Vik’s Pick: Find returns in sideways markets

As the Bank of Canada’s latest monetary policy report indicates, we’re in a period of extended anemic growth and low interest rates.

The Bank ratcheted down its growth projection for the national economy to 2.1% this year, 2.3% the next and 2.5% the year after. These figures, coupled with European woes and China’s falling growth, will limit capital markets returns.

Read: BoC leaves rate at 1%

That means money managers have to come up with investment strategies that will help investors weather this storm.

Steve DiGregorio of Stanton Asset Management, the portfolio advisor for O’Leary Funds, suggests using higher-yielding assets to counter negative news events.

“We think growth-style investment will continue to be challenged, driven by investors’ desire for yield and low volatility,” he says. “Companies with strong dividends, fully covered by cash flow and predictable earnings, are the investments that should outperform.”

For the fixed-income play, though, junk bonds are just what the doctor ordered, says Greg Nott, chief investment officer at Russell Investments Canada Limited. “High-yield bonds do quite well in a low-growth environment as companies put expansion plans on hold and focus on paying down debt.”

Read: Reaching for yield, taking on risk

He also prefers emerging markets debt to government bonds.

Given that central banks, including the BoC, may remain accommodative for the foreseeable future, some managers are reducing their Canadian equity exposures in favour of better growth opportunities overseas.

Nott, for instance, has added emerging markets to his multi-asset portfolios to exploit higher growth and demographic trends there.

“We would also recommend increased global exposure within the fixed-income allocation of an investor’s portfolio,” he says. “[Investors can] obtain higher yields in corporate investment-grade, high-yield, and emerging-market bonds outside Canada.”

On the equities side, though, the pool of quality stocks is dwindling. Hence, investors need to be very selective and, perhaps, less index-dependent.

Take for instance Canada’s base materials sector, which makes up over 18% of the TSX composite. Slowing growth in China, one of the biggest consumers of our minerals, negatively impacts that sector.

DiGregorio says a non-index-tracking product that invests primarily in corporate bonds and has low equity exposure to base materials may prove to be a strategic choice.

While the quest for quality is a strong common denominator, investment managers remain divided when it comes to looking outside North America.

Read: Foreign investors reducing Canadian holdings

Both DiGregorio and Nott suggest investors go where growth is: emerging markets. But Paul Taylor, CIO, BMO Harris Private Banking and BMO Global Asset Management, sees merit in home bias.

“Investors should generally go with quality [and] go with North America,” he says. “We tend to overweight areas that are most stable and are least exposed to issues [in Europe and emerging markets].”

Not surprisingly, yield has been a recurrent theme in most investment discussions lately.

“[It’s] the most tangible thing in the current low bond and equity return environment,” says Taylor. “That means dividends will represent much higher proportion of total return to investors.”

Distribution payout is also the reason why DiGregorio favours cross-over credit, or debt that has the potential to be upgraded from high yield (BB) to investment grade (BBB).

“We see this as the area of the bond market where the best risk-adjusted returns are,” he says. “This is a way to capture some capital appreciation in a bond along with the coupon.”

Trouble is, weary investors are too focused on reducing debt and spending less, and may be losing out market opportunities for potential gains. The challenge for money managers, therefore, is to get these investors excited again about market participation.

DiGregorio points out how cheap equities currently are. “At the moment, the S&P/TSX Composite is yielding 3.01% vs. 1.67% for the 10-year Government of Canada bond,” he says. “The spread of the earnings yield to the government bond is 5.6%, meaning stocks are earning 5.6% more than government debt.”

Taylor, on the other hand, says it’s time for investors to move on from the negative effects of the financial crisis. “They have to disconnect from what’s happened in the last four years and focus on what’ll play out over the next 12-to-36 months.”

In weak equity markets, he asserts, a generous yield advantage can lessen the pain of low returns. On the other hand, high-yielding, low-valuation stocks of dividend-paying companies work as an effective hedge against market turbulence.