Webcast – Canada in context: Economic drivers and global allocation perspectives

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Hello, and welcome to Fidelity Compass.

 

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I'm Pamela Ritchie. Institutional investors are navigating a complex macro

 

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landscape defined by geopolitical risk, energy price volatility,

 

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and renewed inflation pressures.

 

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This is the backdrop for a timely thought leadership piece from Fidelity's

 

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Global Asset Allocation team.

 

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Their second quarter paper, Conflict Favours Commodities in Canada,

 

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makes the case for owning commodities in an inflationary world, and raises

 

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an important question, what does it mean to innovate the traditional

 

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60/40 portfolio today?

 

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Joining us here today to discuss the Global Asset Allocation team,

 

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how it manages risk when uncertainty is elevated, is institutional portfolio

 

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manager, Ilan Kolet. Welcome, Ilan.

 

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Great to see you. How are you?

 

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I'm really well, I'm really well. Nice to see you, Pamela.

 

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Looking forward to our chat today.

 

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Absolutely. We'll invite everyone joining you here today to send questions in

 

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over the next 25 minutes or so we'll have this conversation for.

 

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I mean, it is in the title of the paper that commodities are

 

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where it's at when you have some inflationary impulses which

 

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seem to be all around us.

 

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Just talk a little bit about how you got here because it was not overnight.

 

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No, not at all. I

 

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spent many years as the head of inflation and commodities on

 

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our  asset allocation research team down in Boston before moving

 

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back to Canada in 2021. I think it's fascinating what's happened.

 

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In the last six, seven years, maybe five years,

 

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what has really come into focus is just how critical commodities

 

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can be, and are, to own in multi-asset

 

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class portfolios as, you know, you have to size it appropriately, but

 

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as hedges to a variety of things, inflation, inflation volatility,

 

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US dollar debasement, geopolitical risk, we've really

 

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had this sort of test case for every single one

 

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of those things happen over the past five years.

 

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This is an asset class that I think ...

 

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prior to COVID I think a lot of people were sort of questioning whether

 

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or not commodities were worth the insurance payment

 

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that you have to make every year in terms of foregone return.

 

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Again, we've had every one of those things highlight

 

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how critical it is to have some commodities as

 

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part of those portfolios as a hedge against all

 

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of those really volatile type of events.

 

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With the inflationary story, let's dig right in there, again, you did not

 

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get to the thoughts that you'll share with us overnight, but in any case there

 

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has been an extraordinary inflationary shock.

 

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The question is how long it will last, we don't know, the oil price doing what

 

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it's doing even with a tentative ceasefire in place.

 

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We know that it flew up and we're going to see it somewhere

 

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in earnings, doesn't mean it won't be offset in certain ways,

 

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how are you calculating where this is going to show up and just how broadly

 

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it's going to be showing up?

 

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There's a number of ways that we should be thinking about this inflation shock.

 

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If I was sitting in Boston right now in my prior seat, or even if

 

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I were sitting at the Bank of Canada thinking about inflation as I was a few

 

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decades ago, there's a few scenarios that everyone is trying to do

 

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to try to think about the magnitude of this temporary

 

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supply shock. The way that we would classify what we're observing right now is

 

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quote/unquote a temporary supply shock, meaning prior to the

 

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closing of the Strait of Hormuz demand was generally fine, supply was

 

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generally fine, inventories were fine, which resulted in a certain price.

 

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The main factor that has changed that has lifted the price, unsurprisingly, is

 

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not some sort of surge in demand.

 

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It was a massive decline in supply which choked off

 

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a sizable percentage of the global oil supply which

 

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led to an immediate price reaction. What I'm saying is not shocking to anyone.

 

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The thing that analysts both at the Bank of Canada and the Federal

 

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Reserve and investors are trying to grapple with is how

 

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long will it remain closed. It's sort of open now.

 

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Is it fully open?

 

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Is it going to close again?

 

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The duration of the shock, that's really the tough thing

 

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to think about, number one.

 

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Two, if we see a backtrack, if we see it close fully again, does that mean

 

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oil to 150 or 200.

 

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The way that most people, including central banks, will think about these types

 

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of things is through scenario analysis.

 

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No one knows the answer.

 

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Anyone who says they know the answer is mmm, I can't use that word

 

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on a webcast but I would say probably not overly accurate.

 

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What you would do is you would say, okay, let's assume the

 

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price of oil is what it is today for the next six months, then

 

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let's take the path of the futures curve, which is sort of downward sloping,

 

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and assume that's our forecast, and then let's assume a third scenario that

 

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has oil prices kind of increasing to some really

 

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uncomfortable level.

 

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Those three scenarios would then result in three scenarios for

 

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CPI. How does oil enter

 

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the calculations for consumer prices?

 

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It's through gasoline prices. Oil prices are not directly in

 

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consumer measures of inflation.

 

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They flow through from gasoline prices which is what we buy.

 

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It's a much smaller share of the both American and Canadian

 

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spend than it was in the '50s or '60s for a number of reasons.

 

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It's maybe 2 to 3% of total spend

 

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so it provides less of an upward shock, but with the size of the shock that

 

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we're observing it will still lead to a very significant increase for

 

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total inflation. The last thing I'll mentioned there is the

 

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reason central banks, both the Bank of Canada and the Federal Reserve, will

 

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try to look through upward shocks to inflation prices caused by

 

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temporary supply shocks is they don't represent necessarily, well, they

 

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don't represent the underlying core measure

 

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of inflation.

 

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You know, Pamela, I could probably talk about this for three hours but that's

 

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I love talking about that with you.

 

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Those are some of the reasons.

 

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Exactly. Exactly. What we should expect, I think, from central

 

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banks is they will try to look through this shock as much

 

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as possible, but of course, if oil prices remain elevated that does

 

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seep into other elements of inflation and it could

 

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affect consumer spending. If you have to pay more to fill up your car

 

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you pull back on some of the discretionary items, the vacations and

 

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the eating out and that sort of thing, which then affects consumer spending

 

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which is a much bigger problem for central banks.

 

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The thing is the shocks are all over the place and

 

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they are there often.

 

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Starting with COVID, maybe before that even, it does seem we have to just

 

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kind of get used to the shocks. They happen more frequently.

 

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I'm going to ask you, is that what ...

 

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it's not that that is sort of the core scenario or the base scenario but it's

 

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certainly more than it was and therefore commodities, I mean, is

 

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that part of it?

 

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That is part of it. The way I think about that question is

 

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you really need to innovate and build resilient portfolios.

 

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Sometimes we use the term we wanna build the balanced fund of the future.

 

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This is really the goal here which is you need a variety

 

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of managers that have different styles and sectors, we know that.

 

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You need asset classes. You generally want to be globally diversified, we know

 

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that. You need out of benchmark capabilities, I think we know

 

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that. You need tactical flexibility to lean in or out of asset classes and

 

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geographies, but specifically to commodities,

 

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when I was doing the research in Boston we found commodities were a very

 

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effective hedge against unexpected

 

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shocks to inflation and increases in

 

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inflation volatility. There's two things going on there, not just the upward

 

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shock to inflation. Again, if you own the thing that generates the shock

 

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you hedge the shock better.

 

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Two, inflation volatility, if you own underlying commodities

 

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that can help hedge or defend against some of that inflation

 

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volatility, a great example of that is 2022.

 

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So 2022, a year none

 

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of us want to rewind to, was a year in which bonds and stocks was

 

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down and more down so you needed to own commodities

 

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if you wanted to edge out stronger returns or

 

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beat your peers.

 

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Commodities really came into focus in 2022.

 

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This year and last year the main driving

 

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theme prior to the Iran conflict for us

 

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that motivated our overweights to commodities,

 

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specifically gold, has been

 

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US policy that we believe is, basically, observationally

 

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equivalent to US dollar debasement.

 

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What do I mean by that in English?

 

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Exceptionally volatile policymaking environment makes us think that

 

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the US really has an outright intention to

 

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debase or devalue the value of the US currency.

 

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In a policy environment like that you need to

 

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own the things that protect portfolios against dollar

 

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debasement. Top of that list are going to be the commodities, gold especially.

 

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The third one is geopolitical risk, which we have.

 

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We started the year with regime overthrow in Venezuela

 

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and now we have what we're witnessing

 

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right now. The thing with commodities is there's really strong arguments from

 

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a few different pillars.

 

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No, it's incredible. What if, I mean, this is one of the questions being thrown

 

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around right now, what if the US dollar pricing of, they say petrodollars

 

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but it could be, really, any material that is priced in US dollars,

 

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falters here, if people just start buying things in the currency that they want

 

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to. At the moment we have Iran asking to take tolls in

 

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cryptocurrency. I mean, throw that out there but does it make a difference

 

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to the way you invest in commodities if they're priced not as globally as they

 

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once were in the US dollar?

 

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I think potentially. I mean, it's funny, prior

 

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to maybe a year ago or a year and a half ago

 

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when people used to ask me questions, sometimes that question was framed as

 

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what's the likelihood of the US losing its reserve currency status?

 

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I would go to the IMF data

 

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and look at foreign exchange holdings and look at the time series of data, it's

 

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a fantastic data set that we've used in some of our papers, and

 

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examined what that looks like.

 

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My answer has always been in our lifetime the US dollar will

 

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be the reserve currency.

 

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That's generally still my view but I would say I'm a little less

 

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dismissive or sort of aloof around this idea.

 

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I no longer view it as a question that just came from the

 

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dark corners of Reddit or Twitter.

 

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I think this is now a much more front and centre concern because

 

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of outright ... a policy that really mimics outright dollar debasement,

 

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but also there is some push coming from

 

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other parts of the world. If China starts to

 

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invoice, you know, is invoicing some of their commodities

 

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... if you get commodity invoicing in other currencies that's a pretty

 

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significant change as well.

 

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Again, it'll be gradual but the way that we're positioning in our funds is

 

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for that US dollar depreciation, devaluation,

 

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which goes a long way in explaining why you need those commodities.

 

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Commodities come in different forms, you can get exposure to them.

 

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I'll ask you about the different ways you can do that but ultimately, tying

 

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it back to sort of the Canadian producers, what we take out of the ground

 

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here in Canada, and obviously the question of whether Canada becomes

 

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a ... this is a super cycle for commodities and Canada is right in the middle

 

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of it again. First of all, how do you expose investments,

 

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ultimately, to commodities?

 

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There's a number of ways for us to talk about that.

 

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We can gain a commodity exposure through a wide variety of ways.

 

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In the funds that we manage for Canadian investors right now

 

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we're using a gold ETF to gain exposure to the gold bullion,

 

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the price itself. We can also use an oil ETF to get exposure to the price of

 

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oil. We can buy global natural resources, which we have done in the past,

 

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which is an internal Fidelity Canada fund run by

 

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Joe and Darren. Fantastic fund, we've gained exposure that way.

 

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We have a new capability that gives us exposure to the BCOM

 

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which again, about a third of that's energy,

 

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a third of that is industrial metals, 20% rather.

 

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That gives a diversified exposure to commodities.

 

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The other way is a lot of our underlying managers will own commodity

 

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names as well. If I take, for example, gold, in

 

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our main 60/40 portfolio we have about a 2% allocation

 

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to gold. If you look through to the underlying managers and

 

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sweep up what they have in terms of gold exposure to gold energies,

 

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gold equities, it takes that gold exposure to just over 5%.

 

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So 5% gold and gold equity exposure in a 60/40

 

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portfolio, that's plenty of gold.

 

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Because commodities can be quite volatile you need to size those positions

 

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very carefully in order to manage the overall risk of

 

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the fund because of the volatilities in those underlying asset classes.

 

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There's a number of ways we can sort of get at that exposure.

 

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To be quite frank, this is one of

 

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the really powerful things being at a place like Fidelity, no

 

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one ever comes back to you and says, oh, we don't have that capability and you

 

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can't get it and too bad.

 

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That's never the answer.

 

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The answer is if we want a capability we build it,

 

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we find it, we source it.

 

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We've

 

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seen that in a number of different ways with alts and with commercial real

 

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estate through a variety of asset classes.

 

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That's how we think about it.

 

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Your other question around the

 

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Canada story, that's certainly another interesting one for us to dig into

 

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in terms of why Canada, why now, and why commodities.

 

241

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That's a great question.

 

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This also has to do with, it looks like, a massive policy

 

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shift to much more open to taking things out of the ground,

 

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essentially. I guess I'll ask at this point, what sort of ...

 

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it's not a matter of faith but what is it that you believe

 

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is on track here and is the shift?

 

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It's interesting. I spend a lot of my time talking to clients coast to coast.

 

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I will say this is an area where

 

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... you can kind of read the room, this is an area where a lot of people are

 

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just still kind of generally uncomfortable with our cautious optimism

 

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around Canada.

 

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I think the first question is, why are we cautiously optimistic about Canada

 

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and how are we sort of representing that

 

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[audio cuts out] link to commodities. As I mentioned,

 

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in most of our funds, in our funds we've been underweight Canadian equities

 

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for forever, over a decade, 13 years, I think,

 

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until the start of last year when we started buying back Canada.

 

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We started back Canada in part to do with our concerns

 

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around what was happening in the US.

 

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Again, as asset allocators we have to be thinking about things in relative

 

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terms but also because

 

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we just thought that it may be the case that the secular underperformance

 

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of Canada versus, for example, the US, may be coming to an end.

 

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Why is that the case?

 

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It's because perhaps, perhaps the worst is behind us in Canada.

 

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I'm not going to pretend that we're off to the races from an economy

 

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perspective but we think, basically, the bottom was Q2 of last

 

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year.

 

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Really. Tariffs.

 

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Exactly. Q2 was right after Liberation Day, 30%

 

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annualized decline in exports, CEO consumer confidence falling off

 

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a cliff, really painful mortgage renewals for a lot of

 

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Canadian households in the rear-view mirror.

 

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Since then we haven't become more worse.

 

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That's terrible grammar but...

 

276

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That is terrible but I know that you know that is very descriptive

 

277

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too. Actually, I get it.

 

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If we were both back in Bloomberg they would not be

 

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impressed. Things have not deteriorated

 

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from that low position, and you might argue they've kind of improved.

 

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Trade has kind of moved sideways and hasn't continued to

 

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deteriorate. The unemployment rate has actually come down from where it was in

 

283

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the middle of last year. CEO and consumer confidence has kind of come back.

 

284

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I mean, we still have to stick the landing, there's still plenty of challenges,

 

285

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CUSMA, USMCA negotiations, this recent

 

286

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round of geopolitical shocks, but I would say

 

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it does appear ...

 

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to borrow a line from Mark, if things are priced for very bad

 

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and we're moving towards less bad that's a really good opportunity for our

 

290

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security selectors and a space we want to be leaning into.

 

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Layering on top of all of that is

 

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an environment from Ottawa that is just far less negative towards

 

293

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commodity extraction, the commodity sector, energy infrastructure,

 

294

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and just anything but, you know, well, I'll be nice, it's

 

295

00:18:57.002 --> 00:18:59.838

a warmer environment, I would say, towards actual...

 

296

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And you're from Ottawa. It's cold there.

 

297

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Exactly.

 

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Actual shovels in the ground, productive investment.

 

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This is, in fact, what we need.

 

300

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You have two ways to achieve growth, labour force growth and productivity.

 

301

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Labour force has been turned off, that

 

302

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huge boost has been completely turned off after kind of being mismanaged.

 

303

00:19:24.129 --> 00:19:28.233

The other one, the thing that we're going to rely on for long term

 

304

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growth and productivity has to be the shovels in the ground.

 

305

00:19:30.869 --> 00:19:34.773

To be clear, this is the historic driver of Canadian growth.

 

306

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We dig stuff out of the ground and we sell it to our neighbours.

 

307

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It hasn't always been condos.

 

308

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That's right.

 

309

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Let's talk about how this ultimately looks in a portfolio.

 

310

00:19:48.954 --> 00:19:53.192

We don't need to go too specifically about your funds necessarily but

 

311

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the overall 60/40 was very much what people had

 

312

00:19:57.296 --> 00:20:01.166

in 2022 when both went down at the same time in the same direction.

 

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There's some concern and, I think, recency sort of fear

 

314

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about that. What does it look like now broadly?

 

315

00:20:08.473 --> 00:20:12.477

We're hearing a lot about this sort of 60/20/20, where do

 

316

00:20:12.477 --> 00:20:17.316

commodities fit in that, if that's it?

 

317

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I think the 60/20/20 is an engaging sort

 

318

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of provocative idea to think about, and maybe that is the end state

 

319

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that we get to. I think what that research has really shown is

 

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in the presence of inflation and inflation volatility

 

321

00:20:35.200 --> 00:20:39.004

what gets damaged, and many folks on this call will know this, in fact,

 

322

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everyone, I'm sure, is the inverse relationship between stocks and bonds.

 

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This is the first commandment for asset allocators

 

324

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and investors and why the 60/40 portfolio worked beautifully

 

325

00:20:51.783 --> 00:20:55.988

well for so long, specifically

 

326

00:20:55.988 --> 00:21:00.025

in a risk-adjusted way, the equities give

 

327

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you the upside in periods of growth and the bonds provide you with income in

 

328

00:21:03.262 --> 00:21:07.733

periods of stress. What destroys that inverse relationship,

 

329

00:21:07.733 --> 00:21:11.036

as we found out, was inflation and inflation volatility.

 

330

00:21:11.036 --> 00:21:15.274

It got destroyed in the '70s, if you were in a 60/40 in the '70s you got killed

 

331

00:21:15.274 --> 00:21:20.279

unless you had sort of barrels of oil in the backyard

 

332

00:21:20.279 --> 00:21:23.081

because commodities were fairly uninvestible.

 

333

00:21:23.081 --> 00:21:27.252

In 2022, again, this became front and centre, for

 

334

00:21:27.252 --> 00:21:30.789

multi-asset class portfolios that had stocks and bonds you needed better

 

335

00:21:30.789 --> 00:21:34.793

diversifiers that diversified you

 

336

00:21:34.793 --> 00:21:36.762

against both stocks and bonds.

 

337

00:21:36.795 --> 00:21:41.166

Again, think of that sort of third axis

 

338

00:21:41.166 --> 00:21:42.801

on the chart.

 

339

00:21:42.801 --> 00:21:47.205

We have found that through diversifying our commodity exposure,

 

340

00:21:47.205 --> 00:21:51.243

whether it be oil and gold ETFs, or in-house oil

 

341

00:21:51.243 --> 00:21:55.614

equity, sorry, natural resource

 

342

00:21:55.614 --> 00:22:01.086

equity building blocks, or capability to the BCOM,

 

343

00:22:01.086 --> 00:22:03.555

and as well alternative investments.

 

344

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We have Fidelity Canada liquid alternatives in some of our funds.

 

345

00:22:07.893 --> 00:22:12.164

We have a dedicated capability to private commercial

 

346

00:22:12.164 --> 00:22:15.701

real estate managed by Brookfield that we're using in some of our funds.

 

347

00:22:15.701 --> 00:22:19.604

You just really have to think about how you can sharpen

 

348

00:22:19.638 --> 00:22:21.406

the tool.

 

349

00:22:21.406 --> 00:22:25.644

I do think the shocks that we've observed in the last five years have really,

 

350

00:22:25.644 --> 00:22:29.948

really brought into focus how critical

 

351

00:22:29.948 --> 00:22:33.952

it is to continually innovate the 60/40 and push

 

352

00:22:33.952 --> 00:22:36.054

that balanced fund of the future idea.

 

353

00:22:36.054 --> 00:22:40.125

If you're using the 60/40 of

 

354

00:22:40.125 --> 00:22:43.895

50 years ago it hasn't been good.

 

355

00:22:43.895 --> 00:22:47.699

You need to adjust that for today's realities.

 

356

00:22:47.699 --> 00:22:51.770

The argument of Canada and how it looks outside of Canada,

 

357

00:22:51.770 --> 00:22:55.741

funds around the world wanting to get commodity exposure, taking a look

 

358

00:22:55.741 --> 00:22:59.778

at Canada for exactly that,

 

359

00:22:59.778 --> 00:23:03.849

Canada needs to move a little bit further in terms of spurring the CapEx

 

360

00:23:03.849 --> 00:23:07.486

it appears. I wonder if you can just talk in our last couple of minutes here a

 

361

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bit about what we're on the cusp of, or if we're on the cusp of something.

 

362

00:23:12.824 --> 00:23:16.962

It's interesting. We work really closely with our researchers,

 

363

00:23:16.962 --> 00:23:19.297

our asset allocation researchers in Boston.

 

364

00:23:19.297 --> 00:23:22.634

We have a dedicated team of asset allocation researchers who actually spent the

 

365

00:23:22.634 --> 00:23:25.036

last few days with us up here in Toronto.

 

366

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It was fantastic getting to collaborate with them.

 

367

00:23:28.173 --> 00:23:32.277

They spent a couple of days in back-to-back-to back meetings with

 

368

00:23:32.277 --> 00:23:36.615

various analysts who were visiting Toronto from

 

369

00:23:36.615 --> 00:23:40.318

parts of Canada, including a couple from Calgary.

 

370

00:23:40.318 --> 00:23:44.823

The environment, I think there's been a regime change.

 

371

00:23:44.823 --> 00:23:48.860

That's a big word to throw around but I think we are witnessing

 

372

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a regime change in terms of investor sentiment

 

373

00:23:52.864 --> 00:23:57.002

and attitude towards Canada in large part because

 

374

00:23:57.002 --> 00:24:01.206

of our commodity beta. You had heard about this, I had heard rumblings

 

375

00:24:01.206 --> 00:24:05.644

of this maybe a year, year and a half ago, and

 

376

00:24:05.644 --> 00:24:09.881

it was very dismal. I had heard it in some of the sort

 

377

00:24:09.881 --> 00:24:14.453

of faster money community being called the Canada hope trade, which

 

378

00:24:14.453 --> 00:24:20.158

is just a depressing term.

 

379

00:24:20.158 --> 00:24:20.792

I was going to say, that's not hopeful at all.

 

380

00:24:20.792 --> 00:24:24.963

I do think we are potentially witnessing

 

381

00:24:24.963 --> 00:24:28.967

a bit of a regime change here towards a move

 

382

00:24:28.967 --> 00:24:32.103

back to the historical drivers of Canadian growth.

 

383

00:24:32.103 --> 00:24:37.709

I think we're all ready for it, it's long overdue.

 

384

00:24:37.709 --> 00:24:41.580

Because of the productivity lags that have been so persistent it's actually

 

385

00:24:41.580 --> 00:24:45.550

required. In the words of the Bank of Canada Deputy Governor, this is a

 

386

00:24:45.550 --> 00:24:47.385

break the glass moment in terms of productivity.

 

387

00:24:47.385 --> 00:24:52.591

If anyone hasn't read that Carolyn Rogers speech, I think from March

 

388

00:24:52.591 --> 00:24:55.794

2020, it is absolutely worth a read.

 

389

00:24:55.794 --> 00:25:00.432

It's my favourite speech from the Bank of Canada in the last 15 years.

 

390

00:25:00.432 --> 00:25:03.602

Fantastic. Oh, that is essential reading.

 

391

00:25:03.602 --> 00:25:07.672

Ilan Kolet, what we would do without these amazing pieces of context

 

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to put into everyone's investment vision and dashboard.

 

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So appreciate you being with us.

 

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All the best.

 

395

00:25:15.714 --> 00:25:17.516

Thanks so much. I enjoyed the chat.

 

396

00:25:17.516 --> 00:25:20.785

That's Ilan Kolet joining us here today on Fidelity Compass.

 

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If you have any suggestions for future topics or guests that you'd like to see

 

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00:25:24.322 --> 00:25:28.260

on the show please go ahead and share those ideas with us and stay tuned for

 

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more Fidelity Compass webcasts in the weeks ahead.

 

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Thanks so much for joining us today. I'm Pamela Ritchie.