FidelityConnects: Charting the week: Global Asset Allocation insights

[00:05:10] Glen Davidson: Hello, and welcome to Fidelity Connects. I'm Glen Davidson. The war in Iran has entered its sixth week and North American equity markets opened unchanged. Investors are weighing geopolitical risk, energy prices, and what this could mean for inflation and growth, all while they await an announcement from US President Donald Trump on a potential ceasefire and his deadline to open the Strait of Hormuz fast approaching. This is the backdrop for a timely thought leadership piece from Fidelity's Global Asset Allocation team. Their second quarter paper, Conflict Favours Commodities in Canada, makes the case for owning commodities in an inflationary world, and why Canada might be better positioned than markets appreciate. Joining me now to discuss how the Global Asset Allocation team manages risk when uncertainty is elevated is institutional portfolio manager, Ilan Kolet. Before we jump in, a quick reminder that today's webcast features live French, Mandarin, and Cantonese interpretation. Ilan, great to be here with you today.

[00:06:06] Ilan Kolet: Really nice to see you, Glen.

[00:06:07] Glen Davidson: Now, in the intro we talked about so many different aspects that we can discuss today in a brief discussion but you're going to clear up everything for us, which is wonderful.

[00:06:15] Ilan Kolet: I'll try.

[00:06:16] Glen Davidson: Humour me. As a music guy and a musician I just wanted to kind of relate all that we're going through and what investors are seeing to a very enduring song from Led Zeppelin, Dazed and Confused. Is that a fair connection to what investors may be feeling today?

[00:06:33] Ilan Kolet: I think that probably makes sense. Fantastic track as well, especially the live version, which I know you've heard and listened to many times. I think that is a fair assessment because what we're witnessing right now is a really significant supply shock and that's resulted in an inflationary shock. We know what it's done to stocks and bonds. There's a lot of moving parts here. I think what a lot of people are trying to grapple with right now is assessing the duration of this impact. If anyone tries to tell you with certainty that they know the duration of this they're kind of lying.

[00:07:14] Glen Davidson: Like a communication breakdown.

[00:07:15] Ilan Kolet: There you go, exactly, another good reference That is, I think, what investors are trying to grapple with right now. Our process and the way that we manage our funds is a research-based process. We look through a lot of this volatility and just focus on the medium to long term and what we can do for our investors that way.

[00:07:41] Glen Davidson: Can you remind us, the Global Asset Allocation team which you've been part of for a long time and is enormous at Fidelity, the whole group meets, and I've forgotten, but was it on a quarterly basis, a monthly basis? It's very frequent in Boston and globally, I guess, electronically. Can you talk about frequency of communication?

[00:07:59] Ilan Kolet: I sit with my colleagues just around the corner here in Toronto with David Tulk and David Wolf and John Knowles as well. With regards to the funds that we're talking about today, it's myself, David Tulk and David Wolf, sort of 20 years of combined Bank of Canada experience. That's a core input into our process. The broader team which, of course, we'll never hear from, they're never up here on the Connects stage, they are absolutely critical. These are folks that many advisors will never meet but they are absolutely critical to the day-to-day management of these funds, the creation of new funds, how we think about inputs. We meet with them, we're talking to them very regularly, but we meet them on a scheduled basis every month. It's a meeting I run where we bring together anyone that works on our funds, whether it be a quantitative analyst, an asset allocation researcher, our portfolio analysts, anyone that works in our funds.

[00:08:55] We meet once a month for a meeting that I liken sometimes to a parole board interview. It's a little bit more pleasant than that but we are examining every fund, every risk metric, every position, and thinking about the philosophy, investment philosophy, embedded in our current positioning and if it's resulting in what we expect to see. That's a critical, critical meeting. In terms of meeting with our underlying building block managers, as you know we're talking to the Mark Schmehls and the Hugo Lavallées and the Dan Duponts very regularly. We have meetings with them on a quarterly frequency at an official cadence but at an unofficial cadence, or an informal cadence, we're talking to them as well very regularly because what a company is saying and doing today shows up in the economic data six or eight weeks later.

[00:09:43] Glen Davidson: I'm glad you mentioned the connection to the underlying building blocks, the portfolio managers. That's just a few of the portfolio managers that you talk to because I was thinking of it just as the Global Asset Allocation team but the amount of inputs you have is incredible, and the different portfolio managers, different styles, different capitalizations, and also different asset classes.

[00:10:02] Ilan Kolet: For a recovering research nerd like myself it's fantastic. We have a four pillar investment process. It starts with macro. Macro is the world that myself, Tulk and Wolf come from so that's going to be the starting point for almost every conversation. The bottom-up pillar is what are the underlying managers and researchers saying about what's ... in terms of boots on the ground type of research. That's absolutely critical now. It stress tests the macro in many ways. Again, one of the best things about ... I was in Boston last week meeting with researchers ... is just the quality and the depth of the research is unmatched.

[00:10:45] Glen Davidson: That's amazing. Now, we talked in the intro about a thought leadership piece that's coming out soon, and I got a sneak peek at it a couple of days ago. Big focus on Canada. Do you want to take us through that, Ilan?

[00:10:56] Ilan Kolet: Yeah, sure. We're excited to have this paper come out. It should be out, like I said, in the next few days or next week or so. The entire thesis of this paper is examining Canada and commodities in the context of the chaos and conflict that we've been witnessing. As you know, and as many folks on this who are listening right now will know, we've been underweight Canadian equities for an exceptionally long time. From 2013, call it to the start of last year, we were underweight Canadian equites. What does that mean, just to be super clear? In the Global Balanced portfolio roughly 20, 21% of that portfolio is Canadian equities. We were trimming that by 3, 4, 5% and allocating that principally to the US. That was the right stance to take, as we know from a performance perspective, but at the start of last year, and really through last year, we were buying back Canada, we're neutralizing that underweight. Today, and this is going to be a large part of this paper, we are now overweight Canadian equities for the first time in a very long time.

[00:12:07] The reason for that is the drivers of the Canadian market in many ways are those things that are part of the shock that we're witnessing right now. In nerdy terms the beta that Canada has to the commodity shock, to the upward shock to inflation, is embedded in the Canadian market. 38% of our Canadian market is resources and energy extractors and it goes a long way in explaining last year why Canada, the TSX, did 30% in Canadian dollar terms. That's something that we're digging into this paper, the positioning and how a lot of this chaos and conflict actually favours a reliable commodity exporter like Canada.

[00:12:53] Glen Davidson: If we take the geopolitical, the chaos, and put it aside, that is demand, as you said, for Canadian production, really, but AI is as well for inputs, for data centres and so on. They're looking for resources, they're looking for a lot of what Canada can ... they're looking for what were value stocks, really, that are probably becoming growth stocks in some cases. Were you already migrating to Canada because of the AI boom or is it really more because of the geopolitics?

[00:13:21] Ilan Kolet: It wasn't so much the AI boom. We have distinct views around AI. We don't believe it's a bubble. I do believe it'll be transformative in the long run. We want to own the managers like Mark, for example, that not just have to invest in AI but have to choose the right AI names, exceptionally difficult. The Canada thesis is really around the sensitivity to commodities and the upward shock to inflation. Two, as asset allocators we have to be thinking about things in relative terms. The question is never, how is Canada doing? It's always, how do you expect Canada to do versus the US, Europe, emerging markets, gold, alts, fixed income, the whole host of options. It's not just a Canada question, it's a Canada versus the world question.

[00:14:13] The other thing I would say, another thing that underpins our sort of cautious optimism, we believe that fiscal spending and the regulatory environment and the political environment is in a better place and probably moving to a better place in terms of resource extraction than the prior 10 years where it was exceptionally negative and cumbersome. We need to see more progress and that's a tricky one to stick the landing on. We do believe there's been a bit of a regime change in terms of incentivizing the historical drivers of growth which is we dig stuff out of the ground and we sell it to our neighbours.

[00:15:01] Glen Davidson: As your team, who run an enormous amount of money, invest more in Canada, and we're hearing other investors considering the same sort of thing, what does that mean for our Canadian currency?

[00:15:15] Ilan Kolet: This is the other leg of what we did last year. We started last year... this will be a bit of a longer answer ... we started last year ... I don't think I have any short answers ever ... we started last year with growing concerns that the US exceptionalism story was coming under pressure. What do I mean by that? We started last with the global trade war, frequent threats of firing Chair Powell, criminally investigating Lisa Cook, firing the head of the statistical agency, political appointees to the Federal Reserve. Then into this year, regime change in Venezuela, criminal investigation into Chair Powell, Iran, I don't think I forgot anything.

[00:15:52] Glen Davidson: Has that all happened in a year?

[00:15:53] Ilan Kolet: Just over a year. A pretty volatile policy-making environment which we viewed as not conducive to that US safe haven currency sort of status. At the start of last year we had a 20% overweight to the US dollar in our funds, which really means a 20% underweight to the Canadian dollar, meaning 20% more of the fund was denominated in US dollars, 20% less of it denominated in Canadian dollars. In the span of a few months we took that down to zero and we are now underweight, slightly underweight, the US dollar and slightly overweight the Canadian dollar. What does that all mean?

[00:16:35] Again, for investors in multi-asset class funds, in balanced funds, there are three sources of returns. The equity growth, the fixed income income, and the currency return. You need to get that currency return component correct. US dollar depreciated by roughly 10% against a broad basket of currencies last year. It's been fairly stable recently against the Canadian dollar but we do believe the direction of travel for the US dollar is lower and in that instance it's generally the case that the Canadian dollar strengthens. This is a very significant, I would say, change in view around, as you know, around our Canadian dollar thesis. It goes a long way in explaining why last year we managed, call it $100 billion in assets, and in the first six months of last year we traded $47 billion of funds, futures, and ETFs.

[00:17:29] Glen Davidson: So more of a focus on Canada, less of a focus on the US dollar. Why don't we look at asset classes as well because there's a shift. What I learned a long time ago when I was taking economics in university was the 60/40 split of equities to bonds on the efficient frontier. You think quite differently about that today.

[00:17:47] Ilan Kolet: This question, it's interesting, this question really started to gain traction in 2022. I think every single year, you can summarize each year by one question. So 2022 was a year, only question I was getting asked was GICs. Is it the GIC year? I never want to answer another question on GICs, and I'm sure advisors don't either. In 2023 the only question I was getting was, is the 60/40 dead? In 2024 the question was, when are you going to add alts to the portfolios? The second question was what are alts, in that order? Each question actually relates back to that 60/40 question. If you think about that question as is the 60/40 dead, what I've said is you need to innovate the 60/40 as we've done. You need to build what we've called the balance fund of the future.

[00:18:40] Now, what does that mean? The old 60/40 of all Canada, no change or no diversification across manager styles and sectors, set it and forget it, no tactical flexibility, that 60/40 is dead, and it should be dead. The way that we think about the 60/40 is through a lens of continuous innovation which for us means we choose every single manager in every one of our funds. No managers are forced upon us. We have to choose managers of different style, sectors, asset classes. If there's a manager that we don't have access to that we want access to we'll do the research and then add that manager. Similarly, from an asset class perspective, if there is an asset we want to access to that we do not have access too we'll the research and then if the research warrants it we'll add a position to that to those asset classes. That's what we did in 2024. After a tremendous amount of research we added small allocations to three Fidelity liquid alternative funds in our managed portfolios. In the private investment pools we added an allocation to a dedicated private commercial real estate sleeve managed by Brookfield.

[00:19:56] What I'm getting at though, Glen, is you need to innovate the 60/40 continually. You don't want to change it month to month. You want a very deliberate approach to the inclusion of managers and asset classes. The other thing is that 60/40, that balanced fund, needs to have the tactical flexibility which we have. Our 60/40s can be 75/25s and 45/55s. You need that flexibility as well to harness that additional layer of return.

[00:20:24] Glen Davidson: It's nice to know that the 60/40 is looked at in a very active way. Can you comment on style? Value stocks have done quite well of late and now there's risk to everything, really. Is that an area of shift that you've seen within the portfolio as [audio cuts out] evolved?

[00:20:46] Ilan Kolet: What we generally try to do in the construction of our portfolios is we generally want to be style agnostic. What do I mean by that? It's not just the return that matters for the end investor, it's the ride achieving that return. Part of the air chart but if you're trying to get from here to here it's better to have this than this. What that means is for us, we want to combine managers of different styles so that the end return for the end investor is still above our benchmark, number one, most importantly, but also we can achieve that in a risk-adjusted way. We always think about return in our space in a risk-adjusted framework, meaning it really matters how you're achieving that return in terms of the volatility of that. As an investor myself, and you're an investor as well, you can understand that. Everyone wants that incremental return, slow and steady, follow the path, but the ride really matters. When I started on the team a mentor said to me, who's since retired, the way that we manage our funds is we add one basis point to the mountain one basis points at a time. That's kind of how we think about it.

[00:22:05] Glen Davidson: Kaizen.

[00:22:06] Ilan Kolet: Exactly.

[00:22:05] Glen Davidson: Incremental.

[00:22:05] Ilan Kolet: Incremental. Continuous improvement.

[00:22:08] Glen Davidson: Why don't we get into some specific buckets? Friday the non-farm payrolls came in quite strong, stronger than many had expected. Thoughts?

[00:22:17] Ilan Kolet: There's been mixed signals, I would say, from the US labour market. We really had an exceptionally strong jobs report last Friday after a couple of weak ones. The way I think about this is always in the context of monetary policy, the Fed, and rates. That's the lens that I look at the employment market through. That's just a habit from the Bank of Canada days. In general, I will say ... maybe a bit dangerous for me to say ... I think our industry and the experts that you see on the news and all the ink spilled, they over complicate, or we over complicate, central bank decisions. What I always tell folks, and I mentioned this last week in Ottawa and on the road, handcuff yourself to two indicators when you're thinking about the direction of rates. Those two indicators are the unemployment rate and the inflation rate. Just think about those two variables.

[00:23:20] In the US the inflation, we'll start with inflation, inflation rate was very low. It went exceptionally high, it's come down. It's not quite where the Fed would like it to be. That last mile is proving to be difficult and pretty stubborn, and there are a number of reasons for that. On the unemployment side and on the job market side the labour market was very, very tight, unemployment was very low, it went very, very high, it has come down, and I would say is in the neighbourhood of where the Fed would like it to be. What does that mean for the path of rates? It means how the Fed is communicating right now is exactly in line with what you'd expect based on those two variables. Unemployment is roughly where they'd like it to be, I would say roughly, in the neighbourhood. Hiking rates at this point, there's a downside risk to that, and cutting rates, the risk is actually on the inflation side. If you cut rates too prematurely in the US you run the risk of restarting inflation. As we've learned inflation is exceptionally persistent, and not transitory, and once inflation begins to cook it takes 525 basis points of tightening by the Fed in 18 for it to behave normally. What is the Fed's response to that? Let's take a data-dependent approach, let's examine the data as it comes, and sometimes no decision is the best decision.

[00:24:49] Glen Davidson: There's a few inputs to inflation, there's quite a few input inputs. One is oil right now. Obviously, there's a huge backlog trying to get through the Strait of Hormuz. There's production cuts because of the lack of shipping. There's also fertilizer that's being held up so that's affecting food, it's going to affect it more. These are inflationary. You don't care because you have an electric car and I know you drive right by the gas station and you just laugh but I don't. People are feeling this. There's feeling, I think, if the Strait opens up everything's back to normal, inflation drops. There's going to be a long term ramification from this, isn't there, because there's a backlog that needs to be cleared up.

[00:25:29] Ilan Kolet: There is, yeah. It's interesting, my brother-in-law, I was just talking with him yesterday, he's selling his truck because it costs 200 or $250 to fill it up every time he hits the pump. The way that I'm interpreting what we're observing right now, and I would say, more importantly, how is the Fed and the Bank of Canada interpreting what we are observing right now, this is a quote unquote temporary supply shock. What does that mean? Demand was fine before — let me back up. You should interpret, or we should interpret, every move in the price of a commodity as a function of either the demand, what you expect demand to do, supply, what you expect supply to do, the inventories, which is the buffer, results in where the price goes. They close the Strait of Hormuz, that's a massive negative supply shock. What happens to the price? The price skyrockets, as we've seen. A re-opening, I think, uncontroversially, it would suggest a decline in the price of oil. I don't think that's shocking to anyone. What people, again, back to what we discussed at the beginning of the discussion, what people are trying to grapple with right now is the duration of this shock. This is actually something that Powell spoke to last week.

[00:26:45] In general, the reason central banks look at inflation and what's called core inflation, in most countries core inflation removes food and energy prices, not because we don't consume food and energy — you know I love food — the reason that they remove those things is because it removes the volatile components and you see an underlying trend in inflation which better helps set monetary policy decisions. The hard thing with what we're observing right now is you can only look through an upward shock to energy prices so long. Powell mentioned this, and you mentioned it, Glen, in your question, because of the knock-on effects. Oil is not just a singular commodity. It feeds into every single sort of part of our daily existence. The food that is transported, et cetera, all the fertilizers like you mentioned, if we start to see upward shocks to those things after awful inflation through COVID, that's harder to look through, that becomes trickier to look though. I don't believe, to your point, I don't believe a reopening just results in oil back to where it was before. There could be some lags and delays here. I think what it's pointed out is just how vulnerable the price of oil is to that one sort of pinch point.

[00:28:09] Glen Davidson: Amazing to see. We've just got a few minutes left so I'm going to rapidly go through a number of things. Fed independence, I know you have strong thoughts there.

[00:28:15] Ilan Kolet: When people ask what keeps me up at night, what is the thing I'm most concerned about, this is the top of the list. Maybe geopolitics recently has kind of taken over as number one but a loss of Fed independence, or declining Fed independence, is very, very concerning. Let me just explain why. Central governments have an incentive to run an economy hot. What does that mean? Procyclical fiscal spending, cut taxes, juice fiscal spending, what that does is that runs an economy hot, that lowers the unemployment rate. When an unemployment rate gets low what happens? You compete, you hire the person from across the street by offering them a higher wage. Wage growth increases, wage growth pushes service prices, and service prices are 75% of underlying inflation, that lifts inflation. When that happens the central bank, on the other side of Wellington Street in Ottawa, says, not so fast, guys. We're going to raise rates and cool things down. If the central government, not in Canada but this is a concern in the US, has sort of their boot on the neck of the Fed and says, nah, hold off on raising rates, it's just transitory. Then what happens? You start to get inflation. Inflation is persistent. As we should all very well remember from 2022 inflation is exceptionally damaging to everyone as a punitive tax but to us as investors it's exceptionally punitive because bonds and stocks move in the wrong direction together.

[00:29:47] Glen Davidson: Question's come in about high yield credit globally. Do you have any thoughts on high yield?

[00:29:53] Ilan Kolet: In the context of our portfolios a lot of attention gets paid to the equity side of the portfolio, especially some of our underlying managers have spectacular years. If we own those managers that boost the overall performance of our fund and return of our fund an unsung hero oftentimes is the fixed income side of the portfolio. So in a 60/40 portfolio you have that 40, it really matters what's in that 40. For a very long time we've been underweight investment grade debt and overweight the credit and the spread sectors, high yield, these types of asset classes that are at the front end of the curve where we can really take advantage of fantastic ... well, not take advantage of ... we can harness the power of underlying managers like Adam Kramer, for example, who can boost the income side of the portfolio. That's still how we're positioned right now, underweight investment grade and overweight the credit and the spread sectors. We also own a slight overweight to TIPS, which is the most boring asset class that we don't want to talk about, but an important part of our diversified protection against inflation.

[00:31:03] Glen Davidson: Part of the confusion for some investors is also gold. Gold is coming down as we've seen geopolitical risk increase. Is that just because it perhaps got over its skis, if you will?

[00:31:13] Ilan Kolet: Gold is a very difficult thing to forecast and analyze. No one would have expected the increases that we saw last year. We would have expected an upward pressure given what we've seen, and it has certainly retreated pretty significantly. The way that we think about gold is in the context of an important diversifier against both stocks and bonds. In our Global Balanced portfolio, for example, we have about a 2% allocation to a gold ETF. That gets us exposure to the underlying price of gold. On a look-through basis, meaning if I look through to the underlying managers and sweep up what they own in terms of gold exposure it takes that to a 5 1/2%. 5 1/2% exposure to gold and gold equities is plenty of gold in a 60/40 given how volatile it is. Again, going back to that one question that defines each year, 2025 was the year in which should I sell everything and just buy gold? I think we learned why you don't do that.

[00:32:14] Glen Davidson: It makes sense. Now, you mentioned Global Balanced portfolio, it makes me think of the enormity of solutions that roll up to the Global Asset Allocation team, and we're not going to talk about all of those today, but maybe highlight a few that our viewers and listeners should be thinking about.

[00:32:29] Ilan Kolet: This is a great opportunity to speak directly to the advisor who's listening right now and ask them to reach out to their Fidelity wholesaler, I work with all of them, a fantastic team across the country who can provide that and match the right investor to the right solution. The managed portfolios, which is a lot of what I talk about, have that tactical flexibility, fantastic stack of underlying managers. The private investment pools are similar to those funds, more institutional mandate, more, I would say, downside protected. One unsung hero this year has been the Fidelity Inflation Focused Fund which we launched in 2022. It's got a lot of commodities, it's got gold, it's got the natural resources, it's got the things that effectively hedge the inflation shock, which, unsurprisingly have done, that fund has done exceptionally well year-to-date.

[00:33:22] Glen Davidson: Well, it underlines the reason for people needing to be diversified and who knew? Thank you for taking us through those portfolios. Thank you for being here. You make yourself available across the country and throughout the United States as well for investors and advisors and it's always good to see you here in the studio as well. Thanks, Ilan.

[00:33:37] Ilan Kolet: Thanks, Glen.

[00:33:39] Glen Davidson: Thank you for joining me today on Fidelity Connects. Coming up this week on the webcast, tomorrow we'll hear the latest on global equity markets and the evolving landscape for value investors with institutional portfolio manager, Naveed Rahman. He'll provide an in-depth update on positioning, themes, and opportunities within Fidelity Global Intrinsic Value Class.

[00:33:57] On Wednesday portfolio manager, Patrice Quirion, is back on Fidelity Connects to break down the latest developments in global markets and equities as we head into the second quarter. Patrice will join us first at 10:30 a.m. for a French language webcast and then 11:30 in English.

[00:34:12] On Thursday Fidelity Director of Quantitative Market Strategy, Denise Chisholm, is back to discuss her latest sector thesis and the key signals advisors should be paying attention to for the month ahead. Thanks for watching. I'm Glen Davidson. Take care.