FidelityConnects: The BoC and the Fed: Final call of 2025

[00:05:11] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. The Bank of Canada and the Federal Reserve have made their final interest rate calls for the year. Canada held steady while the Fed slashed their benchmark rate by 25 basis points. While sentiment around Canada has been pretty gloomy, actually, the data tells a pretty different story. Canada has actually been the best performing equity market this year, I think we all know. With the Fed signalling patience and a, potentially, very different looking central bank leadership on the horizon what do all of these central bank maneuvers mean for markets as we head into next year? Joining us here today to discuss rates, personalities, how the Global Asset Allocation team is positioning heading into the new year is institutional portfolio manager, Ilan Kolet. Warm welcome to you. Good to see you.

[00:06:00] Ilan Kolet: Very nice to see you as well.

[00:06:01] Pamela Ritchie: Towards the end of the year, here we are.

[00:06:02] Ilan Kolet: Finally here.

[00:06:03] Pamela Ritchie: Glad to have you help sum it all up for us. We'll just remind everyone that this discussion has live French audio interpretation so please go ahead and join us in either official language. We'd love that. Send your questions in as well. Ilan, what was the most interesting thing out of maybe not the maneuvers or the rate announcements but the discussion of the lineup of what was important to the central banks?

[00:06:29] Ilan Kolet: I think back to a Connects that I did at the start of this year where I said for the Fed and the Bank of Canada they would both love to be done. I said they would love to be done because inflation was not really where they wanted it to be. If inflation is not exactly where you want it to be and the labour market is kind of hanging in there you don't cut rates. Sure enough, we saw cuts since then. What has happened, it's really issues in the labour market. Now, those are slightly different between the U.S. and Canada but the unemployment rate in both countries has drifted higher. There are signs of stress in certain areas. I would say, particularly in the U.S. right now, the tone of the message yesterday was really, I would say shoring up the labour market weakness. It's a little bit difficult to read right now, as we know, because of the lack of data but in Canada the story was a little bit different. In the U.S. we saw a 25 basis point cut. In Canada we saw a pause and I think this will result in a prolonged pause for probably much of next year. But really in Canada the data has actually improved quite a bit, specifically on the employment side.

[00:07:46] Pamela Ritchie: Let's go into that. Does it sound like the rate cutting, I mean, if you had to make a broad statement is the rate cutting cycle over?

[00:07:55] Ilan Kolet: The most honest answer to that, and maybe it's a bit dangerous to be that honest, is I don't know. Neither does the Fed and neither does the bank and neither do the experts on TV or in the newspapers. They are taking a data dependent approach. If we think about the Fed first, what Powell said, and I wrote this down, I have a cheat sheet, the Fed funds rate is now within a broad range of estimates of its neutral value and we are well positioned to wait to see how the economy evolves. So broad range of estimates of neutral he said a few times in the press conference as well. What this means is again, we should go back to that data dependent mantra which is they're waiting to see what the assessment of the data is like. Nothing is preordained, to borrow an old line from then Governor Mark Carney, and they're going to take this data dependent approach to assess whether or not to continue to cut or to pause. I would say the next move for the Fed is very unlikely to be a hike.

[00:08:57] Pamela Ritchie: Yes, and he said that. He's like nobody here thinks the next move is a hike. He actually said that.

[00:09:03] Ilan Kolet: Exactly. The Fed has cut by 175 basis points since their peak. There's about 50 basis points of cut priced in towards the end of next year, September 2026 but those move around a lot. As we know as the data flow changes those expectations and probabilities change as well. At this point I would say, you know, I always say take the governor of a central bank at their word. They're not incentivized at all in any way to pull a fast one. The conversations you have with them in private are similar to the ones on how they speak in public. They are trying to be as informative and helpful as possible. That's what both Governor Macklem and Chair Powell did.

[00:09:51] Pamela Ritchie: We also heard from the ECB this morning as well. I'm throwing all these broad comments at you and seeing whether you agree with them, all central banks, or many central banks, global central banks, seem to be adjusting their growth forecasts up. In a way this is just shockingly good news considering we mentioned gloomy on the way in here. I mean, this is literally the reverse of that, it appears, from central bank forecasting discussions.

[00:10:20] Ilan Kolet: Right. I follow forecast revisions really closely. It's a fascinating thing to follow because sometimes the direction and magnitude of a forecast revision can tell you more about kind of almost momentum from an economist's perspective than just the forecast itself. If we're being honest with ourselves it has not been as disastrous as we would have expected. If I rewind...

[00:10:48] Pamela Ritchie: It almost hurts to say that, doesn't it, but it does seem like it's gonna be okay.

[00:10:52] Ilan Kolet: You have to be honest with your assessments and where they were. I think back to that April monetary policy report from the Bank of Canada where they talked about the tariffs and they came up with two scenarios, which they very creatively labelled scenario one and scenario two.

[00:11:09] Pamela Ritchie: No forecast scenarios.

[00:11:10] Ilan Kolet: They talked about scenario one being a significant slowing in the Canadian economy, tariffs are negotiated away and then growth comes back. Scenario two was an absolute mess. It was 25% tariffs on everything forever, multi-year declines in GDP, that's associated with huge amounts of job loss and an upward shock to inflation. Really, just a complete mess from an economy perspective. If we're being honest there has been, I mean, the tariffs have certainly shown up in the data but as we discussed in our last thought leadership paper, and as we're positioned for, the worst may be behind us. Things sort of may be darkest before the dawn. I think back to not the most recent GDP report but the one before that.

[00:11:58] Pamela Ritchie: So it's September.

[00:12:02] Ilan Kolet: We saw a really significant decline in exports.

[00:12:04] Pamela Ritchie: Yes, which we almost sort of expected because it was--

[00:12:09] Ilan Kolet: We were kind of prepping for.

[00:12:09] Pamela Ritchie: --the tariff story was meant to work its way through.

[00:12:12] Ilan Kolet: Tariffs fell off a cliff and in the next GDP report--

[00:12:16] Pamela Ritchie: Or trade.

[00:12:18] Ilan Kolet: --they kind of stabilized and kind of hooked higher. The level of exports is still much lower than where it was but that's one example. Another example is for the last few years we've been talking about Canadians being over their skis on debt and that debt renewing at higher rates, that expected to be quite painful. It certainly was for some households, I don't want to diminish that, but we're sort of on the other end of that. My colleague, David Tulk, has described it as the pig is almost through the python. It's a bit graphic. What we mean by that is rates are declining, or rates have fallen. The bank has cut by 275 basis points cumulatively since its peak. Most Canadian households are now on the other side of that really painful mortgage reset. Again, the way that we're positioned right now is for the first time in 13 years, I think, we're neutral Canada. We're cautiously optimistic that the worst may be right behind us. It'll be interesting to see how this plays out.

[00:13:21] Pamela Ritchie: It's absolutely incredible. Let's go into the asset allocation. We'll come back to the labour picture because that's very important to everything that we're talking about. A neutral on Canada means that the underweight is gone. You've been working towards this for some time. You've also been working towards international for some time and tilting just a bit out of the concentration of U.S. equities for some time. Tell us sort of where you are now, what has culminated?

[00:13:50] Ilan Kolet: This is critical for us to discuss. The first thing I want to do when I discuss this is explain what it means and what it doesn't mean. If we think about the main fund that we use to communicate, our Global Balanced managed portfolio, globally diversified 60/40 portfolio stocks and bonds, 21% of that fund is Canadian equities. For the last 13 years we have trimmed that exposure down to 15, 14 at times, and taken that 5 or 6% away from Canada and allocated it elsewhere, principally in the U.S. That was absolutely the right thing to do. Between 2014 and 2024 the U.S. decidedly outperformed Canada but people forget that from '04 to 2014 Canada outperformed the U.S. We forget this because the U.S. had a one in a hundred year financial crisis, almost 10 million Americans lost their job so huge negative. Canada had the commodity super cycle. I was at the bank at the time, I remember it well, and I was covering commodities. We believe that right now this long period of Canadian equity underperformance may be coming to an end. Again, we're cautiously optimistic. Now, what that means is we're not leaning in. So the 21 is not a 25 but it's not a 15 either. The 21 is a 21.

[00:15:18] Pamela Ritchie: What are you waiting to see to make it an .... or what would it take?

[00:15:25] Ilan Kolet: Where is the cautious optimism placed? I would say there's a few spots. This has as much to do with our concern around the U.S. as with what's happening in Canada.  A couple that I've hit on is the worst may be behind us. We talked about the trade, we talked about the mortgage rate resets. Another great example is resource extraction. Between 2014 and '22 the inflation-adjusted oil and gas CapEx in Canada fell by 50%.

[00:16:02] Pamela Ritchie: I mean, the tap's just turned off.

[00:16:04] Ilan Kolet: I have no idea how it comes out of the ground but they turned off the taps, or they stopped putting straws in the ground, or however it comes out. It used to account for one in every 10 dollars of Canadian CapEx and by '21, '22 it was one in — sorry, it used to account for one in three, now it's one in ten. To borrow a line from Mark Schmehl, you can add a lot of value and a lot of basis points when things are going from very bad to bad. If Canada has been priced for very bad but things get less bad, again, if that that 50% decline just flattens out or goes slightly higher this is a great opportunity for our security selectors.

[00:16:44] Pamela Ritchie: Broadly, from an economic perspective do we see a commodity story attracting money out of the housing market, which is where it went to sort of couch itself for a zero interest rate over a decade.

[00:16:57] Ilan Kolet: Capital will flow, I mean, we talk about this all the time amongst us, capital will flow to where it receives the best risk-adjusted return. In Canada it has been the housing market. Since 2010, well, really post-financial crisis, rates were lowered and then Canadians did what low rates incentivize you to do, they heaped on debt but they also invested in condos. Too much of the growth in Canada was one thing, which is highly unproductive, which is the housing sector, whereas in the U.S. it wasn't as skewed. The global financial crisis emanated from the housing market so that took very, very long to heal but you saw investment into other things. For example, the cumulative increase in capital spending in CapEx in the U.S. from 2019 to now is 70%, roughly 70% increase. In Canada it's 8.

[00:17:55] Pamela Ritchie: Not 80, 8.

[00:17:56] Ilan Kolet: No, 8, 8%. Again, you can just imagine the alligator jaws when you think about that chart.

[00:18:03] Pamela Ritchie: Wow.

[00:18:04] Ilan Kolet: A lot of people think that the productivity and the AI boom that we're seeing right now has come out of nowhere. That's not the case. It's come from 15 years of constructive investment instead of plowing money into the housing market.

[00:18:17] Pamela Ritchie: With your cautious optimism on Canada how does the productivity story help sway that to a growthier marker for other parts of the economy?

[00:18:29] Ilan Kolet: What do we need to see in Canada? Again, we may be at the worst or the worst may be just behind us. Again, we work with our teams down in Boston very closely. Our Asset Allocation research team believes that recession probabilities in Canada have declined meaningfully. We were basically flirting with recession for the last, I don't know, post-COVID, basically, and flat growth for a long time can be just as bad as negative growth, almost worse maybe.

[00:18:56] Pamela Ritchie: 'Cause it's longer.

[00:18:58] Ilan Kolet: It's longer and it's kind of, you know, as we talked about earlier, we've all had this kind of Eeyore mentality of nothing's gonna get any better and things are always...

[00:19:06] Pamela Ritchie: You mean Canadians broadly.

[00:19:08] Ilan Kolet: Right. Some of that's gotta be the seasonal adjustment but I would say we're cautiously optimistic. We're cautiously optimistic also on the direction of fiscal policy. I know this is a touchy subject but if we get capital spending projects started and, even better, completed that aren't building condos this should improve jobs, productivity and growth. We can't be picky. In general, in Canada, sort of have two sectors. We dig stuff out of the ground and we sell it to our neighbours, and we work in our industry, finance. We need to get growth moving and without capital spending and capital investment we will not have sustained growth.

[00:20:03] Pamela Ritchie: How does Canada look to the rest of the world right now as an investment opportunity?

[00:20:07] Ilan Kolet:  I'm not sure the consensus is quite at the point where we're at, which is an advantage for us. A lot of international investors or international institutional investors kind of view Canada with a bit of an EM playbook, like a commodity play.

[00:20:27] Pamela Ritchie: EM's doing really well.

[00:20:29] Ilan Kolet: EM did well this year but so did Canada. I would say it may take some time to see sort of statistical proof that we are turning the corner in order for that consensus to move but for us, we view that as an opportunity. If we can be neutral Canada right now, and those security selectors that we use, the great building block managers we use in our funds, can pick this name instead of this name that'll boost the performance of our fund.

[00:20:56] Pamela Ritchie: Tell us about EAFE more broadly, taking us largely to Europe but other places as well. The international story is something that you were well ahead of, caught it, the question is sort of where does it go from here? Does it continue? How are you allocated and invested towards it?

[00:21:15] Ilan Kolet: Right now the EAFE region, if we talk about Europe is the largest overweight on the equity side of our funds. That's been there really since the start of this year, or the earlier part of this year, when we thought, you know what, valuations are an important input into our investment process, our asset allocation investment process, but valuations alone are not enough to drive an allocation decision.

[00:21:42] Pamela Ritchie: Which has been the Europe story for a very long time.

[00:21:45] Ilan Kolet: It has been forever.

[00:21:45] Pamela Ritchie: It's cheap but...

[00:21:46] Ilan Kolet: It's been the story forever, same as emerging markets. I've joked we waited a long time for emerging markets to emerge but look at them now. The same story I would say is there in Europe, attractive valuations. When I was a researcher working down in Boston we'd do this Europe research trip and I'd hear this every single year, attractive valuations and we're about to turn the corner with these great structural reforms. As asset allocators we have to think in these relative terms. For us what an attractive valuation requires is some sort of catalyst.

[00:22:30] Pamela Ritchie: To diversity.

[00:22:33] Ilan Kolet: To sort of rerate those stocks. We believe what we saw earlier this year was that catalyst. Europe removing extreme fiscal restraint, defence spending kind of hooking higher and the performance in Europe this year has not just been defence, it's been the banks as well. We've leaned into that this year and that's been additive to the performance as well. To your question, how long can this be sustained and is the gas out of the tank in terms of Europe, because for the last couple of months Europe's moved sideways. There was a lot of return but it's moved sideways.

[00:23:08] Pamela Ritchie: It was cheap, got bought and then it sort of...

[00:23:11] Ilan Kolet: It's sort of flattened out. This is where working with our researchers is so critical because, as you know, the funds move incrementally and over time if we see different signals, if we see that the wind has come out of the sails of Europe based on our research that overweight would would change. As of right now it's still a pretty significant overweight.

[00:23:33] Pamela Ritchie: So interesting. So 2026 is a story, Europe is in it significantly.

[00:23:39] Ilan Kolet: To be fair, when people used to ask me about Europe, I'm not sure if I can say this, but when people used to ask me about Europe I would say Europe's a wonderful place to visit and a terrible place to invest. I love going to Europe but anyone who's allocated to Europe instead of the U.S. over the last 10 years is poorer for it.

[00:23:56] Pamela Ritchie: Let's go to AI and discuss ... actually, you're gonna give us a sneak preview of a report that you're working on. I think it's not due out till the new year but the question for months and most of this year probably is AI a bubble? I know that's something you'll start with. Let's go there because it's part of the catalyst question for diversifying around the world and anywhere else, really.

[00:24:17] Ilan Kolet: Absolutely. Again, these thought leadership papers that we publish once a quarter, I know they're very well read and we take a lot of time and a lot of effort to pull in research and our latest thoughts to really address the questions we're getting. I've spent a tremendous amount of time on the road this year, the most I've ever spent in my life.

[00:24:36] Pamela Ritchie: How much?

[00:24:38] Ilan Kolet: At the end of next week I'll be at 90 flights.

[00:24:40] Pamela Ritchie: Oh, gosh, for 2025.

[00:24:42] Ilan Kolet: Yeah, and I think I'll hit 90 nights in Marriotts this year. I don't know if that's a good thing or a bad thing, probably a bad thing. The conversations that I've had with thousands of advisors coast to coast inform what we choose to answer in these papers. Our goal in these papers is we want to answer exactly the questions that we're getting in a jargon-free manner, using the Bloomberg way, so to speak, jargon-free and in the most accessible way possible so that these are helpful to advisors. Even in the case that an advisor may disagree with our view at least they fully understand why we have the view. One of the questions we've been getting quite a bit is, is AI a bubble? For this we have to look at the researchers that we work with. One of the pillars in our investment process is a bottom-up. Myself, David Wolf, David Tulk, we all come from the macro world.

[00:25:43] Pamela Ritchie: You all, incidentally, come from the Bank of Canada.

[00:25:43] Ilan Kolet: That's right, 20 years of experience, roughly, combined at the Bank of Canada.

[00:25:47] Pamela Ritchie: And Bloomberg.

[00:25:51] Ilan Kolet: Right, and Bloomberg. What companies are seeing and doing matters just as much. As an economist it's a bit humbling to say, what a company is seeing and doing today shows up in the economic data six or eight weeks later. Earnings revisions, particularly in the U.S., have been pushing higher and for that reason we have to really push back on this idea that the AI expansion is strictly a bubble. It could be this sort of once-in-a-lifetime productivity innovation that we can't necessarily lean away from. In terms of what that means for positioning, we are underweight U.S. equities right now but ... it's a bit nerdy but we can use futures overlays to short out specific parts of the market, perhaps small-cap which are not overly profitable, and keep great managers like Will Danoff, Mark Schmehl who are invested in the AI themes fully invested, and we can still benefit in our funds from that theme.

[00:26:56] Pamela Ritchie: Without having to be all-in on that particular exact discussion.

[00:26:59] Ilan Kolet: Exactly.

[00:26:59] Pamela Ritchie: But you wouldn't be there, for instance, if you thought, which they aren't, investing in a bubble.

[00:27:05] Ilan Kolet: No, exactly. We work really closely with our underlying managers and our researchers to examine this very closely, but it speaks to the importance of having diversified sources of returns. Our concern, really, in the U.S. is more to do with some of the underpinnings of exceptionalism coming under attack, a politicized Fed, what that might mean. For us that's really also resulted in a significant change in how we're positioned around the Canadian and U.S. dollar.

[00:27:40] Pamela Ritchie: Just say a bit more on that because that has to do, I mean, I don't think it's a secret that the administration in the United States, it appears, has a real bias to getting the dollar ... its value has gone down and they sort of like that and that seems to be a directionally thing that you maybe could count on.

[00:27:57] Ilan Kolet: Exactly. When I was at the Bank of Canada we had this term, this is also pretty nerdy, called observational equivalence. For example, if I go into a party and I come to say hi to you and you turn your back and you snub me, you haven't told me you're being kind of a jerk but you're observationally equivalent to one. This is the idea of observational equivalence.

[00:28:26] Pamela Ritchie: I hope that's not me.

[00:28:27] Ilan Kolet: I'm making a big assumption that I'd be at the same party as you. In terms of observational equivalence, everything that the U.S. is doing we view as observationally equivalent to a weak dollar policy. They haven't told us we have a weak dollar policy but if you frequently threaten to fire the head of the Fed, if you fire the head of the statistical agency, if you criminally investigate a member of the Federal Reserve Board, if you add political appointees to the Federal Reserve, these all smell like...

[00:28:56] Pamela Ritchie: You want to talk about a duck here somehow?

[00:29:01] Ilan Kolet: These all smell like weak dollar policy. For that reason, if we think the value of the U.S. dollar is likely pushing lower and the credibility and safe haven status of the U.S. is at risk, we don't want to expose our investors and our funds to any additional U.S. dollar weakness, so we've changed our currency position pretty meaningfully.

[00:29:27] Pamela Ritchie: To go back to the central banks and some of the discussions yesterday, something I found fascinating, I don't know if it's just me, but Tiff Macklem, as well as Jay Powell, essentially, put into words the affordability crisis. It certainly is an affordability crisis in a lot of ways but they basically said, look, prices aren't coming down. You need to get over that, prices are not coming down, what we can do is create central bank policy, and the fiscal levers, those are there too, to have wages catch up with high prices.

[00:29:59] Ilan Kolet: I talk on the road...

[00:30:00] Pamela Ritchie: They've never said that before. They blamed it on groceries. This is not a judgement call but they were so clear. Why were they so clear?

[00:30:09] Ilan Kolet: My sense is, again, in having hundreds of conversations through the year is I'm not sure Main Street has as strong of an understanding around inflation than perhaps central banks think. What do I mean by that? Inflation, we know this, inflation measures the rate of change in the price. The price today, the price 12 months ago, that change is the rate of inflation.

[00:30:35] Pamela Ritchie: Which is benign but the prices went up massively in COVID.

[00:30:38] Ilan Kolet: Exactly, right.

[00:30:39] Pamela Ritchie: And have never come down.

[00:30:40] Ilan Kolet: You can measure prices from a month ago, three months ago, six months ago, 12 months ago, any period, it's just a data series. One of the things I talk about is ... when I say things like, oh, for the Bank of Canada inflation is roughly where they'd like it a lot of people will kind of furrow their brow and raise an eyebrow. The reason for that is everything is so much more expensive. Think about the price of anything now versus pre-COVID, it's at least 20 or 25% higher. Cars, groceries, houses.

[00:31:11] Pamela Ritchie: Snow boots.

[00:31:12] Ilan Kolet: Snow boots, shovels, everything is much more expensive. Nothing is coming down in price. Things are getting more expensive at a slower rate. Central banks are tasked with controlling the rate of inflation, which is the rate of change in the price, and what they discussed was ideally what you have ... so you've had this huge increase in the price level, ideally you have wages catch up. If you can have strong growth, strong productivity and wages catch up then every single year that shock to the price level that we've observed and experienced gets a little bit easier to handle.

[00:31:51] Pamela Ritchie: And you invest in your fund which has some of the companies charging those very high prices.

[00:31:56] Ilan Kolet: No, exactly. It goes a long way in explaining why we still maintain inflation protection in our funds, gold, TIPS, things like that.

[00:32:04] Pamela Ritchie: Tell us just a little bit about that allocation right now because it reflects how you feel about inflation.

[00:32:08] Ilan Kolet: Well, absolutely. This is neat for me having done the research when I was a researcher and then now seeing it on the implementation side.

[00:32:15] Pamela Ritchie: Inflation is your favourite topic.

[00:32:16] Ilan Kolet: It is. Not sure what that says about me either.

[00:32:19] Pamela Ritchie: Well, it's pretty interesting.

[00:32:21] Ilan Kolet: There is really no better asset class to protect against the damaging effects of inflation than commodities, specifically gold. If you want to see what the damaging effects of inflation are rewind to 2022. To me, the most damaging effect is it messes up the  inverse correlation between stocks and bonds. They suddenly move together. So 2022 was both of them going down and since then it's ... 2023 was certainly both of them going up. You need diversifiers in the presence of inflation and for us the top of that list has been gold on the equity side and TIPS on the fixed income side.

[00:33:02] Pamela Ritchie: I've only got a minute so sorry about this. Big story for next year is, obviously, the trade deals. CUSMA, USMCA, whatever you want to call it, it needs to get renegotiated, it appears. Do you think we'll have a broader like America's north and south trade deal? What do you think's gonna happen on this platform of discussion?

[00:33:20] Ilan Kolet: This will be the topic of next year, that and whether or not we're starting to gain some sort of escape velocity in terms of growth in Canada. This is the topic to watch and our plan is to work very closely with our researchers and communicate those takeaways and findings here on things like Fidelity Connects.

[00:33:40] Pamela Ritchie: You'll be there before we are anyway because you see it first. Happy holidays to you, happy new year.

[00:33:45] Ilan Kolet: Thank you. Yeah, to you too.

[00:33:46] Pamela Ritchie: Ilan Kolet, thank you for joining us on Fidelity Connects. Coming up tomorrow, Fidelity Head of Quantitative Index Solutions, Bobby Barnes. He joins the show to unpack the factors he's favouring in today's market environment and what he believes the Fed announcement also might signal for 2026 within the context of how he views the markets.

[00:34:04] Coming up on Monday, Fidelity Director of ETFs, Andrei Bruno. He joins us for a discussion on the latest in capital markets, an update on Fidelity All-in-One ETFs and ultimately how they work within the market, how he makes sure they work properly in the market, some of the factors at play, certainly, within the market cycle. We'll bridge this year and next year and his thoughts on that.

[00:34:26] For Tuesday of next week, portfolio manager, Salim Hart. He joins us in an in-depth update on Fidelity Global Micro-Cap Fund. Fascinating part of the market to invest in. Salim's been doing this for years and years and years and now very specifically within this fund. We'll talk about how regional trends are evolving, which sectors are shaping the micro-cap universe and where Salim sees opportunities as we head into next year. The shows on Monday and Tuesday, they'll feature live French audio interpretation so do join us, of course, in either official language. Have a great rest of your day. I'm Pamela Ritchie.