Despite the current economic malaise and volatile stock markets globally, managers of some of Canada’s largest balanced mutual funds are more bullish on stocks than on fixed-income.

Although most managers of balanced funds have a baseline weighting of stocks, bonds and cash, they also typically have the freedom to move within a range as opportunities arise.

For example, the $5.7-billion RBC Select Balanced Portfolio, sponsored by RBC Global Asset Management of Toronto, has 60% of its assets under management in stocks, a level that is above the fund’s benchmark of 55%. This tilt comes at the expense of fixed-income, which stands at 35% of AUM, which is below its 40% benchmark. Cash is neutral at 5%.

“Barring further deterioration in the economy or a significant shock, equities have the best valuation backdrop and better upside potential,” says Sarah Riopelle, portfolio manager with RBC Global Asset Management, who makes allocation decisions for the fund.

The financial crisis of late 2008 precipitated a significant round of cost-cutting as corporations hunkered down and repaired their balance sheets, she says, and this is now bearing fruit in the form of rising cash reserves and fatter margins.

“As the revenue cycle improves,” she says, “there is great leverage to the bottom line and potential for strong earnings.”

On a global basis, the first half of this year saw stocks down by 9.5% on a worldwide basis, as represented by the MSCI total return index. In contrast, bonds, seen as a safe haven in a depressed growth environment, gained 4.2% as measured by the Bank of America Merrill Lynch global broad market index, leading to a performance gap of almost 14 percentage points between stocks and bonds.

“We acknowledge that growth may be slow, but are not expecting a double-dip recession,” Riopelle says. “As consumers begin to spend again, it will have a positive effect on the bottom line of corporations.”

RBC Select is a fund of funds composed of 12 to 14 RBC funds. The biggest holdings are currently in U.S. and Canadian equities, but Riopelle is excited about the long-term potential for emerging markets. RBC Select has about 4% of AUM in RBC Asian Equity Fund and another 2% in RBC Emerging Markets Fund, with the emerging markets being a new exposure since last March.

“Emerging markets are an area of great potential,” Riopelle says. “And our intention is to make them a more meaningful part of the portfolio.”

At Investors Group Inc. in Win-ni-peg, portfolio manager Dom Grestoni, who oversees the $1.7-billion Investors Canadian Balanced Fund, is also tilting more aggressively toward equities than the fund’s neutral mix of 50% stocks and 50% fixed-income. He has the leeway to move by 20% on either side, and is close to the upper end of his range with a 66% weighting in stocks and 4% cash, leaving him with a slim 30% in fixed-income. If Grestoni spies opportunities in any stock market weakness, he will spend his cash and bring the stocks up to 70%, as his fund “is meant to be an active,” he says, “if not aggressive, asset-allocation fund.

“There is value in equities, particularly those with a dividend yield,” he adds. “As far as we’re concerned, we’d be putting risk on the portfolio by buying bonds now. The surprise for the market in the next few quarters could be that the U.S. economy will exceed expectations.”

Grestoni expects U.S. annual gross do-mes-tic product growth to be 2.5% this year, with corporate profitability increasing and unemployment rates coming off the bottom. And Canada, he says, will be even stronger, at 3%. Although the U.S. will not be the global engine it once was, global GDP growth could come in at 4%, with major contributions from India, China and other developing markets.

“The U.S. will play a diminished role in global expansion, but a more diversified global economy is better,” he says. “We see continued improvement and stabilization. It won’t be a straight line up, but we won’t be spooked out of our positions, as we see better times coming for consumption and job creation.”
@page_break@On the fixed-income side, Grestoni is concerned that rising interest rates are imminent. Rising rates are bad news for bond markets, as they make bonds issued at previously lower rates look relatively unattractive, so their prices drop. In recent months, nervousness about the flagging economy has driven investors to seek the security of bonds and has driven prices up and yields down. With a 10-year government bond currently yielding a meagre 3%, he sees a lot more choice in dividend-paying stocks with yields of 3% or better, which also have the potential for capital appreciation.

On the fixed-income side, Grestoni remains flexible with a focus on corporate bonds and an average duration for the portfolio of a relatively short 4.8 years, which is less than the 6.1 years of the Scotia Capital mid-term bond index.

“Eventually the market will realize there is more risk in a 3%, 10-year government bond than in a 3%-5% dividend-yielding stock, whether it takes a week, a month, a quarter or a year,” he says. “The current valuations look backward to us, and that will change. It’s mesmerizing to us that folks wanting to take risk off the table are buying U.S. treasuries. What they’re buying is paper in a government entity that needs to do more financing than ever before — but these same folks won’t go near well-financed, strong and growing companies that are an integral part of the economy.”

James Dutkiewicz, head of the fixed-income team at CI Invest-ments Inc. of Toronto, who contributes to asset-allocation decisions for the $1.8-billion Signature Canadian Balanced Fund, says the fund has lightened its fixed-income position to about 25% of AUM from a neutral level of 40%. It has equities of 68% of AUM and a slightly elevated cash position of about 7%.

Dutkiewicz says an “overabundance” of investors desperate for fixed-income securities have pushed down the yields of debt products and made them less attractive while making equities “cheaper and more attractive.” As an indicator of the trend, he points to a recent issue by U.S.-based IBM Corp. of a three-year corporate bond with a sparse annual coupon of only 1%. By contrast, IBM stock has a dividend yield of 2%. With Dutkiewicz’s outlook for sustainable but sluggish growth as developed economies continue to heal, there’s opportunity for the stock to appreciate.

“The lack of risk appetite has meant a disproportionate amount of assets have flowed to government and corporate debt,” he says. “We expect more activity that will be beneficial for shareholders vs bondholders, including rising dividends, share buybacks and increasing merger and acquisition activity. There’s a lot of excess cash on corporate balance sheets, and the pendulum should shift during the next six to 12 months.”

The risk that could undermine this sunny scenario would be an “unhindered and unjustified” rise in interest rates, Dutkiewicz says. A significant rise in rates would hurt growth, decrease economic activity and increase the risk of a double-dip recession. However, he expects government policies will be supportive of growth and doesn’t expect “draconian austerity measures.”

The view from south of the border appears more clouded. Bob Swanson, the vice president and portfolio manager based in Rhode Island who leads the asset-allocation team at the $12-billion Fidelity Canadian Asset Allocation Fund, sponsored by Fidelity Investments Canada ULC of Toronto, is defensive and thus slightly underweighted in equities. His stock holdings currently stand at 63%, less than his 65% neutral position, and cash stands at 7%, a little more than the 5% neutral weighting.

“We’re now seeing a hangover after the initial surge in the economic recovery,” Swanson says. “The risk that the economy may slow more than expected is greater than a month ago. There’s more risk to the downside than the upside.”

If rates stay low, he says, equities will be a good place to be in a year or two. But first, he’s looking for a recovery in wages and job creation, which will lead to stronger consumer spending. Meanwhile, he’s focusing on dividend-paying stocks.

IE