely at and maybe just a little bit of a new regime out there that we're all traversing to different degrees.

[00:32:42] David Wolf: Maybe my advice would be a stronger version of the advice I usually give, which is don't get caught up in the day-to-day and the minutia and the next headline and what have you because, generally speaking, we try to take a longer erm approach, we're very patient with our capital, we know individuals are relying on us to produce returns over a long period of time and not just a short period of times. We try to kind of look through the noise, and that's good advice for anyone who's doing investing, particularly in this environment when things can be very different in terms of not only the decisions that are made but who's making the decisions, that you really want to be not chasing what's happening in the near term and having that longer term view. That's something that's very important to us. If we do have other investors in the market who are chasing the short term and, again, willing to sell us undervalued securities or the reverse then we'll take advantage of that for our clients.

[00:33:41] Pamela Ritchie: David Wolf, fantastic to have you here at this particular pinnacle. Thank you for your time.

[00:33:45] David Wolf: Thank you.

[00:33:46] Pamela Ritchie: David Wolf joining us here at Fidelity Connects. Coming up tomorrow, a special episode with Peter Drake. He is former Vice President of Tax and Retirement Research at Fidelity Canada. Peter comes back to share personal reflections and professional perspectives on how life goes after work, the retirement story. He'll share how advisors also can better support clients going through this evolving retirement journey. Today and also tomorrow's webcast, of course, have been in English with live French audio interpretation.

[00:34:16] On Wednesday, Étienne — that won't help you for Monday because it's already done now — Étienne Joncas-Bouchard joins us on Wednesday. He is Director of ETFs and Alternative Strategy. He'll be taking us through sort of his positioning and thoughts on where the ETF industry has been going, really interesting on the flows story. He'll present at 10:30 a.m. en français and then the Fidelity Connects show that we will have will be at the regular Eastern Standard Time at 11:30. All of that to come this week.

[00:34:46] On Thursday, portfolio manager, Lee Ormiston, he'll be unpacking what this week's rate decisions may mean for your clients in fixed income markets more broadly, for Canada and the U.S. We'll zero in on that with Lee on Thursday. Thanks for joining us. Have a good day. I'm Pamela Ritchie.