President and CIO of Outcome Metric Asset Management highlights geopolitical tensions, high household debt, and productivity challenge
Following the record inflation levels and accelerated interest rate-hiking cycle that defined the past two years, many investors in Canada are undoubtedly going into 2024 with a newfound appreciation for portfolio risk management. And for one investing leader, several risks are top of mind for the year ahead.
“One of them is what is arguably the most unstable geopolitical climate we've seen in maybe decades,” says Noah Solomon, president and CIO at Outcome Metric Asset Management. “We have at least two conflicts – one in the Middle East, and the other between Russia and Ukraine – which could easily metastasize into something much larger and much more market-impactful.”
Recession risks and productivity hurdles
Solomon underscored the sharp increase in interest rates by central banks, the likes of which haven’t been seen since the time of Paul Volcker’s Federal Reserve in the 1980s, as a source of risk facing investors in Canada as well as globally. So far, he says, the data isn’t flashing unequivocal signs of recession or spikes in unemployment, but the lagged response between rate hikes and its impact on the economy means it’s too soon to tell.
“There is some reason to suspect that the lags might be a little longer this time than they have been historically,” he says. “When central banks started to ratchet up rates in early 2022, households were much better fortified than in previous rate-hiking cycles. During the COVID crisis, central banks and fiscal authorities flooded the system with money, so the amount of savings households had in aggregate was abnormally large.”
Despite that large savings cushion coming out of the pandemic, Solomon says Canadian households today are the most indebted in the world on a debt-to-disposable income basis. With so much of their budgets now having to go towards debt payments and other non-discretionary expenses, he says Canadian families will have to go on a “forced diet” to get their balance sheets back in order, which will create a near-term drag on growth as consumption takes a back seat.
“The other thing – and I really can't be subtle here – is that from a productivity perspective, Canada is basically nothing short of a dumpster fire,” he says. “Our output per hour is falling further and further behind other countries, which not only limits profitability of companies – and in turn, can limit stock prices – but also compromises Canadian standards of living.”
Policy experts have argued that addressing the slow growth of productive capacity could help solve a raft of economic challenges, including inflation and recession risks.
The ability to produce more could help soften the mismatch between the amount of demand and supply across several sectors, for example. Increasing supply through productivity gains would also mean less tightening from the Bank of Canada in order to keep demand close to supply.
“Productivity growth is the mother's milk of increased profitability and standards of living – and we're really bad at it,” Solomon says.
A better long-term picture for asset allocation
But as the old saying goes, “no pain, no gain.” While many portfolios haven’t fully recovered from bloodbath across both equity and fixed income markets in 2022, Solomon says the long-term picture for asset allocations has gotten much better.
“Historically, bonds have really served two key functions: First, they provided a respectable if not spectacular yield or return. Second, they served as very good ballast for your portfolio during tough times for stocks,” he says.
During the dark days of the tech wreck and the global financial crisis, Solomon says high-quality bonds rallied to offset losses in equities and mute volatility in portfolios. But in the near-zero era of interest rates that followed, bonds provided very little yield or return, and they weren’t effective diversifiers either.
“When interest rates were zero for over 10 years, you either had to increase your exposure to equities to get your target return and take a lot more risk, or not change your asset allocation and be satisfied with a lot lower returns because your bonds were doing nothing,” he says. “You’ve had a lot of pain in bond markets, and now yields have been restored to normal levels … I think life just got a lot easier for wealth managers and asset allocators.”
