Hello and welcome to The Download. I'm your host, Dave Richardson, and it's Stu’s days. Let me tell you, Stu, this is a really good Stu’s days for me. You know why? Because I'm fresh back from a European tour. I was in Norway, Denmark, the U.K., and I finished off with Italy. I maintained my weight until the last five days in Italy. Then I took ten pounds on. No one told me the food in Italy is that good. Shouldn't that be part of what you're telling us here on the podcast?

That's right. So, you're above normalized right now.

That's right. I might have looked like the markets coming into this year with some of the tightening conditions. The tightening conditions I'm experiencing are my suits right now, because I had to wear a suit and tie this morning for a meeting; rare these days, and it's not that comfortable. Okay, enough of my weight and travel issues. Although, I can report, in terms of the post-COVID environment in Europe, it was very interesting in terms of just the level of activity that you feel in these different cities, particularly London and Rome. It’s just bustling; restaurants full, bars full, etc. Really quite extraordinary to see. It almost felt like nothing has happened. But we're two weeks since our last podcast, Stu. A lot has happened in the market. What are some of the things that you've keyed in on and is it moving us any closer to getting an understanding of where we go from here?

A little bit, in some respects, and a little bit not, in others. I think the one thing that we are evolving towards a couple of weeks ago is that the future was going to really be about earnings. I think that's still the case. We think about the S&P 500 and that 235 number for next year. There's a lot of discussion around the composition of consumer spending. We had some companies warmed. We've had other companies who have been quite fine. The consumer spending, 70% of the economy. I don't think it's a surprise to people that there's a real shift going on from goods towards services as the COVID restrictions ease. The second question is multiples. Multiples have declined as people worried about the future. They also are driven by interest rates to some degree. The interest rate curve has shown more stability in the last six weeks or so than the market has, on this notion that inflation is in the process of peaking. We're going to get into the end of the year, I think when you look at inflation, it is in all likelihood peaking. The question is, will the path of descent be to 4 or 5% or will the path of descent be to 2 or 3%? That's going to be pretty important. The Fed Governor Powell spoke in a Wall Street Journal interview, and said, we're not going to let up until we see inflation dropping, not just forecasted dropping, but until we see it. That’s going to be important on liquidity conditions as we get into the back half of the year. But generally speaking, the bond market has been more stable through a lot of this conversation. The multiple of stocks, plus or minus one point, there's been work done there. The next question will be how the earnings picture evolves. On that front, there's been a lot of companies speak, and they're saying that they're still seeing a quite good demand for a lot of things, but the pressures are building. The thing about services, of course, is that the tap on services can get turned on and off pretty quickly. Services aren't quite as inflationary as goods; you can only produce so many and when the demand rises, then you get inflation. The fact that consumption is switching is a positive for inflation. But on the services side, you might plan to go out for dinner two weeks ago or two weeks from now, and then you change your mind. It's harder to gauge that in the economy.

You clearly haven't ordered a beer in Norway recently. Those prices just always go up.

That really speaks, your last point on inflation. In order for inflation to get back down to those acceptable levels, it's going to be very focused on wages and likely the price of oil. That's the last point for today on the macro side, is that it's not just interest rates, it's when you remove liquidity. What they're focused on is financial conditions. So tightening financial conditions are higher interest rates, wider spreads, lower stock markets. If you get a reversal of those things without inflation coming down, the central bank says, wait a second, that's not what we want. We want inflation down. In order for markets to really rally, you're going to need more tangible evidence into the back half of the year around what the plate of inflation might be.

You know, Stu, the ratings have been going up quite a bit. People love Stu's days. We've got some binge listeners. A very important concept that Stu touched on when he started his comments was the idea of $235 of earnings for the S&P 500— the 500 largest companies in the United States— you aggregate, you pull together all of their earnings, it totals $235 per share. Let's just keep the math simple, if we put a multiple of 20— which would be the kind of multiple you'd have in fairly normal times— you're at 4700 (that’s 235 X 20) for the index, and that would put you several hundred points ahead of where you are right now. Then, as Stu has explained many times, when you go into a period of tighter financial conditions or future slower growth, that's where you can see that multiple go down. Maybe it's not 20 now; maybe it's 18, or 17, or 16. That's one way the market can go down. The other way is, if that $235 of earnings ends up being $220 because the economy slowed down, and you can see how the math changes each time, that's where Stu is using different models and projections, based on his years of experience and the team, and all the analytics and research that they do to try and come up with the potential for the market for earnings and the multiple to go in different ways. That's where they make their decisions around investing and where to position the portfolio. Did I characterize that at all in the way you do it, Stu?

That's bang on, Dave. If you take the PE multiple and divide it— one for the PE multiple—, it gives you an earnings yield. A 16 multiple is 6% earnings; a 17.5 multiple, where we sit today, is 5.7% earnings yield. Then you subtract the government bond from that, call it around 2.9 or 3%, that's your risk premium. A risk premium of 3% is not bad. Sometimes it's 4%, sometimes it's lower, it moves around, and it's sensitive to the actual interest rate and the extra amount that equity investors want. In the last month, we've seen this bounce around a little bit, and that's why markets are volatile, because they're trying to get to the right number. That takes into consideration what might occur on the earnings front.

But although they're moving up and down a lot, they seem to be stuck in a range, as you say, kind of waiting for that final outcome. One of the things that's really interesting that we were talking about just before we started taping, was this whole idea of where the Fed sits on the sidelines. They're evaluating what they've done in terms of tightening financial conditions and seeing how the market reacts. I guess when the market starts to go up a little bit and it has a nice rebound like we've been experiencing over the last several days, they look and they go: maybe there's some room for us to be a little tighter with things. And when the market’s going down, they go: wait a minute, maybe they're signaling that we're going to move too fast. That's at play in terms of creating a lot of this volatility we're seeing in markets?

A hundred percent. We have more inflation data to come, although I think the current inflation data is one thing; really, where we're headed in six months is going to be another. But that is bang on. When asset prices rise, markets do a little bit better. It creates some wealth which gives the Fed a little bit of a leeway to say, okay, we can be a little bit tighter. Then there's a vice versa to that, as they try and engineer a soft landing in the economy. We have three scenarios in front of us: a soft landing, a modest slowdown— which when you look at where employment sits and where consumer balance sheet sets, they're in pretty good shape relative to other periods—, and then you have a more severe slowdown, where 15% to 20% of earnings are in play. Those are the three things that the market is trying to maneuver between. For the Federal Reserve and for all central banks, it's a very delicate process to cool things down without going too far. Of course, on top of that, it's not just their actions the markets are trying to interpret in advance as well. When you hear a lot of people say, well, interest rates are going to rise, they're going to rise in terms of the payments that a lot of consumers need to make on different lending. But the stock market or the bond market has already tried to get in front of that. For markets, it's not just, are they going to rise, it's whether they going to rise more than we've put into the yield curve. When a Canadian five-year bond is 3%, that is telling you that they think the Canadian central bank is going to increase interest rates, but they could increase interest rates without the five-year bond moving, because it tries to get in front of it.

Just one other thing: we're taping today on Tuesday, June 7, and Target, which is a huge retailer in the United States, came out with a profit warning this morning. The profit warning is what it is and the stock is doing what it's doing, but I thought there was some interesting stuff in there with respect to supply chain and some of the challenges companies are having in the supply chain. Both Target and Walmart— and other huge retailers all around the world—, all of a sudden have a glut of stuff that nobody wants. What Target was saying this morning was, we've got all this stuff that nobody wants, we got all this extra inventory, it means we're going to have now to get rid of it. We're going to have to almost dump it out into the market at reduced prices, and that's going to affect our profits. Is that in any way suggesting that consumers are behaving in a way that will help manage inflation down, or as I think you were suggesting, you've got the big things, which are oil and accelerating wage growth, and that is what needs to really get under control or we don't get down to the inflation levels that we need for markets to really push forward from here?

These are all good questions there. I think a lot of retailers looked at the supply chain and said it's going to be really hard to get stuff. They made their best guess on what demand was going to be, and they bought stuff and they put it into the shipping channel so that they would have it in case things overtight and they overestimated some of that stuff. Demand has fallen and shifted to services, and you're left with too much inventory. That said, we talked about normalized. We can look at a businesses like Target and we can say, well, this has been the margin of that business over time. What they're guiding to now is a below-average margin. As they flush the inventory out of their system, they're not going to make as much money on it as they normally would in normal business conditions. As far as inflation is concerned, prices can be high, it's the change year over year. Like a $115 barrel of oil a year from now is not inflationary. But if it was declining, it provides a fair amount of cushion for some other things, maybe wages to keep rising. When we look through the basket of inflation, a lot of things look to have peaked, except for those two categories that still have to grind their way through, that's why they're very important. The final thing about inflation is that we look a lot at expectations, because what the Fed doesn't want is for inflation to become embedded in longer-term expectations. Those are two ways that it gets a little bit more embedded in that longer-term expectation. I do think Governor Jay Powell has changed a little bit of his tune. He's always said he would be harsh on inflation, but now he's very focused on this notion that he wants to see it declining, not just forecasted declining.

One of the shades of hope out of that is that, if those price increases can be pushed through the economy by companies to consumers with higher wages and strong consumer balance sheets, they go in and pay the higher prices. But if you're seeing some changes in that behavior where they're starting to pull back on some of that stuff, hopefully that's a sign of optimism. I'm back from vacation, so I'm optimistic about the world again, before I get beaten down by the rigors of work through the remainder of this week. But certainly not doing the Stu's days podcast. That's always light and easy.

That's right. No, you're bang on. People are watchful and demand is changing. You can see it in the way, even when people go to the gas station, they're buying less gas each time they go, there's a bit of a contraction in terms of their ability to do certain things, and that fuels the decline in demand which eases one of the main sources of pricing pressure.

The kids are going to get a high level of usage out of their bicycles this summer. That's the plan.

That's right. Trailers and bicycles.

Maybe dad and mum too, and I know you're always cycling and staying in shape and always on top of everything that's going on around the markets. Thanks for the catch up. We ran a little bit longer than we normally do but again, we haven't been able to connect for the last couple of weeks, but thanks for everything. Really insightful and I think really helpful in terms of understanding all the different things that are going on in the world economy and how it comes down to your investment portfolio.

Great. Thanks, Dave.