Counsel Views – Episode 7: Eric Savoie

Stu Morrow (Host):

Hello, our listeners, and thank you for joining. 2020 will go down in the market history books for many reasons. We've seen all-time highs, a 34% bear market correction and now we're on the cusp of making new all-time highs. From a portfolio perspective, it's certainly paid to remain invested and be well diversified this year. Bonds have done their job as a portfolio ballast. Despite the low interest rate environment, they've provided a cushion to the portfolio, as volatility increased this year.

But after the recovery we've seen in stocks and bonds, what lies ahead? Here with me to discuss the outlook for both stocks and bonds is Eric Savoie, Associate Investment Strategist with RBC Global Asset Management. In his role, Eric constructs and maintains top-down forecasting and valuation models for global fixed income, equity, and currency markets. He also analyzes capital markets and macroeconomic data used to drive market forecasts, asset mix, country/regional allocations, and sector recommendations for balanced portfolios.

I had the privilege of working with Eric during my time with RBC Global Asset Management, and I've always thought of him as a very bright and insightful investor. He began his career in the investment industry when he joined RBC global asset management in 2012, and he has been working alongside the Chief Investment Officer, as well as the Senior Portfolio Manager of RBC Global Asset Management's portfolio solutions since 2013.

Hi, Eric. Good to see you again. Thank you for joining me today.

Eric Savoie (Guest):

Thanks for having me in today. I'm honored to be a part of your podcast.

Stu Morrow (Host):

Well, thank you, thank you. Maybe, Eric, I've given sort of a cryptic bio, but maybe, in your own words, explain the work you do, and your team does, for RBC investors.

Eric Savoie (Guest):

Sure. So I work as part of the investment strategy group at RBC GAM, and our main job is to establish a macro outlook for capital markets, so what we do is we generate forecasts for interest rates, bond yields, and stock markets, and this is a view that drives the asset allocation decisions on many of our fund-of-fund or multi-asset strategies that we manage for our clients. To do that, we maintain a variety of models and charts, and we're constantly refreshing and updating these over time. That's what me and my team spend a lot of our time doing, as well as keeping up with the current events and their impact on markets on a day-to-day basis. We also do a lot of writing, so we communicate our view on a quarterly basis through our global investment outlook publication, and there are some more timely pieces that we put out on a monthly basis to keep our views fresh and up to date. We're actually currently in the process of updating our New Year 2021 strategy, and that's going to be published in early December, so I hope with all of that, it kind of gives you a good overview of what I do as part of the investment strategy team at GAM.

Stu Morrow (Host):

That's great. Thanks, Eric. If you're looking back over the last 11 months, we've both been working at home since March, from your perspective, from RBC Global Asset Management's perspective, what were some of the lessons learned so far in 2020?

Eric Savoie (Guest):

Oh gosh, yeah. It's been an incredible year, Stu, and aside from having to learn how to fully operate on a work-from-home basis, there are a few other things that we've learned along the way. For one, we recognize that anything can happen and change the course of the world in a very short order. We saw that with the COVID-19 pandemic that came out of nowhere. Initially, we thought that we were encountering something similar to a SARS or Ebola outbreak, which would have had a short-lived impact on the economy and markets, but it became quickly apparent that it was going to be something more severe than that, especially as economies started announcing lock downs, but one of the things that we are also reminded of was the power of human ingenuity.

You know, in times of intense pressure, when our backs are pinned against the wall and we need to find solutions to large and complex problems, humans tend to figure it out. Whether it's the entire health industry putting brilliant minds together to develop vaccines in record time or governments and central banks deploying unprecedented amounts of fiscal and monetary stimulus, where there were problems, solutions are quickly being put into place, and so while it's easy to get pessimistic in these kinds of times, it's good to remind ourselves that human ingenuity can accomplish great things, and so it's often beneficial to be an optimist, rather than a pessimist, in these kinds of situations.

Some of the other things that at least I learned personally, and mostly as a benefit of working alongside peers, again, that have much more experience than me, so one of those things that I learned was having models or investing in a game plan over the long term is extremely useful in these times of stress. Having the models and investing framework really helps strip out the emotion from investment decision making, and allow us to focus on the opportunities as they present themselves in times of extreme volatility, like we saw in March and April. So yeah, it's been an interesting year for sure, to say the least, and there's a lot to learn from it, certainly.

Stu Morrow (Host):

Yeah. I echo your comments on the optimism side. I'm probably a natural pessimist myself, so I struggled at times, and I recall, when I was with GAM in '08, during the financial crisis, that I relied on some of those senior portfolio managers and Dan, the CIO, just for that guidance, that steady hand, and I can see that coming through in what you and your team have been writing and talking about the and the changes you guys have made throughout the crisis this year. It's been great. Really much, kind of like you said, it's short-term pessimism but long-term optimism.

If we take a step now and take a look at the asset mix and think about parts of that, and equities maybe to start. You know, I said in the opening remarks, stocks have recovered well in the last 6-9 months, and that's due to a number of factors. But as it stands now, from RBC Global Asset Management's perspective, what's the outlook for earnings growth in the US and in Canada and maybe touch on also... Are stocks expensive right now? Are they not expensive right now? And we'll go from there.

Eric Savoie (Guest):

Right. So earnings have indeed plunged in 2020. Given that we've had one of the deepest ever recessions on record. It's quite deep, quick, and painful. But profits already appear to have bottomed in the spring and the summer months, and earnings are actually now starting to climb again. And so the outlook for earnings is actually pretty good, and it's been improving as the data has been coming in better than analysts have expected. For the S&P 500, for example, profits are expected to decline by 15% this year, which is a pretty big drop, but if we compare that to initial expectations of a 25% loss, and so it really doesn't look that bad. And then, moving into 2021, we can expect a continuation of that rebound in profits, so we're looking like something more in the realm of 20% growth for next year. Generally.... and these are big numbers, but it's not uncommon to see very strong earnings growth following recession as profits recover to their long-term trends. And so, with that, the S&P looks like it's going to reclaim its prior earnings peak from 2019 by the end of next year.

We see a similar situation in Canada with the TSX, though the extent of the drop and the subsequent recovery is much more pronounced here because of the more cyclical nature of the Canadian market, so there's a lot more energy and financials in the TSX’s weighting that leads to more volatility in the earnings stream, so for 2020, we look for something like a 20% drop in TSX earnings, but then a much bigger rise of 31% in 2021. And so, again, just like the S&P, that would bring the TSX back to its level that it was before the COVID crisis by the end of next year as well.

So all in all, the COVID crisis has represented a big shock to earnings, no doubt, but the impact is expected to be relatively short lived, and within just two short years from the start of the crisis, we could back at the levels that we saw before the pandemic began. And so, on your point on, "Are stocks expensive right now?" it depends where you look. We tend to focus a lot of our attention on the S&P, and for good reasons. It's one of the most widely followed stock markets in the world, and it's been rising to new highs, and so actually, on a number of metrics that we monitor, the S&P actually is quite expensive, and it is the most fully valued of the major markets that we track. If you look at price-to-earnings ratios, they are elevated, in part because earnings are depressed, but even on forward-looking metrics, the S&P is quite rich.

Looking at our own valuation work that we do, the S&P, we would say, is roughly a full standard deviation above what our estimate of fair value would be. Now a big reason for that is that we're in this low interest rate environment, so stocks still remain appealing to fixed income. Investors are pricing in favorable earnings outlook, like I just mentioned, and then some of the risks actually have been fading in recent weeks, particularly surrounding the vaccine developments. So we think, in this environment, valuations actually can remain high, and valuations are rarely a good excuse on their own to sell stocks, but that being said, we should be mindful that prices are higher, and we might want to moderate our return expectations accordingly, so maybe something like mid-single digit returns for the S&P over the year had to be somewhat of a base-case scenario.

Stu Morrow (Host):

That's good advice on a number of fronts. I completely agree with more moderate forward return assumptions, and that's a good way to frame the discussion of US versus Canada, the fact that we have much more cyclical bias in our main index compared to the S&P 500, which everyone talks about. One thing that I wanted to ask you about was... One of these sort of debates that's going on in the stock market today is value versus growth. You talked about where we've come out of the cycle, where earnings expectations are, maybe start with, if you could, for our listeners, define for us value versus growth investing and whether you can address the difference. Is there a trend there? Is there a trade there between value and growth stock investing?

Eric Savoie (Guest):

Right. The growth versus value debate has been going on for a very long time, and just to start, growth and value can be thought of as different buckets of stocks that have certain characteristics. So your growth stocks are companies with a track record of delivering high earnings growth on a consistent basis, and you'd think here of companies like Microsoft, Google, Facebook, or Apple. Those are the popular ones. Value stocks, on the other hand, are those with attractive valuation metrics, so these would be stocks trading at a low or attractive price-to-earnings ratio or a low price-to-book ratio. And so these stocks generally are considered cheap, and so some examples here may be your bank stocks or your energy companies. We have to be careful to think that... Not all value stocks... Cheap doesn't always mean better. Sometimes stocks are cheap for a reason, and it's because they're not good companies, and so sometimes there can be sort of a value trap there, where you think you're buying something because it represents good value, but really it's a dying business. And so we have to be aware of that.

But in general, growth stocks trade at a premium because their earnings are growing at a much faster rate than those of the value stocks, and these are especially valued in a low economic growth environment, like the one that we've been in since the financial crisis, but that doesn't mean that they're always better investments, because sometimes that premium will get too stretched. It'll get stretched a bit too far, that it gets that risk of being dialed back in. So, like I say, people have been trying to time this for a very long time, whether they should jump into value stocks or rotate other growth stocks, but actually recently we are starting to see some signs that value stocks could potentially make a comeback. So, for one, that valuation gap between value and growth stocks has grown extremely large and was actually accentuated by the COVID crisis and is now reaching levels not seen since the late 1990s tech bubble. Especially we're seeing this in the US market.

So in the event that we do see a sustained economic recovery, perhaps helped by the vaccine or supported by sufficient monetary and fiscal stimulus, could see value stocks get some attention, and the reason why that is that, if the economy's going to accelerate, then the cheapest way to access the earnings growth is actually through these value stocks, because a rising tide will lift all boats. So in the environment where earnings of all companies is likely to rise, then the premium that investors were paying for the growth stocks actually becomes less worth it. So we've actually started to see a little bit of rotation out of growth stocks and into value stocks in the last few weeks. And so it's always hard to tell whether this is the start of a new trend or maybe it's just a blip, but certainly some of the elements that we'd like to see for value performance seem to be falling into place.

So it's always hard to know for sure, but we think, at the very least, investors might want to get a good handle on the value and growth exposures in their own portfolios, as it's a risk that they probably want to be managing here.

Stu Morrow (Host):

Well said, well said. We certainly advocate a diversified portfolio and not trying to, in any way, time those changeovers in terms of leadership style investing, so we advocate exposure to both styles as well, we which we get through RBC Global Asset Management, of course. So one thing, Eric, that's a favorite topic on these audio recordings is interest rates. And we could have a whole series on this, of course, but I wanted to sort of get your input on where interest rates are headed. Are we going into a lower for longer environment that everyone's been talking about and believing? That's certainly been the case for the last number of decades. Interest rates have been continuously on the downward spiral. And if so, maybe give some thought or let us know what you think about what sort of factors or drivers might change that thesis over time. And tie that in maybe with an inflation outlook, which is kind of on the minds of most of our clients today.

Eric Savoie (Guest):

Right. Yeah. So here's another interesting one for sure. Like you said, since I began my career, and these asset mix meetings and forecasting meetings at GAM, quarter after quarter, it always seems that the view was for interest rates to go higher, and certainly there were some periods that rates would rise, but the long-term trend is that rates just kept falling. And you would think that 0% is the lower boundary for interest rates, but in some regions, they've actually gone into negative territory. So here we are where rates are at rock-bottom levels and near zero or even below zero in some regions. The thing is, though, when you look around the world, there's no real urgency for rates to go higher any time soon. Unemployment is elevated in many regions right now because of the virus, so economies are still grappling with the damage from the pandemic, and so there's a lot of these shorter term factors that are keeping interest rates low, but even when we look over the longer term, there's many secular pressures that continue to keep real rates of interest depressed, and some of those things are aging population, slowing population growth, the increased desire for saving versus spending, and the fact that much of the emerging world has already emerged.

So these long-term secular factors are not going to change any time soon. At least we don't think so. And so we do truly believe that we're in a low-rate-for-longer environment. We think that, if we are wrong, that the direction of rates is likely higher, not lower, but the magnitude of that change will likely be limited.

Some of the factors that could cause us to change our view would be if we saw a very strong economic recovery. Much stronger than anyone is anticipating. If somehow unemployment rates were to fall drastically back to levels that we haven't seen since before the COVID crisis. Or if inflation came back in a big way. So if some of these things happened, of course, we would have to measure interest rate and bond yield forecast a bit higher for sure.

So on the point of inflation, we have seen a fair amount of stimulus injected in the economy, and technically that is an inflationary impulse, but there are still lots of near-term pressures holding inflation down. You've got a pretty big demand shock from the COVID crisis, high unemployment, lower oil prices, and so we think that, in the short term, anyway, the deflationary pressures are outweighing the inflationary ones. Not that we're calling for outright deflation but just rather looking for more muted inflation over the shorter term, if that makes sense. But certainly, if you look over the longer term, if we shift our focus to the longer term, we do think that there are some things that may point to higher inflation, so if we continue to see highly accommodative central banks, for example, debasing currencies, the value of currencies, over time, then that will put upward pressure on prices.

Also, the Fed has recently adjusted its policy framework such that it's willing to tolerate a little bit over 2% inflation for some period of time, and that's to make up for the times that inflation's been below that. So we could be going into an environment where the Fed is actually encouraging a little bit more inflation than we've grown used to. In addition, you've got high public debt load, and so governments are severely indebted, and they would probably want to promote higher inflation rather than less, because that would erode the value of their debt and make it less burdensome. And so, with that, there is some reason to believe that maybe once economies kick into gear and the crisis fades in the rear view mirror, we could be looking at a period of a bit higher inflation over the longer term when all of this resolves, but we're not quite there yet. That's more like a three-year-plus outlook, where we think maybe inflation will cause interest rates to rise gradually from there.

Stu Morrow (Host):

Great. A lot of great information there, Eric. Given the outlook, I think it's safe to say we're going to definitely have you back to keep us up to date on what RBC Global Asset Management is thinking in terms of that rate outlook and the inflation outlook. But we end each one of these sessions, Eric, with me asking the guest for any sort of book or podcast recommendation. Aside from Council Views, which is a hit in terms of the audio recording series, what else have you been listening to these days that maybe our listeners would want to know about?

Eric Savoie (Guest):

Yeah, so one book that I actually have on my desk right now is called “Superforecasting” by Philip Tetlock [editor’s note: co-author Dan Gardner], and actually I have this on my desk because just last week we actually had the “Superforecasting” workshop seminar virtually at GAM, hosted by these people at the Good Judgment Open, which is mentioned in this book. And so the seminar that we went through at GAM was to help us learn about tips and tricks to boost our forecasting accuracy. And this book actually came as a recommendation from our Chief Investment Officer Dan Chornous, and he's such a big fan of this book. He actually encouraged all of our investment staff to read it, and he wants all the investment staff to attend one of these “Superforecasting” seminars. I thought it was funny, but he actually read the book from front to back twice. That's how much he liked that book. I mean, it's a good book. And the book discusses various characteristics of what makes a good forecaster, how to get better forecasts out of teams or how to structure discussion to refine forecasts for improved accuracy, so it's not just applicable to financial markets. There's all sorts of ways to apply this information, but it definitely is applicable to the investing world for sure.

I think, reading this book and going through these seminars and through my career, I feel like forecasting is kind of like a muscle, and you need to exercise it. The more and more you use it, the better you'll get at it, so yeah. I think it's a good book. That's the one I'm reading right now. Again, it's “Superforecasting” by Philip Tetlock, “The Art of Science and Prediction”.

Stu Morrow (Host):

That's great. It's a great book. I've got it on the shelf behind me to read over the holidays and give it another whirl, but that's great, Eric. On behalf of RBC PH&N Investment Counsel, thank you very much for spending the time with me today to share your thoughts on all of these key topics. I hope you'll come back and share some of your time again with us in 2021, but wishing you and your family a very safe, very happy holiday season.

Eric Savoie (Guest):

Thanks. It was my pleasure, Steuben. And happy holidays to you as well.

Stu Morrow (Host):

Sure. Thanks, Eric. Talk to you soon.