FidelityConnects: Fixed Income: Fourth Quarter Insights

[00:02:10] Pamela Ritchie: Hello, and welcome to Fidelity Connects. I'm Pamela Ritchie. After the U.S. government shutdown delayed a key economic indicator September's CPI report is out. The latest U.S. inflation data came in softer than expected but building the case for more Fed cuts. Following the report's release we saw equity markets rallying and the U.S. 10-year note fell below 4%, just below. With everything going on in the markets our next guest highlights that there is still attractive yields in fixed income and it's still an area that you may not want to overlook. Where is Canada's place in all of this and how might it impact Canada's market environment? Joining us here today to unpack the fixed income landscape is fixed income portfolio manager, Sri Tella. Warm welcome to you Sri. How are you?

[00:03:00] Sri Tella: I'm great, thanks. Good to see you.

[00:03:02] Pamela Ritchie: Good to see you as well. It looks like there's some lovely leaves in your background. You've got that sort of fall look. It's really, really nice. You are a Blue Jays fan. You're a Canuck, actually. You're in the Boston area but you're a Canuck. Is the Blue Jay's your team?

[00:03:21] Sri Tella: I grew up an Expos fan. Having grown up in Ottawa I was close to Montreal. It was a sad day when they left but with the Blue Jays now being Canada's team I'm 100% behind them. Today was a really important day, not because of the CPI this morning but because it's the first game of the World Series I'm looking forward to that.

[00:03:41] Pamela Ritchie: We know you have your popcorn and peanuts ready. Okay, fantastic. Let's talk about bonds here and get into the discussion of CPI. I'll ask you about that to sort of pick it apart a bit and what you did like about it, but the idea through the last week and probably going into next week, we've got a Fed announcement, we've got tons of geopolitical discussions. The so-called event risk. Really, it's statements being made about tariffs, about trade. We've got a huge U.S.-China meeting. It looks like a Canada-China meeting at the end of next week. What do you do with these announcements that, in theory, could throw the market in either which way?

[00:04:23] Sri Tella: I think the key is to always sort of have a longer term outlook when you're thinking about investing, so thinking about the impacts of all of these headlines. Oftentimes, headlines can have a negative impact, especially given where valuations are now, and that can be tough in the short term but we view that as actually providing opportunity. It gives you an opportunity to enter the market or add risk at points where valuations become more attractive. The key right now is really thinking about the headlines and what is really more posturing and negotiating tactics that are out there versus what could have a longer term impact on fundamentals and the economy and pricing in the markets. Really, we're looking for headline volatility to actually provide opportunity for us to either add risk or reposition the portfolio to areas that look more attractive.

[00:05:23] Pamela Ritchie: When you see the barbs being shared about the trade negotiations with Canada, U.S., Canada, there have been some more of those the last 24 hours but there are often those. Does that provide an opportunity? Do you find markets are reacting?

[00:05:39] Sri Tella: I think it can. The big thing right now is the market's kind of evolved into knowing that a lot of this is negotiating tactics and posturing. Back at the early part of this year a lot of these headlines would have had a much bigger impact. It seems like the market is starting to look through a lot of this until they determine what the longer term implications are. I think there can be opportunities from time to time and then on any given day you might find one or two sort of hidden gems that sort of present themselves. We're finding more and more that a lot of the headline posturing is not having long lasting impact in the markets as we may have earlier this year back in April when even then there was opportunity, and we took advantage of that, but even then it was fairly short-lived as Trump's rhetoric sort of flip-flopped and headlines changed from one day to the next.

[00:06:45] Pamela Ritchie: There's been this thought of resilience in sort of the economic ability for Canada to power through here amidst a barrage of trade war worries, basically. From your perspective, from an investment perspective, Canada is doing okay. Do you see that as something that continues? Are there particular pieces of so-called event risk in the next, I don't know, few months that either worry you or present opportunities?

[00:07:19] Sri Tella: If we kind of look back at the past year the early part of the year was characterized by better than expected growth and you could sort of point to a couple of things. One, you had the Bank of Canada that was very aggressive in cutting rates and that provided a support to the economy. You also had an element of front running of tariffs that boosted activity and trade activity, etc., in the early part of the year. The second quarter kind of characterized with sort of a turnaround and starting to see some of the impacts, not just tariffs but uncertainty, changes in immigration policy that slowed down population growth so we did see negative growth in the second order. The third quarter is expected to be a little bit more sideways but if you look back and think about the amount of cuts that the Bank of Canada has put in place, the easing of financial conditions because of the strength of the markets and a number of other factors, and even a more competitive exchange rate from Canada's perspective, those all have supported the market.

[00:08:31] What I will say is that the economic surprises have come in more negative more recently in Canada. We've seen the labour market soften up a little bit, notwithstanding the last print. We've seen growth come down, retail sales slowing and housing a little bit weaker. All of those things do point to a little bit more caution in the economy. Inflation has become a bit less of a focus in Canada. I think there is continued resilience but given that there is some trade uncertainty and some cracks out there that kind of does warrant some caution in terms of what the growth outlook looks like going forward.

[00:09:15] Pamela Ritchie: The importance of bonds in one's portfolio has been actually a pretty interesting conversation this year. There's a discussion of things that are correlated and aren't correlated for your audience here today. Do you want to kind of go into that spot for bonds? Gold has been competing, we know this. Also, alternatives, other types of strategies within a portfolio, do you want just kind of come back, replace us at the place for bonds at this moment but always in a portfolio.

[00:09:47] Sri Tella: As always, I think it's all about thinking about overall asset allocation and fixed income is always going to have some role to play. Obviously, when rates were at zero there was less of a compelling case to be made given that you weren't really earning anything, but given where yields are now, even though we've actually come off sort of the peak in rates, overall yields still look attractive on a historical basis. When you look at credit spreads they are trading at the tighter end of their historical ranges but when you at all-in yields we're still kind of in the third quartile in terms of attractiveness of yields on a historical basis. I think you're going to earn that yield and it also still provides some downside protection because if risk markets do take a turn you do have some scope for yields to rally, whether it be through additional cuts from the central banks or just sort of a safe haven trade. That's something to think about.

[00:10:56] You made the point about gold, I'm not a gold expert but, obviously it's done very well. Even our asset allocation teams have advocated for an allocation to gold. As a replacement to fixed income, something to keep in mind is that the fixed income has that element of in a soft risk market can add some protection. On top of that you also earn some income by owning fixed income on a regular basis. That can't be necessarily said about gold.

[00:11:29] Pamela Ritchie: Let's go into the inflation report today. There's sort of its discussion within a government shutdown and why it's an important data point because we aren't getting other ones. Maybe we'll just leave that to the side right now. The idea of where inflation is, if you're comfortable with it, because inflation really upends, bad inflation can upend the story for bonds. What do you think of this number? Are you comfortable with ... what's your call on inflation?

[00:11:56] Sri Tella: In terms of the outlook for inflation, on the surface inflation has come off its peak. It's obviously given cover for both the Bank of Canada and the Fed to start cutting rates again. If you look at the underlying components, breaking down today's number, for example, shelter inflation was kind of the big driver of bringing down inflation and it was also focused on a specific region in the U.S., in the south. That is something that has been anticipated because when you look at rent data in the private sector and so on, rents have been softening, housing has been weaker. That's somewhat expected but the magnitude of today's drop was a little more than expected than would have been indicated by some of those other measures. There's a possibility that it's just the volatility from one month to the next that could be offset but then the big concern is, obviously, the impact of tariffs. When you think about the tariff pass-through into inflation, that's something that was actually a little negative in this print.

[00:13:05] We saw goods inflation rise in today's print and you're starting to see it in components like apparel and so on where some of that pass-through seems to be occurring. I think what's happened over the last little while is that companies have been reluctant to pass through pricing because they don't know the extent of tariffs and how long they're going to last because policies keep changing from time to time and we're still in a negotiating process. As we get into next year you could start to see companies start to feel some pressure on cost increases and have to start passing that through to consumers. The question will be, will there be offsets, for example, in energy or housing that potentially offset that inflation. The tariff risk is still something that is out there. One caveat...

[00:13:58] Pamela Ritchie: Because it hasn't really appeared, sorry, so it's something that's hanging out there, to an extent.

[00:14:06] Sri Tella: Yes. Well, the thing is it's felt like companies have been holding off in terms of increasing prices but at some point they're going to start feeling the margin pressure, it's going to impact their bottom line so they'll have to start thinking about making those changes. The flip side is, though, to date the impacts of tariffs overall in an aggregate basis haven't been as bad as feared. Even if you think about the case of Canada, there was fears that the tariffs would equate to double-digit percentage tariffs on goods but when you look at it all in we're probably looking at mid-single-digits increases in tariffs on Canadian goods in aggregate. Now, obviously, there's specific sectors like steel and aluminum and lumber, and autos initially, that's been softened a little bit more recently. There are specific sectors impacted but overall in aggregate so far it's actually been relatively manageable.

[00:15:13] Pamela Ritchie: If you take a look at sort of the industries in Canada that you just mentioned, and also maybe let's go into positioning a little bit on kind of the corporate side of things, and then we'll also talk maybe a bit more about what you like about either provincials or sort of the government debt story. There's been resilience in corporations as well. Tell us just a little about your positioning within the Canadian corporates market.

[00:15:40] Sri Tella: For the corporate sector the tricky thing is that valuations across the board on a historical basis look pretty rich. We're trading at the tightest levels post global financial crisis in both the corporate market as a whole and in most sectors, for that matter. When we're positioning, as I mentioned because of the attractiveness of fixed income in general we want to have some exposure and some yield to generate income in a portfolio. On a whole our corporate exposure is actually at the lower end of our historical risk exposure. That's really because we're cognizant of the risk-reward based on where valuations are and so we want to leave ourselves a lot of dry powder to be able to add risk as we get in sort of volatile periods like we did back in April, for example.

[00:16:35] When we think about specific sectors, let's start sort of at a higher level, we actually like provincial bonds on the margin, especially in the long end of the curve, and that's because of how compressed corporates are to provincials. All valuations are tight but provincials will be a little bit more defensive compared to corporates so we actually favour provincial bonds out the yield curve relative to long corporates. Where we do have our corporate exposures in the short to intermediate part of the curve where they're just more efficient, you have more protection against spread widening because of the coupon income and the yield can offset a lot of that given the shorter duration.

[00:17:24] When we think about specific sectors, because of how compressed things are we are generally focused more on more liquid and relatively higher quality sectors. In Canada the banks make up 50% of the corporate market. That's a spot that even though valuations are tight we tend to have an overweight too because you're not really getting much extra spread or yield to go into sort of riskier sectors. The other couple sectors that we favour are REITs but when we do look at our REIT exposure, REIT spreads have actually been some of the biggest outperformers over the past couple of years but if we look at our actual exposures it's in very specific names in the space that have better trajectories, more stable cash flows focused on anchored tenants etc. That's another space. Those are probably the two sectors we have larger exposures to.

[00:18:28] When we look at moving into sort of the triple-B space we like the pipelines. Pipelines compared to other triple-B sectors leverage is relatively high in the pipeline but we're talking about large companies like Enbridge, TransCanada, Pembina Pipeline, that have pretty stable cash flows, they have a lot of capex but they're managing through that. They've actually underperformed over the last little while compared to some of the other triple-B. Those are some examples of corporate sectors that we like.

[00:19:09] The telecoms have done really well but a lot of that's being priced in now. They've been buying back debt, reducing leverage so that's been priced in. That's actually been a good performer for us of late but that's an area where we're maybe a little more cautious and that's mostly due to valuations, nothing to do with fundamentals.

[00:19:32] Pamela Ritchie: That's really interesting. The opportunities that you might, or the moments that you might go looking for are sort of the geopolitical story which is kind of what we started out talking about, that could see things waver a little bit. The yield story for most of the investments that you're taking a look at in Canada, they're stable, they're not so risky. You mentioned the B area, how far down the line do you go there?

[00:20:01] Sri Tella: It depends on our different mandates but typically we're predominantly focused on investment grade. We do have some mandates that will go into the high yield space so we have some exposure to that. When we start to go down ... guess to take a step back, when we look at these inflection points like COVID and where market opportunities present themselves we're a little less discriminant about what we buy because the markets are attractive across the board and you just want to get market risk on, but in an environment like this we're much more methodical about the names we own in the portfolio. I shouldn't minimize, we're always looking for names that we like and and focus more on strong fundamentals but in this environment especially we're thinking less about broad market risk and really more about specific names that we like.

[00:20:58] Now when we look at our triple-B exposures there are very specific names, either names that we think are very stable companies with strong fundamentals and strong cash flows but just happen to maintain high leverage which keeps their ratings in that triple-B category, or they're names that have a catalyst, either an improving credit story, tailwinds to their business or improving cash flows and a potential ratings upgraded. Those are kind of the things we're focused on. In this environment, because of where valuations are we are much more focused on those idiosyncratic exposures as opposed to broad market exposure.

[00:21:56] Pamela Ritchie: The trade discussion obviously is there. There's a Canadian budget as you know coming around the corner on the 4th of November. A number of sort of concepts and pieces have been announced but the details are not there. I'm curious from an investment perspective you'd like to see there or what would be unhelpful if it cropped up in the budget? What broad strokes would you like to see? What does Canada need from an investor perspective?

[00:22:25] Sri Tella: I think what's going to be interesting about this budget, it's been telegraphed that the deficit's likely going to come in much larger than previously announced. There's talk of it going anywhere from 1% of GDP to as high as 2.5, 3%. I think the key for the government will be to balance these long term projects with also providing short to medium term things that may be more tangible. The issue with longer term projects, from a long term perspective infrastructure spending and developing or investing in long term projects is probably a better thing in the long run. Obviously, there are also some headwinds being faced now with investment uncertainty and trade issues that will require some support to the public on a shorter term basis. The key will be looking at how that's balanced.

[00:23:33] The bigger focus from a market standpoint is how big that deficit is going to be and how it's going to be funded. That's really what's going to impact how we think about positioning in the market in the near term. Canada has the capacity to increase its deficits because it's coming from a relatively strong spot relative to other G7 countries. There's also, I would argue, a shortage of debt to fulfil the demand that there is in the Canadian market. I think...

[00:24:05] Pamela Ritchie: Is that in the long end? Where is that demand?

[00:24:10] Sri Tella: It's generally more noticed in the long end. There's a lot of demand from pension money and other institutional investors for the long end and the supply of long issuance. Other than the provinces we're not really seeing enough long-dated bond issuances. I think that might be welcome to some extent. I think it's really how the government chooses to fund and what the size of the deficits are that will be a big focal point. Also, this notion of the government's talked about separating out its operating budget and its capital budget. What the breakdown is of that will be important as well.

[00:24:58] Pamela Ritchie: The deficit itself, how these big ideas are funded, early stages they'll probably invest in things that are a bit closer to being shovels in the ground or shovel-ready and so on, and then there'll be other bigger things. At what point could you take a look at ... you mentioned pipelines, it's hard to know what's going to be announced and how that will come under the umbrella of companies or other types of organizations. Could you invest in some of these bigger projects or is that pretty far down the line?

[00:25:33] Sri Tella: I think some of that will be a little further down the line, especially when you think about even if the government's able to reduce the red tape required to get approvals and move forward with projects that's still going to take time before companies start to think about their investment plans and raising money for these projects. One of the things we do pay attention to is what that ... I was going to say pipeline for lack of a better word, pun not intended, the pipeline for issuance and raising money and how that looks does come into play but generally, I think a lot of these companies have done a good job historically of managing that issuance and managing their leverage and thinking about the impact that they will have on their business going forward.

[00:26:37] We would often actually see things like that as an opportunity if there was pressure on spreads because they're funding for projects that are going to be incrementally positive down the road and they have a good path to deleveraging, they have good funding plan, that often will create an opportunity for us to invest in names like that.

[00:27:01] Pamela Ritchie: Would it be useful ... we've seen the U.S. government, for instance, take direct equity stakes in certain companies that fit with their overall plans and to develop ... if we want to call this an industrial revolution, a lot of people are. In Canada there's been discussion of maybe the pension funds with deep pockets get involved in some Canadian projects themselves. Again, would it be useful to sort of speeding things along, I guess, is the question, from your perspective.

[00:27:30] Sri Tella: I think it definitely could. You did see an example of that in Canada with the TMX pipeline that the government fully invested in, well, the government bought it. Obviously they're still working through it and it was an expensive project but that could work out in the long run. I do think the idea of having large institutional investors like the pension funds join alongside, I think that would be helpful. I guess, from our perspective in the public markets that actually is an incremental negative because that's more the private funding, JV sort of approach to funding these projects. It theoretically takes the opportunity away from public funds to invest in some of these projects.

[00:28:25] That being said, I think it would be beneficial in terms of getting some of these projects off the ground and getting broader support. The one caveat being is I think that the federal government needs to find a way to make these opportunities look attractive to the pension funds. It's all great to say, the government's telling the pensions that they have to invest alongside but you have to remember this is pensioners' money and they need to be able to earn a good return that's competitive with where other places they can invest. Those opportunities need to be made attractive enough for the pension plans to be on board.

[00:29:10] Pamela Ritchie: Just a couple of final thoughts as we close out, Sri. Flows are good, there's demand, clearly, for fixed income, maybe you can just make a comment on that, and just also looking out for weakness and what that means for a bond investor. If people are worried in the economy they might want to be in a more stable investment. Just sort of the flows and general caution, if you could just comment on those as we close out.

[00:29:38] Sri Tella: In terms of flows, we have seen pretty significantly strong flows into fixed income broadly, both in the U.S. and in Canada. It's a combination of a couple of things. One, reallocation out of other asset classes that have done well, for example, rebalancing out of equities into fixed income because of how strong equities have been in order to keep sort of a more stable asset allocation mix. The other thing is just thinking about all-in yields and returns and the still perceived safe haven nature of fixed income. Given the attractiveness of overall yields money has come in. Now, those flows were probably even bigger when rates were 40, 50 basis points higher but we continue to see money coming in on a regular basis in the fixed income. I think that's partly what's been supportive of some of these valuations in the market. We don't foresee that changing anytime soon. Not only do you have relatively decent fundamentals that support fixed income but also the money coming in is a positive.

[00:30:48] Pamela Ritchie: On caution.

[00:30:49] Sri Tella: In terms of caution, we're looking at economic data that's come down, uncertainty that's continuing to exist. I think while fixed income is attractive you have to pick your spots on where you invest. That's why we have sort of lower risk profile right now in our portfolios. We have a lot of dry powder and we're being much more methodical in terms of thinking where we invest that money. At the same time yields look attractive so we want to make sure we stay invested.

[00:31:30] Pamela Ritchie: It's a really interesting moment to be speaking with you, particularly about this and taking a look at the different mix of narratives within the bond market. Sri Tella, thank you for joining us and go Jays.

[00:31:43] Sri Tella: Yeah, go Jays.

[00:31:43] Pamela Ritchie: You'll be watching. All the best. That's Sri Tella joining us today. Next Monday, hope you have a great weekend in between, next week Fidelity Director of Global Macro, Jurrien Timmer, he's back to unpack macro themes on his radar. He'll come armed with those amazing charts, beautiful, different charts that you can help shape your investment thesis for the week ahead.

[00:32:02] On Tuesday portfolio manager, Darren Leckerkerker, he joins the show to mark a decade of North American Equity Class. In this special webcast Darren is going to reflect on the fund's journey, explore today's market landscape and take a look at what is ahead the next decade for the fund.

[00:32:19] On Wednesday, we will shine a light on Fidelity portfolio intelligence. This is analytics optimization, it's a tool to help advisors align investment portfolios to their clients' goals. Ben Romulus, who is portfolio strategist, he first joins us at 10:30 a.m. Eastern, that's en français, and then Cameron Chamberlain, Director of Portfolio Solutions, he's joining us at 11:30 Eastern Time to share what the team is hearing from advisors and trends that they are seeing in portfolios, what they're trying to address. Fascinating conversations so do join us for that. Have a great weekend. We'll see you soon and hope you enjoy the ball game. I'm Pamela Ritchie.