Hello and welcome to the Download. I'm your host Dave Richardson, and it's Stu's days but again, we're on Wednesday because of our terrible travel schedules.

That's right. I might need a new name, Dave.

Well, Wepner or Widner or something like that?

Yes, something like that. Webster maybe?

Maybe, Thurston? But he tried that before. As it worked out, this was not by accident. This was a stroke of brilliance on my part because I knew this afternoon on the 21st day of September, the Federal Reserve was making their announcement. So I thought the podcast would be more relevant if we waited until after the announcement. Then we have the discussion with you, because then you have a whole bunch of wisdom to share about what's happened because something's actually happened.

Yes, that's right. Because even before, I would have said, well, the Fed will come out and the market will go up 50 points, down 50 points, up 50 points, and then down 50 points all within the two hours since the decision. And that cumulative return, if you got each of those swings right, was about four or five percent.

Did you get them right?

We didn't venture into that area. But it is indicative of the struggle that investors are feeling in the very short term.

Yes so here, let me tell you where we are going to venture, Stu. We're going to venture back to camp- Camp One and Camp Two we talked about last week. So the Fed comes out with their 75 basis-point raise, and some other stuff around the DOT plots, which are now suggesting that the Fed funds rate may peak out more around four and a half then, three and a half, four to four and quarter, as we may have thought before the 10-year Treasury in the U.S. just continues to just kind of creep higher. Although, it went up and fell back down again after the announcement. So let's go back to our Camp One and Camp Two. Who do you think got the best of this announcement today?

Well, I think kind of like where we've been before. Neither camp is totally happy. Camp One thinks rates have to go quite a bit higher to snuff out inflation. Camp Two says there's a lot of market-based indicators, - PPI, inflation expectations - many things in the basket are coming down. Even the wage increases that we saw a big settlement with the railroad workers at about five percent a year for three years, could have been worse. So, Camp Two is of the mindset that inflation is in the process of alleviating. If the Fed keeps going on interest rates, then they're going to push the economy into more of a slowdown. And that's going to be bad for earnings. There are two kinds of things around something being bad for earnings because the stock market is always forward looking. So in a recession, you can have a decline in earnings. But, as that decline is happening, the Fed has already started to reverse course and started to add liquidity back to the market. They start lowering interest rates, in which case, the market looks through that because they say, yes, that doesn't matter, it's going to get better. The issue that Camp Two has right now is the duration of some of the higher interest rates. It's not that they're going to go five or six percent or whatever. But, if they go to four and a quarter, four and a half, and they stay there for a longer period of time, then that could suppress earnings for a longer period of time as well, which the stock market needs to take into consideration. The same thing you said on the 10-year bond, which is you kind of been one side or the other and five or six basis points of 350. But, when you think about a bond, I can buy a one-year bond today, and I can go and look at what will a nine-year bond be in one year's time, or I can buy a 10-year bond today. So when you start to move shorter-term interest rates up, then it has to fall a little bit into all bond prices because if I'm buying a two-year at four percent and a five-year at 375, and the 10- year at 350, well, if the if the two-year goes to four in a quarter, then the 10-year probably needs to be a handful of basis points higher.

Sure. And we're seeing a lot of Canadian investors are skewed that way. They're making more conservative calls. So whether it's bonds or cash equivalents, they're staying shorter term in terms of what they're doing. Because A, you get a higher rate shorter term, and secondly you are just looking to get over a period of uncertainty right now. This is where we're seeing a lot of Canadian investors do that.

Yes, I think that's interesting. On the Canadian side, we talk so much about the U.S. 10-year, but when you get into an economy where people are more convinced that the central bank has been successful. In June of this year, the Canadian 10-year bond was about 10 basis points higher than the U.S., 10-year bond. We sit here today with the Canadian ten year, almost 50 basis points lower than the U.S. 10- year bond. So it can happen quite quickly. Once you get into a situation where markets are more comfortable that the central bank action is going to be enough, and they can begin to say, I can really start to see the end of it, you get a lot different dynamics in the bond market. We're just not there yet in the United States. But yeah, thought that was kind of an interesting example.

And you flipped me a fantastic chart over the weekend that really looks at that. We get all these different announcements around the various price index, consumer price index from U.S., Canada, Europe. But a lot of times, those are those are really looking in the rearview mirror. So what you sent to me was something that tends to be a little bit more forward-looking in terms of where prices are going. Why don't you share that? And what that shows that's different from what we're seeing or ahead of what we're seeing, I think is a better way of positioning it, with the Consumer Price Index.

Yes, this was around the Purchasing Price Index - excluding Food and Energy. So this is what's kind of going on, call it the business side. And that is quite a bit more contained than what's going on inflation-wise. The last buckets of inflation on a CPI front are really in the services area, which are heavily influenced by wages. If you took the railroad workers, for example. If you had 100 cents of revenue at a railway and maybe you had $0.6 of costs and maybe half of that was labour. If that $30 is up five percent, then the railroad needs to increase prices by one-and-a-half percent if they don't get any productivity to offset that increase. Now, normally businesses get some form of productivity. Right now, that's been under pressure for a couple of reasons. I think one of them is COVID. As we talked about, you lose labour productivity with people staying at home sick. The impact of long COVID, and certain things like that. Wages in some instances can be contained at an inflation level that's not too high. Meanwhile, if you're going for straight service, such as a visit to the physiotherapist or you go get a massage day or something like that, they need to charge you an extra six or seven percent, it's going to be up six or seven percent. Those are some of the dynamics that are going on the inflation front that gives you some comfort on the forward side. When we think back and say, well, what were the ingredients of inflation? Monetary stimulus, fiscal stimulus, supply chain due to COVID, and the Ukraine war. The impact of those four is largely starting to come off. Wages are still moving, but they're kind of a lagging indicator, often on inflation. Those are some of the things that people in Camp Two really hang their hat on.

Yes. The one thing through all of this that we've talked about before - the whole idea of pushing the economy down, release it, it overshoots, and now it's kind of normalizing - lost in a lot of the discussion as I look at long-term charts of 10-year bond yields. They typically float between two and five percent. And so, if we top out at four, even if we top out at four and a half percent, we're very much in a historical range. We're not talking about extremes. And if even if they went that high, the data that you're seeing right now suggests that it's not likely to stay that high for too long.

That's right. If we look at the real rate of interest, we take a 10-year bond and subtract the inflation expectation, then we're back to where we were in late 2018. That was a level that was a challenge for the market and for the economy. There is tightening that has been embedded into the system. It just takes a bit of time to show up. So investors are focused on will the Fed go too far and cause more pain? Yes, that's always possible. It's often quite brief. I think the other thing that always comes to mind when we're in these situations is companies adapt. Right now you have companies that have been functioning in one environment. Sometimes it takes them a bit of time to refocus on the new environment. But when they refocus on the new environment they find ways to be more productive. They find ways to control their costs. The economy starts to do better and the revenue that then gets generated in the recovery ends up creating a lot of profits because of the actions they took during the downturn. Sometimes you get into situations where you kind of wish you could just fast forward the movie, because you know how the cycles are going to play out. As investors, it's pretty hard not to get focused on the here and now and what's going to happen, this time, that time, right off the bat. But the cyclical nature of how earnings and the economy works through these periods of time, is something that long-term investors really want to be thinking about. Because, yes, the economy's likely to slow down. Maybe there'll be a recession. But once we've had enough of Fed tightening and we start to move back towards stimulus, the market will then look towards better days and multiples will expand. It'll be on higher earnings expectations at the time. And that'll be an attractive time to own stocks. In the interim, we're big fans of dollar cost averaging. But, when you get into a situation where sentiment is negative, there's going to be some type of a slowdown, the amount of chatter around recession is quite high. It can be very frustrating for investors. It's an emotional period of time, but it's also the time to sharpen your pencils, and think about what is on the table here on the other side of this valley.

By the way, I just won my bet because you mentioned dollar cost averaging before the 15-minute mark of the podcast. The over/under was 15 minutes, so that's good. You're still Dollar Cost Average Boy. But one of the fantastic things that you get to do that so many investors don't, me included, is you get to go out and meet with those leadership teams of the companies. It must be fascinating to see. We and the listeners work in companies – we see this stuff going on around us. Brilliant people who are experts in their industry, and how they adjust to different environments and make it work. And then, of course, we come out of an economic downturn.

100%. We try not to really ask management exactly what will happen. We try and understand what would you do if this happens? So, then when it starts happening, we kind of already in our head know what they're going to do. They look at their revenue line. They understand how that might change. They understand, there are certain products that we could emphasize. They look at their cost structure. Could we realign it this way? Could we make better use of these resources? Just the way anyone deals with a problem that's in front of them. These management teams not only want to do well, they're incented do get the returns on capital that the shareholders want. So they're busy at work. They got all sorts of plans and some things work, some things don't. But in the fullness of time, it all turns out pretty well across a broad swath of good companies.

Yeah. And then over time, because you've been investing for a long time, you get a feel for what companies have leadership and management teams that respond effectively in these situations versus those that don't have that same track record. And that's something you can apply to what you're doing in terms of managing assets.

Yeah, there's a handful of buckets that we really like. Companies that were winners going into them have good balance sheets. They win going into downturns. They often come out winning even more than before. Companies that have challenged balance sheets, operating in very competitive markets, they're not great businesses to begin with. Hopefully we don't have a lot of them, and they normally struggle even more during the recession. Then we have some businesses where, they were really focused on growth because they were early in their development. The stock market struggles to see their current profitability. But as growth starts to mature, they can then go back and look at the business and say, well, we were kind of overinvesting in this. We should we should change that or change this. All of a sudden, you have a business that was growing at a good rate, but maybe wasn't profitable, and the profits appear and the stock market rewards them for it. So, there's lots of things to think about. It's varied business by business. During this period of time, focusing on quality, making sure the balance sheet is in good shape, making sure you understand how their business is to develop, normally pays dividends – that would be another thing that I like. Point to note, is that it normally pays dividends over time.

All right. Well, I hate to tell you, I lost my second bet because you didn't say dollar cost averaging twice. I'm back to breakeven. Everyone's benefited from your wisdom today, Stu. Thanks for checking in on what ended up being a fairly exciting day in the markets after the Fed announcement. We'll check in with you next week.

Great. Thanks, Dave.