Hello and welcome to The Download. I'm your host, Dave Richardson, and it is everyone's favorite day, except for my kids. I know all the listeners like (S)Tuesdays. My kids love snow days, which is what we got yesterday because we got a foot and a half of snow here in Toronto; biggest snowfall, I think, in twenty-three years, or something like that. That made it quite fun. In fact, they got a back-to-back snow day. Two snow days in a row; we got that much snow. But Stu, how did you handle the snow? I know you're pretty good at weeding the garden, but how's the snow shoveling?

I like to get out there. It's a bit of a debate in our family; do you clear off the whole path or do you do one just narrow enough for you to get through? And I'm a whole path kind of guy. If there's stone there, I want it clean.

Do you go out and you do it several times in one snowfall to keep it easier and keep it as clean as possible or you wait until the end and then go out and do the whole thing?

Well, that is a tried-and-tested technique. That would be like my grandma and my mom's approach. I tend to let it all settle. That was a bit of a mistake yesterday, because there was a lot of it.

There was a lot of snow. My wife's mom, she gets out there, she's out with the broom when it starts snowing and she just sweeps it away the whole time. I think she may have been overwhelmed, though, yesterday, because it was quite something. There you go. There's (S)Tuesday's weather update. And that's enough for this week. Do we have anything to talk about? We got bank earnings, don't we, Stu?

We do. We had a Canadian bank conference, and we had some U.S. bank earnings. So we got lots to talk about on the banking front. I would say in the capital markets area, we think about the Canadian banks, or what they call universal banks, so they have lots of business lines, and one of the business lines that has started to slow is the trading business line. That already happened a little bit to Canadian banks in their fourth quarter but it definitely is taking place in the United States. And then, the thing that surprised people a little bit was on the expense front, again on some of the capital markets business arms, most notably inside Goldman Sachs. JP Morgan also came out and they surprised on expenses, but more from an investment standpoint. They just said, we're going to spend money because we think the economy is getting better and we have a bunch of businesses that we want to spend and invest behind, because we think we'll get good returns on it. Outside of capital markets, around loan growth and interest margins, the commentary there was pretty constructive from some of the banks that also reported. So, when we think about those, as I say, universal banks in Canada, the trading businesses and current expectations are already expected to slow. Some of the other business lines around maybe higher net interest margins or some improved loan growth, that might present itself in 2022.

Quite specifically, Goldman Sachs, which reported today referenced compensation increases as driving a lot of expenses. We all know in financial services, people cost more than anything. Is that something that concerns you? Because one of the expectations around banks was, if we see higher interest rates, that's ultimately good for net-interest margin, so that's a tailwind behind the banks. Is this expense growth something that we need to be concerned about if you're investing in financial services?

Well, you always want to be focused on it. The thing that we look for the most is operating leverage. You want businesses to be investing. You want to see expense growth where you think you're going to build out a new business. Some expense growth comes from just having to recalibrate how much people cost. I think that was a bit more the case at Goldman Sachs, although JP Morgan talked about it as well. In some of those very complex trading and advisory businesses, there is a competition on for talent. It's not just between the banks, but it's also between some of the tech companies that are building all sorts of new businesses as well. That's put some upward pressure on compensation in those areas. And it's not just in financial services; last week in The Wall Street Journal, there was an article about Facebook or for the Metaverse, doubling the compensation for some software engineers that they were stealing from Microsoft. So, that's a process that we're going to have to deal with a little bit inside of a variety of businesses as they attack new markets.

Now, is this inflation? We've seen the price inflation, particularly in commodities, some areas— rental car or used cars—, is that we're seeing now the other side of it, a lot of wage growth, or is that what you expect?

Yes, we do expect wages to grow. There's wage growth around high demand for special skills, and then there's wage growth just because the pool of employees hasn't come back quite to the level that it did pre-Covid. And there's businesses out there looking for people. Both of those are driving wage growth for sure. And we expect that to continue. Businesses also have had pretty reasonable pricing power as well, in certain pockets, which helps defend margins. I think in the case of some of these banks where the trading business has come off, but the spending may have been put in the books during the year, that's kind of crimp things a little bit more in this quarter.

We carry that on into the inflation discussion, where we've been seeing some huge numbers in terms of reported inflation. But some of that is just math, right? I mean, if we look forward for inflation expectations over the next couple of years, that comes way down from the 7% headline number that we've seen reported, correct?

For sure. I think this year we've seen inflation ratings in the 6 to 7% range, and we've talked in the past about what percentage of that is transitory versus what might be embedded. Next year, it's not that inflation won't come down, it's how much will it come down. The key measure next year is going to be, are we at 3% inflation or 4% inflation? It'll certainly decline. I think the current market expectations are somewhere in between those two numbers, and we'll just have to measure it against that type of an expectation. When we look out over the next twenty-four to thirty-six months, inflation is going to be above the longer-term target of 2%, and the degree as to how it shakes out. But that has led to discussion around more Fed tightening, led discussion to higher interest rates. That's going to be one of the key focuses. We've talked about it for a couple of weeks; where will the Fed have to go, and will there be too much discussion of tightening and can that slow the economy? It's a delicate balance between a soft lending and too much tightening, as it always is.

Great. Let's just shift gears just for a moment because we don't want to go too long. But an interesting deal was announced today: Microsoft buying Activision. A fairly large acquisition for Microsoft, I think, the largest in several years. Does that say anything about where we are in the market? We're seeing some pretty poor performance in the technology world. Typically, you're not going to see that deal happen right in front of a downdraft in stocks in that area. Does that say, maybe people are worried too much about the Fed, worried too much about higher rates and how that affects valuation, or is there something else that's going on that you would think, with what Microsoft's doing here?

Well, Activision had stumbled recently around some management issues, which I think presented Microsoft with an opportunity. As we all know, they have the Xbox, they're in the gaming business. So this was one of the more significant franchises that came available, due to some unique circumstances. But when you think about a business wanting to grow over time— first off, Microsoft generates a tremendous amount of cash flow; to be able to cut a check for $70 or $80 billion and just drive on, that's quite something. But when you talk about the Metaverse, how we will spend our time in the future and how much of it will be in the real world and how much of it might be wearing a pair of goggles or what have you? They're provided with an opportunity to put some chips down on that potential opportunity at what they think is not a bad price. They have a lot of cash and not earning anything really on the cash. This helps them expand their business. I do think as we go through the tech sector, which has struggled so far this year, we're always looking out on what type of growth can these businesses generate over the next five, eight, ten years, and what type of margin can they generate on those businesses as they grow. And many of these technology businesses have outstanding margins— by that, I mean like 25% to 30% cash flow margins—, and their growth is normally at least as high as the economy, if not higher. We have to always recalibrate when we look at these businesses and say, if this revenue grows at 10% and these margins are achieved and it trades in this manner, what type of return potential do we get today? And that has improved certainly as we've gone through the last three or four weeks. We always have to take into consideration interest rates. Rising interest rates change some high growth valuation— we've talked about that in the past—, but that has changed fairly dramatically. Like anyone who's out there doing investing, you're always wiping the slate clean at the end of each night and looking forward, as the stock market does, and saying, are these scenarios now presenting themselves in a more opportune manner? Has the return profile of the businesses that might be available improved? And also, has the business profile of things I own? Maybe not as robust because they've done quite well. We've seen that money has really slushed from one side of the stock market to the other in the last three or four months during this growth of value trade. Any money manager has to always be evaluating prices as they sit today relative to the potential, not just being content with how things are going.

It's a really interesting spot that we're at right now; almost that we could go one way or another, because there's so much uncertainty about exactly where interest rates are going to go and where inflation is going to be, as you highlighted in your comments. It'll be interesting to watch. And that's why people should come back and listen, every Stu’s day, to the podcast and get the update. Does it snow in the Metaverse?

If you want it to, Dave. I'm pretty sure. But you don’t have to shovel.

Excellent. Well, someone wanted $800 to plow my driveway one time yesterday, so that's how things can get mispriced. If you want to look at mispricing, around supply and demand. But Stu, always great to catch up with you. Thanks for being here and we'll check in with you next week.

Thanks very much, Dave. Have a good one.