Monthly portfolio brief

The value of leaning into laggards

What you need to know

• Rising yields have pressured portfolios for a few years now, but there are reasons to believe the future looks brighter, including for bonds.
• With tighter financial conditions weighing on the economic outlook, international allocations can help offset risks within the Canadian economy. We recommend underweighting Canadian large-cap stocks, while overweighting U.S. large-cap stocks.
• The drawdown in fixed income has been painful, but bonds have become increasingly attractive. Diversified allocations can play a valuable role in a portfolio.
• Consider rebalancing by leaning portfolio allocations toward laggards that have become underweight.

Portfolio tip

You can help manage risk and benefit from diversification by looking at how investments may work together in your portfolio.

Where have we been?

Rising yields have been a headwind for bond portfolios, but higher yields could provide a tailwind from here. Interest rates have moved sharply higher in recent months, with the 10-year Canadian government bond yield jumping to over 4%, a level not seen in more than 15 years. These recent moves continue the three-year upward trend in yields: The 10-year yield was less than 1% in 2020.

“Higher for longer” interest rates have pressured portfolios for a while, but the reasons for rising rates have shifted over time. They include tightening central bank monetary policies to fight inflation, resilient global growth and higher yields more globally, among others.

Given the pressure from rising rates, bonds have been a pain point for investors. Canadian investment-grade bonds have dropped 1% in 2023 and by about 4% on average over the past three years, pulling bond-heavy portfolios into negative territory. However, moderating inflation and a likely end to central bank interest rate hikes may signal long-awaited relief.

The best single predictor of future returns for high-quality bonds is their starting yield. Given where yields are today, the future for bond allocations is looking brighter than what we’ve experienced over the past three years.

Higher rates have impacted broad markets, extending the recent weakness through October. Rising rates have weighed on asset prices more widely than just within fixed income, particularly considering the impact tighter financial conditions may have on future growth. Almost all asset classes fell last month, and some economically sensitive investments led the way down.

Small- and mid-cap stocks, which tend to be more cyclical in nature, weighed on portfolios the most in October. U.S. small- and mid-cap stock allocations have recently been a significant underperformer, falling nearly 4% last month. They've trailed all asset class over the past year, dropping about 3%. Canadian small- and mid-cap stocks were down 8% in October, but remain up over the past year, returning 3.5%.

Large-cap stocks, which tend to be higher-quality, have generally held up better this year, and have also provided among the greatest support for portfolios over the past 12 months. U.S. large-cap stocks were up slightly in October and have returned 12% from a year ago. Overseas large-cap stocks dropped about 2% in October but are still in the lead over a one-year period, posting a return of over 16%. Canadian large-cap stocks dropped 3% in October, weighed down by weakness within the financial sector.

What do we recommend going forward?

We favour U.S. large-cap stocks over Canadian large-cap stocks. We believe the Canadian economy has become increasingly sensitive to higher rates, particularly when compared to the U.S. economy. For example, the Canadian housing market has grown meaningfully over the past couple decades, variable-rate and short-term fixed-rate mortgages are more common, and household debt levels are more elevated. While potential interest-rate cuts from the Bank of Canada could provide relief over time, we expect the impact of high rates to weigh on the housing market and consumption in the near term. 

Some uncertainty may have already been priced into Canadian equity markets, but we believe stronger economic growth prospects within the U.S. will continue providing strength for U.S. large-cap stocks in the coming months. Therefore, in this environment, we recommend an underweight to Canadian large-cap stocks, offset by an overweight to U.S. large-cap stocks, relative to the long-term targets within your investment strategy. 
 

Revisit the value of a well-diversified bond portfolio. The drawdown in fixed income over the past three years has been painful. But not all segments of the fixed-income market have been impacted in the same way. We expect the value of diversification to continue benefiting bond allocations as yields peak and begin to pivot lower.

We recommend allocating to bonds across a variety of maturities. Cash and short-term bond investments may provide stability for your portfolio but tend to be a drag on returns over the long term. Reducing overweight exposures can help you manage reinvestment risk. Longer-term bonds have become increasingly attractive as rates rise, given the greater income potential and enhanced diversification benefits of today’s higher rates.

Lower-quality bonds offer a yield premium relative to higher-quality bonds, and international high-yield bond allocations have supported portfolios in recent periods. We believe neutral allocations to this asset class can help your portfolio benefit from their higher yields while balancing the potential that they could underperform if the economy weakens.

Rebalance by leaning into laggards. Underperforming investments may become underweight in your portfolio, potentially causing you to drift too far from your original intention. Rebalancing back to your target allocations can help tie your portfolio to your risk and return objectives.

Consider allocating to areas of the market that have lagged and became underweight in your portfolio. For example, look at small- and mid-cap stocks, value-style stocks, and investment-grade bonds, given the softness we’ve seen in these areas. Opportunities may be forming to add quality investments at more attractive prices. Markets remain sensitive to economic trends, supporting our neutral recommendation in these areas, but balancing these allocations can help you prepare for a more sustained recovery ahead.

We’re here for you

In a diversified portfolio, there will always be an allocation that lags in performance, possibly over an extended period. It’s important to remember that each of your investments plays a specific role. Talk with your financial advisor about the “why” behind your allocations and whether there is an opportunity for you to lean into the laggards. Doing so can help ensure your portfolio is positioned to deliver on your risk and return objectives and aligned with your financial goals.

If you don’t have a financial advisor and would like help evaluating your portfolio, we invite you to meet with an Edward Jones financial advisor to discuss your goals and investment objectives, as well as our recommended portfolio allocations.

Opportunistic asset allocation guidance

Our opportunistic asset allocation guidance represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into a well-diversified portfolio may enhance your potential for greater returns without taking on unintentional risk.