Transcript
ANNOUNCER: TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management.
[MUSIC]
INGRID MACINTOSH: Nowhere to hide.
As we approach the midpoint of 2022, we are witnessing a market landscape that customers and advisors alike have likely never experienced. One where all asset classes are moving in the same direction and at significant rate.
As we record this podcast, in the middle of June, North American equity markets are down anywhere from 10% in Canada to 22-30% in the U.S. At the same time, on the fixed income side, bonds have been challenged by rapidly rising inflation and central bank response, meaning that traditional bond funds are down almost 15% year to date.
Equity, fixed income, and balanced investors have been hit hard and are likely going to be quite surprised when they open their statements come this July.
Hello and welcome to this week's edition of TDAM Talks. I'm your host Ingrid Macintosh and I am joined today by Justin Flowerday, Head of Public Equities here at TD Asset Management, and together we're going to talk about the current state of markets and offer some perspectives to investors and advisors alike in terms of what's going on and what we can expect going forward.
Welcome, Justin.
JUSTIN FLOWERDAY: Thanks for having me on, Ingrid.
INGRID MACINTOSH: A great conversation we're having here because, you and I both have been in the markets for a long time and I've not witnessed anything like this in my last 35 years. Let's narrow the timeframe down a little bit.
The last few weeks have been a whirlwind to say the least, what can you tell us about the current state of markets and some of the things we should be thinking about?
JUSTIN FLOWERDAY: Yeah. Um, whirlwind is a good word. Typhoon could also be used... CAT 5 hurricane…
It's been extremely challenging conditions and it really was the combination of the June 10th CPI report that surprised everyone to the upside, and the subsequent 75 basis point rate hike by the Fed that's shaken confidence in the potential for a soft landing, and that sent most financial assets to new lows.
And it was, as I was saying to clients just yesterday… it's been three to four decades since investors have been this acutely focused on the rise in prices of goods and services. And this adjustment in the market is all about trying to answer one basic question, which is: 6, to 12, to 24 months out, what is true inflation going to be?
And I think everyone agrees that the 8 to 9% CPI print that we've had in the last couple of months, it's not going to last, but I think most people also realize that we're not going to rush back to 1 to 1.5% inflation that we've had in the last decade. And so, yeah, there's still a big gap there and a world of 2 to 3% inflation versus 5 to 6% inflation spells two very different outcomes for financial assets.
And, and that's where the volatility stems from. In response to all this, I think it's also worth pointing out that according to most technical indicators and sentiment indicators, the level of bearishness and pessimism out there is at extremes. And as a colleague of mine, Damien Fernandez sometimes likes to mutter, "I'm so bearish and bullish."
INGRID MACINTOSH: So, let's talk a little bit more about this.
Let's talk about some of the factors that have potentially been driving the acute inflation, maybe the war in Europe. COVID-19. Can we talk a little bit more about that, Justin?
JUSTIN FLOWERDAY: Sure. And you know, I don't want to rehash kind of some of the same stuff we've discussed, and you've had folks on talking about, but the same issues that were present, three, four or five months ago are still present. And we're… the war in Ukraine hasn't slowed and it looks like this is going to be a prolonged conflict.
COVID, we're seeing pockets of spikes in different areas of the world, but for the most part COVID is moving into the rear-view mirror.
What, what this really is about is the central banks hiking, and hiking like we haven't seen in a long, long time. And so, after the last move by the Fed, we now have an overnight rate that stands at 1.5%.
So, we started at zero. And the futures market would argue that we're almost halfway to where short-term rates need to be, which is somewhere between 3 to 3.5%. And I should mention the same goes for Canada. It's kind of same similar type of trajectory.
And, look, by historical comparison and on an absolute basis, this isn't really that big a deal. This isn't the end of the world, but the higher rates do mean higher mortgage rates for consumers. It does mean higher debt servicing costs for corporations. And ultimately, it will result in a slowing of economy and possibly a recession.
And you've already started to see the beginning of this slowdown, Ingrid.
TMIs have rolled over.
Housing prices in North America are weakening.
Retail sales are disappointing.
You're starting to see some cracks in meaningful pockets of the economy.
The last thing I'd mentioned is with respect to equity prices, you know, we'll go back to kind of finance 101 here and valuations essentially get priced.
Those higher risk-free rates translate into a higher discount rate that is used to calculate the present value of future cash flows. And so, the intrinsic value of companies today is lower than it was a while ago when rates were a hundred basis points lower.
INGRID MACINTOSH: You know, I was a bond trader back in the early 90s where we started the trend of downward rates. And I remember acutely the day the Fed made the first move to cut rates. And we have now been in a 30+ year cycle of declining rates or low rates where bonds have really had this tailwind of both rate move and coupon to guide them.
And as we see the central bank activity, and I said this at the outset, traditional bond fund returns in Canada will be down 14% year-to-date through this sort of rising rate environment and central bank move. And I think it's important for our customers to understand that - or investors to understand that - that this is sort of a price shock to their fixed income portfolios.
So, with that in mind, can we talk a little bit about the central bank activity and what we see going forward more specifically?
JUSTIN FLOWERDAY: Sure. And I think what we heard from Powell more recently was a significant change in tone. And again, it was on the back of the CPI print.
It was back on the back of the University of Michigan announcement. And what it really indicates is that he's willing to put the economy into recession in order to kill inflation and wants to make sure that he leaves this job with inflation back into a reasonable level. And so, I think he's on a track, and I don't think anything will stop him until we get not just 1, not just 2, but 3, 4, 5, 6 month-over-month decreases in the CPI print.
And once we start to see that I think he's going to realize, yeah, I mean, my job is getting close to being done and we may start to discuss the Fed pivot, but that's not next month.
That's not in August, that's still months and months out.
INGRID MACINTOSH: Yeah. And I think too, as horrible as a shock to bond prices and, you know, the bond returns has been, it's actually a little bit of a good news story going forward because we've had this structural impairment or penalty on savers for quite some time with these historically low rates. We're actually coming to a more normalized rate of return. A risk-free rate for bond investors.
Now, when we talk about central banks, we're talking about kind of managing that demand side of the equation, but we also know there's the supply side of the equation here. And this is where the extraneous factors are. What's our outlook for, for some of those elements?
JUSTIN FLOWERDAY: So, thanks Ingrid. When you think about the supply side of the equation. Yeah, I mean, you've got some things that are happening that are more positive than what we've seen. And you've seen companies talk about easing in some of the supply chains. You still have pockets where things are not moving as quickly. And it's in ports in China, it's in manufacturing plants in China. It's also in ports in Los Angeles. So, you're still seeing pockets where the economy isn't working as fluidly as we would like it to.
With respect to oil, there is absolutely a supply-driven environment. And, you know, part of the issue there is that you have the two main providers of incremental supply that the world looks to in these times, they're not able to turn on the taps and that's the OPEC and that's the shale oil base in the US. And the reason is because there's been a lack of investment for years. There's been an unwillingness to put new money into the market because of fear of $100 oil maybe not lasting and with interest rates going up, you know, to make that new investment, you have a higher cost of capital that you need to meet. And so, for a bunch of different reasons, the oil supply hasn't come back on.
I would say that with respect to oil, the Fed is starting to do its job, and the economy is starting to weaken, and you're going to see oil start to -- it's not going to be 130 forever -- and we're going to see it come back down below 100, but to get it back into kind of meaningfully lower levels, you need supply to come back on and it's going to be awhile.
INGRID MACINTOSH: Yeah. And I think too, you know, if people emerge from 2.5 years of pandemic lockdown, I think they're probably less price-sensitive when it comes to things like travel, etc. Plus, they, you know, in some cases got more passion there in their pockets than they did at one time. But I think, you know, we'll probably swing that pendulum on consumer demand as well, once people have really re-acclimatized.
Okay. So, I've put you on the hook a little bit here just by making you talk about rates as an equity guy.
Let's pivot our conversation to equity markets. Let's do a lightning round. I love doing this, and I'm gonna throw some words at you and maybe give me your thoughts.
First of all, let's talk about the financial sector.
JUSTIN FLOWERDAY: Sure. You heard from the Canadian banks a couple of weeks ago, Ingrid, and, results were really, really solid loan growth continued to remain strong. The interest rate sensitivity started to really come through and you saw a net interest margin increases across the board at the banks. And then the big one, which is PCLs. I mean, they're at really, really low levels. I think the average PCL for the banks was two to three basis points. So –
INGRID MACINTOSH: So, there's provision for credit loss.
JUSTIN FLOWERDAY: Yes. Yes. Provisions for credit losses, apologies. And look, going forward, I don't expect double digit loan growth from a year. I think loan growth is going to come down significantly.
I don't expect two to three basis points of provisions for credit losses. I expect that to move meaningfully higher in the next couple of quarters, but I also look at the valuation and the banks are now trading below 10 times and expectations for the sector are really, really low. And I think, in general, the risk/reward as the stocks have come down, is looking a lot more favorable than it was, let's say six months ago, particularly taking a two-to-three-year view.
INGRID MACINTOSH: And so, when you say 10% on the multiples, what's a longer-term average?
JUSTIN FLOWERDAY: Yeah. So, so the banks historically have traded anywhere between 10 times and 13 times forward earnings. And anytime they get below 10 times, it is a bit of an attractive entry point. All else equal, obviously there's events that can derail the economy, derail the kind of PCLs.
We don't think that this is an environment where the banks are going to see the kind of spike in PCLs that let's say the US bank saw back in the 2007, 2008 crisis.
I know there's been a lot of chatter. And over the last 10 years, you've had the hedge fund community in the US come up and there's been a big bear story with respect to Canadian housing, that's been told time and time again. And they continue to kind of push that narrative every three years. And we're starting to hear it again. And I think you're going to hear a bunch of that in the next six to nine months. But when I look at the Canadian housing sector and as a portion of the balance sheet for banks, I'll just throw out a few stats.
Number one -- about half of Canadian homeowners own their home outright. So, it's very, very different than the dynamics in the US. And then when you look at the folks that have a mortgage, they're going to have obviously more pressure paying their monthly mortgage payments, because rates are higher, but loan to values across the border are in the 50 to 55% range. And so, there's a huge cushion for prices to come down, and it's not going to be a 10% price decrease or a 20% price decrease that's going to really impact banks earnings in a meaningful, meaningful way and impact potentially bank capital.
It would have to be something way more significant in the kind of 40% range in order for the banks to start to, I think, feel real pain.
INGRID MACINTOSH: No, it's great perspective.
Okay. Let's move on energy. We talked a little bit about the energy environment, but let's talk about energy stocks.
JUSTIN FLOWERDAY: Yeah. So, we've had incredible results from the energy producers in North America. And it really has been quite remarkable to see, because this has been a revival and it's been a revival for a group that's been in the doghouse for much of the last decade. And I actually think that doghouse was important because while in that doghouse, they became much more efficient organizations. They became much more disciplined operators, much more disciplined capital allocators…
Obviously with WTI over a hundred, they're just generating gobs of free cashflow. So, the results have been really good, and the stocks have been absolutely ripping this year. They're going to take a break for a little bit, but I don't think oil goes back to 50. And, if oil stays above 65, these companies continue to generate significant free cash flow and they continue to return that free cash flow to investors.
INGRID MACINTOSH: Okay. Technology.
Technology is a sector that's been beaten up a fair bit. What are your thoughts there?
JUSTIN FLOWERDAY: Yeah, it's been a tough slog for the tech sector and a bunch of it relates to the discount rates I was referring to earlier, but there are a few interesting trends we're watching.
One of them relates to the labor market. And it's actually a little different from things that we're hearing outside of the tech sector with respect to wages, believe it or not, many software companies have seen margin pressure over the last couple of years and not just the last couple of months. And most of it was due to a supply/demand imbalance for computer engineers that led to really high wage inflation for that group of, of employees.
And, ironically in a time of high inflation in the general economy, we're actually seeing softening trends in wages, in tech.
Layoffs in the software sector at the highest level since April 2020, and a bunch of it relates to an inability to raise funds in the private markets. So not necessarily the public markets, um, which is leading to cash conservation by private companies who used to have the ability to raise money at their beck-and-call and they no longer can. And so, they're actually laying off employees and conserving cash.
If this trend persists, we actually see an opportunity for our public portfolio companies to benefit from a slowdown and wages, which at the end of the day, it would be a decent support for margins.
INGRID MACINTOSH: Okay.
Last question, before we wrap it up. Is there a market cap bias as we look out in the landscape going forward?
JUSTIN FLOWERDAY: That's an interesting question. And I think the way we think about it is less with respect to market cap more about the quality of the company and, you know, does the company have pricing power and do they have strong balance sheets? Do they have flexible cost structures? Can they adapt?
I think, you know, when I think about that last point, there is an argument to be made that small caps may be in a decent position. And, you know, the last time small caps actually outperformed large caps for a meaningful period was back in the 1970s when we had this inflationary environment similar to today. And, and I think a bunch of it may have been because they were so adaptable and because they were able to adjust their cost flexors, certain cost structures, a little quicker than, um, larger cap companies.
It'll be interesting to watch.
INGRID MACINTOSH: A lot is going to be interesting watch as we go forward.
Justin, thank you so much. We've covered an awful lot of ground from, from fixed income, to rates, to the economy, to equity. Thank you so much.
INGRID MACINTOSH: I'm going to sign off here. Thank you again for joining me.
JUSTIN FLOWERDAY: Thanks very much for having me on, Ingrid. Fantastic.
And for our listeners, as always, you can find our most recently published Wealth Asset Allocation Perspective Report on our TD Asset Management site, along with more of our latest thought leadership commentary. And also, you can always check us out at Twitter at @TDAM_Canada and on LinkedIn at TD Asset Management.
Everybody up there, stay well, stay safe.
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