Hello and welcome to the Download. I'm your host, Dave Richardson, and we are pleased to be joined today by you, Dan, for only about the second or third time. We should get you on even more often, but it’s always great when we have Dan Chornous, the chief investment officer at RBC Global Asset Management. We are at a time where we have markets at all-time highs, we got some uncertainty about when rates are going to start to come down, exactly how strong the economy is going to stay. It's always great to have someone with Dan's wisdom and experience to come on and give his thoughts on where we're at. So, Dan, thanks for joining us today.

Well, it's always great to be here, Dave. Thanks for asking me.

You've been like me. You've been all over. I think it's probably the first time either of us have been kind of off for three weeks, or at least out of the country for three weeks. Where did you get to? Did you get to anything interesting other than when we were in London together?

Well, I just was skiing in Switzerland, which for those of you that are in Canada would be a little jealous, if you're skiers. There's great snow right now in Switzerland, and they're closing the hill this weekend in Canada. So I got very lucky that way.

Excellent. We also had the opportunity earlier this week, we were in front of a huge group of advisors in Toronto, and we saw your presentations in a different form, in a direct presentation where you go slide by slide. But we'll try and capture that in this conversation, the essence of what you were sharing with those advisors. So we look at the economy right now. We usually get Eric Lascelles on about once a month. We've been having trouble connecting with the hardest working economist in Canada. So where are we at with the economy right now, from your perspective?

Well, I think a pretty important change or an evolution of the scenarios we work with. We gave Eric a week off, by the way. I think he deserves it. As you know, we work very much with the baseline forecast and then the most-likely and least-likely outcomes, and that's evolved over time. We were quite concerned as we approached later into 2023, as you had the maximum intensity of monetary tightening work through the economy. It usually takes about 22 months from the first-rate hike until the beginning of a recession. So if you put that on a calendar — people got bored waiting for it — but it was unlikely that a recession was going to take hold before the fourth quarter of 2023 anyway, maybe the first quarter of 2024. And it wasn’t just rate hikes. You also had this quantitative tightening take hold. You had a drawdown of the domestic money supply, and things were looking tougher for the economy. Then you had most of Europe and even Canada pass through back-to-back quarters of shrinkage GDP, which by the weakest of definitions would say, wow, they've experienced some kind of a recession. A very mild one, if you should try to term that. But as we pass Christmas and into January and February, that recession in the United States simply failed to happen. And where the stock market should have been signaling a recession, it took off and got a second leg. So we've looked at the data and, in fact, that monetary conditions become less and less intense as we move through 2024 into 2025. So unless there's an accident — and that accident would likely be an unexpected uptick in inflation — we might have passed the biggest danger point for the economy. Now, it doesn't mean the economy is going to take off and get back to the level we grew up with — 3 or 4% growth — but it may well have dodged the bullet rather than pass through a recession. And we had expected some kind of a mild recession in the first half of 2024. We now believe that, as the stock market is reflecting it, it's more likely to be a soft landing. So what does that mean? 2 to 2.5% growth for 2024. With luck, we'll get the same for 2025. So mild growth conditions, but no recession, nonetheless. And I think that's an important change in the forecast.

Yeah, Dan, I know for a long time, the general consensus was that we were going to have a recession — not a severe recession, but at least a little period where we had a contraction — because you just look at all the traditional indicators to signal a recession, they were pretty much all there in terms of pointing that. This just has to turn into a period of negative growth, yet it never happened. Or again, it was a month here, a month there, in different economies around the world, or we had sort of a rolling recession through different parts of the economy. But anything you attribute that to? I look at debt levels in the US or the extent to which they're spending — just that constant flow of money. Is that overwhelming some of these other measures or indicators that we have for a slowdown? Is that why we were able to avoid it? Any sense that you have of why we were able to do this?

I think, structural change in the economy. We're coming awfully close to saying it's different this time, I realize, but there are risk changes in structure. And I think the first of them is that when the economy used to grow 3 to 4%, we had this concept called stall speed. And the real swing factor in the economy was capital spending. You had big manufacturing sector; capital spending was an important part of it. And once you got below 1.5 to 1% growth, it was like CFOs everywhere said: shut the capital spending budget down because there's a recession coming. It would literally push the economy into recession as a result. Well, the economy isn't as sensitive as that for two reasons. Capital spending is still a very important thing, but it's less dominant in growth. Consumption is, of course, the dominant piece of growth. And secondly, stall speed doesn't seem to apply in an economy that grows at 2% in a good year. Eric Lascelles has come up with this concept: maybe you also need panic. And we didn't get the panic. The panic would come in the employment part where people start losing jobs or whatever. And families shut down. Even working families shut down. That didn't happen this cycle. It leads us to think about, as you're ruminating, what's different in that? Well, the first thing is if you look at the fixed obligations ratio. This is the cost of cash flowing for all commitments you have. So obviously your mortgage and your visa card, etc., but also your car lease, your house rent, the things that if you don't pay for them, they get taken away from you. That ranges between $0.14 and $0.19 on every dollar. $0.19, you have 2008 shutdown in the economy. $0.14, you're back to 1980s levels of debt in the economy. That's actually where you've been. The reason has been these massively low levels of interest rates. Now they're rising, I realize, but you entered this period where there was actually very healthy US consumer, because while they had a lot of debt, they weren't paying much on it. So that was a bit of a buffer. And then the second thing, and perhaps even more important is what we're calling US exceptionalism, which is: where debt exists in the US economy and the duration that that debt is written at. The US mortgage market is written on 30-year loan. And so when the Fed raises interest rates and everybody thinks it's going to be so hard for homeowners, well, it hits the US economy very slowly. If you stood in line at the bank this afternoon in the United States to negotiate a mortgage loan, you're going to pay a little over 7%; call it 7.1%. But if you look at the effective rate of interest on mortgages in the United States, they're 3.8%. So everyone's scared about rolling over. But it’s distributed over the next 30 years of rolling over. And the best proof of that is: why did Germany, the UK and Canada have such a problem with higher rates when the United States didn't? Because we have five-year, three-year durations of mortgages, so we're constantly rolling into the new rate. So it's almost like the rest of the world was a Petri dish for the Fed who could raise rates and say, well, how hard will this hit us if we raise rates at this level? Well, we know that those economies had a problem. These are the reasons some structural change in the economy — less sensitivity to capital spending, getting used to a slower speed of the economy at any rates — and stall speed doesn't really happen as much anymore. And this duration of debt issue — pretty unique circumstances — plus a healthy consumer going into that. As a result, as I said, we dodged the bullet. It looks like a soft landing.

Yeah, and a healthy consumer, as you say. They're all working too. So you don't ever get to that sense of panic because, hey, I feel pretty good about my job, so I just go and spend as I normally would and that consumption is driving everything. So away we go. Always amazing talking to you, Dan. Always. What does that do in terms of your view of inflation? Despite not seeing the impact on the economy in terms of it going into recession, but you're still getting that downtick in inflation. Where do we get to from here? Because we're not all the way as far as we need to go.

I remember being taught in university — and that's a long time ago for me — that inflation itself isn't a problem. Inflation expectations are the problem. We made this point through the piece that what the Fed and other central banks needed to do is convince people that what was happening with inflation was symptomatic of the pandemic and the exit from it, and that underlying conditions for inflation hadn't changed. And that's what's being reflected in market-based measures of inflation. And just the way that people are looking at it. The first thing that happened was that the pinch points that created the inflation — the supply chain disruptions, natural gas spikes on Russia's invasion of Ukraine, all these things. Used car prices would spike; they have now gone negative. There's a bunch of things that really would have been driven higher for a variety of reasons — most of them connected to the pandemic —symmetrically rolled out of the equation and came out of the numbers. The second thing that happened is that the monetary sources of inflation, mostly M2 growth, which had spiked super high when the economy shut down, have been drawn right down into negative territory. So the monetary basis for inflation is now no longer contributing to it. And when you look at these longer-term measures of expectations, they're still anchored around 2%. I’ll explain one other point that you mentioned about employment, too, which I think is important as it relates to interest rate, is imparted and very strong. The Fed has two overarching responsibilities. The first one is to hold inflation close to 2%, the optimal level. And the second one is to do it without crushing the employment market. Hold the employment market at the same time as close to full employment as possible. Well, for a long time — and I think the Fed has been as surprised as anybody — they've only had to worry about one thing, which is inflation, because if anything, employment's a little bit too strong, as we saw again this morning. It's fine, but you don't want to rise too much above this, because then you do get into shortage conditions and wage pressures. So that put us into an environment where Fed says, if I got two things to worry about, I only need to focus on inflation. There's no real need for them to ease quickly then as a result of that. That puts us into this higher-for-longer world that we kind of feared before, but we've grown to live with. So I think that's really an important dynamic of what's happened as we've moved into 2024. So at one point, at Christmas, Jerome Powell says about inflation, wow, so far so good. Suddenly the market prices in six cuts in Fed funds rate for 2024, gets yields all the way down from 5 to 3.75%. And, oops, it's not going to be quite that. We’re only looking for three cuts now, a much more reasonable and conservative step down of rates. Importantly, we've seen the peak for interest rates. We've seen the peak for bond yields as well. But they’ll come down as rapidly as it was priced in as recently as Christmas.

So that's the Fed «three times» we heard from yesterday. What about Canada? Is Canada generally going to have to go lockstep, or is there an opportunity for Canada to do something different? Of course, interest rates have a bigger and faster impact in the way the Canadian economy is structured.

Well, I don't think that Canada can wander too far away from what the Fed policy is. And we already have a lower rate structure in Canada than we do have in the US, especially move out to the long end. That will have an impact, though, I think, on the currency. Dagmara Fijalkowski and Dan Mitchell, the real currency experts in this firm, look for as much as a 5% improvement in the Canadian dollar to the US dollar over the year ahead, partially as a result of how purchasing power parity is measured, that is, of course, inflation differentials relative to interest rate differentials. And so that part of it is actually quite an attractive outlook for Canada.

Interesting. Just before we go into fixed income and equities, and your thoughts there — because we're talking about Canadian interest rates and what makes Canada a little bit different from the US and the rest of the world — and one of those things would be immigration and population growth in a developed economy. What are your thoughts on the housing market in Canada? You've been taking a little bit of a look at that? We've got this situation where prices are elevated to a very high level despite higher rates. We've had a little bit of softening in prices, certainly a softening in activity, but we've still got all of these people coming into the country who are going to need a place to live. We don't have enough places. We're not particularly good at building new stuff. How does that all work out in terms of housing from your perspective?

It almost feels like it muddles through, because of the dynamics you just talked about. If you removed immigration and other sources of new demand, particularly at the low end for housing, you'd say, gee, this is tough because these are high interest rates. They're going to get down, but these mortgage rates are still pretty high. And when you look at affordability and particularly for young people, it's tough. On the other hand, we can't build things fast enough in order to absorb the number of people that are looking for those affordable units. And there are other institutionalized constraints as well: where you can build, how high you can build, how fast you can change those rules. So in the net of all that, you think, maybe there's some weakness ahead, as we've seen. Real crisis. There's a bid in that market it's hard to get rid of.

Yeah, that's what we've been talking about with customers for a while now when we're out talking to them on the road. So then let's get into the more traditional markets that you're looking at, which are the fixed-income and equity markets. And so, as you said, we’ve likely seen a peak in yields for this cycle. Rates are going to start to come down. The Fed and bank of Canada are going to be cutting rates. I know in November you were super positive, or I guess we'd even go back to September and October is when you really started to get excited about fixed income. Are you still as excited, or has the move we've already seen taken some of that excitement out of you?

No, I'm mostly as excited as I am. Only, the «mostly» versus «absolutely» is we're 50 basis points lower and not 75 basis points. But at that time, it would be sort of mid fall of 2023, there was almost an amazing alignment of factors that said that yields were going to fall. The first thing is that, if you look back in history, that's simply a chart that overlays short term interest rates, administered interest rates on long bond yields, they peak at the same time. And so if you believe that rates had peaked, you should also be believing that bond yields had peaked. And that happened again this cycle. So that was the first thing that came in. The second thing that came in was that we had, in both cases, short rates and long bond yields had been moved over the prior 18 months from being ultra-low — and we thought forever unsustainably low and dangerously low — up through fair, to a point where, in case of rates, there were a big pressure on the economy, and in case of yields, that they were embedding too much of an inflation premium or too high a real rate of interest to be sustained. So valuations had gone from way too expensive to really attractive, and not just the US, but virtually every modern economy in a space of about 18 months, something very seldom seen. The third thing was that inflation had clearly peaked. And things like the domestic money supply or the US M2 growth rate suggested that while it was going to be an irregular path downwards, it's locked into a lower rate, so that the need for more Fed policy, the need for more quantitative ease, whatever it is, this wasn't there anymore. And then finally, the technical underpinnings of the bond market were really attractive. So year over year, rates of change had moved to unsustainably negative levels, and bearishness was completely dominant in that market. Amazingly, as much as we moved so much in that market, everybody's still bearish. The sentiment doesn't work real well at the top. You can have people bullish for an awful long period of time, but you can't keep them real bearish for long. They tend to have spike lows, tremendous amounts of depression and the market moves. And that's what happened. And so you put those four things together and suddenly we weren't at 5.02. A while ago when we passed 5%, the market shadow was 6% is the next stop. In fact, 4% was the next stop. It was a confluence of factors. Now it went too far. We get down to 3.73% or whatever it is, and then we got back towards 4.35& on the 10-year. But we still see reasonable value there. I think at the very least it gets you keep your coupon over the year ahead. If we get down towards the 4% level, actually, that's more of a 5% to 6% return, which is kind of in line with what we look for in the stock market. I should also say, because my partners reminded me of this, this is the first time in over a decade we've actually had overweights in fixed income relative to neutral. So that's kind of a statement on our part. That's never our position.

That's right. I know from working with you for a long time now — and I share this belief and maybe somewhat you formed it for me — I lean on equities as a long-term investor. If I stay overweight equities, I'm going to win over time. There's going to be obviously some periods where that doesn't make as much sense. And this is clearly one of those unusual periods where you want to stay a little bit more neutral?

The reason why, and I think that the basis of your view, however one articulates it, is that we believe there's an equity risk premium. And if you have an appropriate time horizon — and most of our clients hopefully do; they're saving for retirement, education, something in the future — that the equity risk premium kind of churns it out for you. There will be some bad days. If you don't need access to that money on those bad days, this thing may revert. We typically almost always express that. And, for example, if our neutral weighting in equities is 60%, we'll typically be over 60%, reflecting that we're going to earn that equity risk premium, which we had to take it from somewhere, which will we take from bonds. The fact that we're right now sitting on neutral for equities is actually a very conservative structure for us, because we're saying there's no equity risk premium right now. It doesn't mean that we believe that there's a bear market out there. It's just not that we're getting that little bit extra that equities should pay you relative to bonds to make you want to take that extra risk or volatility.

Yeah. Now here we are. We've got Canada, the US, different indices in Europe, Japan, all at all-time highs. And is that as much of a call, again, just on valuation and where we are, given we're on the higher end of an interest rate range and the economy is good and may not have a recession, but it's likely going to slow a little bit as long as the rates are higher. Is that sort of the way you put that together in terms of the elimination of the risk premium?

Yes. Let me take it a step further as to directing the risk into the market, because the market is a bit confusing right now. It's not quite a two-tier market but it could develop into one. So there's been a lot of chat that it’s 1999 all over again. The Mag Seven is driving again, the market has been steeply tiered. In 2023, the US stock market was up, bought at double digits, but the Magnificent Seven was up 81%. So most of that was the seven or eight largest stocks in the US. Those stocks now traded something like 30 times earnings on average. So they're not cheap. That's dragged the overall multiple of the market up to about 20 to 22 times. In our math, the right P/E for the market is just about 18 times. And that would be the level that would make it statistically consistent with its relationship with inflation and interest rates in the past. So the market is either a little bit expensive or a whole lot expensive. If you look, though, at the average level of P/Es — and this gets into kind of a mathy, but bear with me for a second — you take the Magnificent Seven, take the average of what's left, you're about 17 times earnings. So once you take that dominant group of performers out, this market isn't cheap, but it's not wildly expensive. The second thing is, it's not actually acting like 1999 either, in two ways. The Magnificent Seven has a strong base of earnings. People are paying more for those earnings than they are for other companies’ earnings. But in 1999, the leaders had no earnings and no concept. There was no plan to get earnings into it. So maybe the earnings are expensive, but we can just use break-even growth mathematics to back that out. They basically need to grow at about 33% a year every year for the next ten years in order to justify the current valuation spread to the rest of the stocks. That's pretty steep, but they have been growing at 22%. So it's steep but not impossible. That's the difference with 1999. In 1999, it was impossible, and of course it all came down. The second thing that's happening is that earnings growth in the rest of the market is going to pick up this year. And breadth, which is the number of stocks rising versus falling, is actually positive. That's different than 1999. In 1999, there was nothing happening outside of the IT sector, and the advanced decline line was falling even though the market was rising. So there's a bit of a disconnect. But it's more like speed limit disconnect as opposed to directional. And I think that to some extent it doesn't eliminate, but it attenuates the risk that we're facing in equities. You step out of the United States, and you see, except for Japan, as you say, stocks are either quite attractively valued or beneath fair value. Beneath fair value in the United Kingdom and Europe and in emerging markets. They're in the band, but just into the band in Canada. There are some interesting valuation stories, even in equities. As I say, our asset mix points in such shape, there are very high hurdles that need to be achieved to keep this level of growth happening in the United States stock market. But I don't think it exhibits the type of risk factors that the real bears are concerned about. This isn't 1999, at least not yet.

Yeah. And then I think when we were up on stage together on Tuesday, I asked what I thought was a very important question — and apparently most of the 300 or 400 people who were there missed the nuance of what I was asking. But I'm going to ask it again, and hope that the audience listening to the podcast enjoys the answer a little bit, or the question more. Your answer was great. You've been doing this for 40 to 45 years, somewhere in there. I've been around a good part of that myself. And we've seen historically, you're also a market historian, you've seen all the things that drive the stock market higher over time. Investment markets. If I invest, I stay invested, I invest regularly — I might have a bad year, I might have a bad two years — but I'll look back 30 years later and I'll have done really well. And it's actually surprisingly consistent how well, how I do over those extended periods of time. As you think of all of what you know from the past and you look into the future, is there anything there that you see that would fundamentally change the idea that over time companies are going to function in growing economies, make more money, and the value of those companies are going to increase and you want to own those companies?

First of all, I want to reset that. I thought it was a really good question and a clear question that you asked, but it's a deep question. Rather than taking it at the most obvious point, which is what could disrupt the world such that the past isn't repeated into the future? Recognize that there's been massive amounts of disruptive things that have happened in the 150 years of stock market pricing that we have. And somehow it bounces around and oscillates in the kind of range it always does, sometimes bigger, sometimes smaller. And I think the reason is that we showed a chart at that presentation, and it actually appears in most GIO's or global investment outlook. It simply detrends the earnings growth of the S&P 500. It grows its earnings at about 5.8% to 6% a year. Hey, sometimes it gets up to 15% a year and sometimes it crashes like it did in 2008, but it gets back up to that 6% level. And the reason is, I think when I was taught first year economics, which was 44 years ago, actually 48 years ago, which is that once you get growth rates and earnings above a certain level, you attract a lot of competitors. And I don't know what they're going to be competing in in 10 years or 20 years or 30 years, but they're going to be competing and they're going to compete and compete until they get down to that level of excess profits or away, and you're probably back to a sustainable 6% growth rate. And then as far as what P/Es do we assign to that? That's a matter of clarity and behavior and all those things, but they are inextricably linked to duration calculations or interest rates and inflation, and I think returns on equity as well. So that also has mean reverting. For a while, people can go crazy and pay whatever for stocks, but at the end of the day, other things compete for those funds, or rational behavior returns and P/Es get moderated towards equilibrium. And that's the basis of all of our modeling. What's the normal rate of growth of earnings? What's the normal amount you should pay for those given underlying inflation and interest rates. And that's what we call equilibrium. And when you get too far above equilibrium, you should be taking some chips off the table, because one never knows what will force it back, but we do know it ultimately always has been forced back. The opposite is true, too. In those really dark nights, like March of 2009, you can remember about equilibrium. There is a force drawing you back. I think for me, that's the answer that works, because I'm just not smart enough to figure out what all those possible disruptions are in the future. In fact, it's been shown that the most disruptive things, even when you're shown what they'll be, you won't understand it anyway. And the best example of that is the first time you're shown a camera and a cell phone. My response was, this is stupid. I don't need that. I got a camera. Of course, it changed the way. There's no cameras anymore. Even when they’d show it, I couldn't figure it out. Why would I need that? I know now.

Yeah, although my kids would fight you on that. They've just bought cameras, and as they're carrying them around when we were away on vacation, I go, why are you carrying that? You got your phone, and the camera is better on the phone anyways. So who knows why? But no, that's a great answer, Dan, and a great example of, again, why you invest for the long term and do a lot of the things that we talk about on this podcast with you and other guests about having that financial plan, being consistent, invest regularly, stay invested long term, and it will all work out because it always has. And it'll be some short term, as you say, short term gyrations that'll cause you a lot of angst. But don't worry, we'll bounce back to normal from the upside or the downside, that's historically what's happened. It’s likely going to be what happens from here on out.

I agree with that.

Anyways, Dan, always great catching up with you. And then the benefit I get is I get to see you next week in Montreal. So safe travels and we'll see you down the road. Thanks for always offering up your time.

Well, I look forward to next week. Thanks for having me.