Hello and welcome to The Download. I'm your host Dave Richardson, and it is a Canada Day weekend Friday, except someone messed up and put Canada Day on Wednesday, so it's not a long weekend. So we have 2 days off on the weekend, 2 days at work, Canada Day off— yé— and hopefully we get better results out of the soccer team. Then 2 days at work and another 2 days off. It's all confusing. So to make sense of weekend planning and Canada Day positioning, we've got all-Canadian bond expert Steve Pitts back with us today. Steve, thanks for joining us on the Friday of a not-long weekend.

My pleasure. You could argue Sunday's maybe Canada Day because that's the day Canada is playing its World Cup game, so we can add that to another Canada Day.

See, that's what I mean. That's why we have you on the podcast because you come up with great solutions like that. And particularly for so many of our investors who have to be a little bit confused about what's going on in the bond market. We've seen a lot of gyrations, particularly in government interest rates. And then of course, we've got everything that's happening around the war in Iran, which is over— but maybe not, we're not really sure— and oil prices have come down, but still lots of talk from the Federal Reserve and even Bank of Canada concerned about inflation and where inflation sits right now, which is often a time where they're starting to look at raising rates. And then the bond market is trying to figure out what's going on there. And that's why we wanted to get you on today. We always appreciate you taking the time to join us.

My pleasure. Certainly lots going on. And as you alluded to, it does seem like the main story is what oil prices are doing, and how it's affecting everything from inflation and then the flow-through to different asset classes, be it equities or bonds. And then you have, of course, this AI theme going on in the background as well. All of that we can touch on to some extent today.

Yeah. And as we speak, I think oil prices are at $69 a barrel, which I think is $50 below where they ultimately peaked through the war. I think we got just a touch under $120. I may be a buck or two off there, but nevertheless, it's basically gone down $50 a barrel, and came down with the agreement. We just had Mr. Trump out earlier this afternoon talking about Iran who had violated the ceasefire agreement. Again, the market is somewhat treating it as done, but there's still some stuff lying around. Nevertheless, quick drop in the price of oil. Then we had inflation numbers out in the US and Canada over the last couple of weeks that were okay, but the Fed has a preferred measure that they like to use when they're thinking about inflation. Why don't you talk about that, where the number came in, and then what you think it means for markets?

There's a few ways you can measure inflation. The Fed determined— I think it was Greenspan in the early 2000s— that the PCE inflation, the personal consumption expenditures, is their preferred measure of consumer inflation over CPI, which is one you hear about. There's a few reasons for that. We won't get into it, but it's more dynamic in terms of adjustments to spending, less skewed by housing. But anyway, that core PCE inflation number came out yesterday at 3.4% year over year. That was for the month of May, which was up from 3.3% the previous month. Headline number was actually over 4%— 4.1%. Certainly, the highest we've seen in quite a while. I think 2 or 3 years. I would say it's broadly in line with expectations, so there wasn't really any significant market reaction to it. But it is well above the Fed's 2% target from an inflation perspective. But having said that, as you alluded to, with oil coming down— the core isn't affected by oil, but there are other industries like transportation and airline fares that will decline over time with this lower price of oil. We may be at or near the peak in terms of tariff effects as well. We haven't talked about that as much, but that has something that would certainly have fed into that higher core number beyond what we've seen in oil. I think that the sense is we're likely going to see that, over the remainder of the year, drift lower. We may be at a point where it is peak inflation, but certainly, the market has really reacted to that along with Warsh's first meeting, but then the market is actually now expecting the Fed to hike interest rates by at least 25 basis points over the next year, as early as the fall. Interestingly, on the inflation side, with your comment on oil, we've really seen a collapse in bond market inflation expectations. What's being priced into the 5-year part of the bond market, in March, that was about 2.7%. The market was basically expecting average inflation over the next 5 years to be 2.7%. Now, that's 2.2% today, actually lower than before the war even began and the lowest in almost 2 years. Part of that is, I think, the drop in oil prices. Part of it too is I think the market is somewhat pleased regarding Warsh's emphasis on getting inflation back to 2%. There was some concern around that and certainly his comments definitely supported Fed inflation-fighting credibility there. Then maybe just quickly on Canada, Canadian CPI, headline was up 3.2%. A little hotter than expected, but the core is just over 2%. Inflation is much less of a concern in the Canadian market. The Bank of Canada's really hoping that there isn't a lot of large second-round effects, if you will. The market, again, is expecting Bank of Canada to be more on hold this year, maybe a modest chance of a hike. As a reminder, the market was pricing in 3 hikes at one point in March after the war began, but we do have a bit of a softer economic picture and less of an inflation problem to deal with there, I think.

Yeah, we had Andrzej Skiba on earlier this week. By the way, this is designed almost to be two pieces because Andrzej is an expert very specifically in US bonds. We had a great conversation about that. Steve's got more of a breadth of focus, and so Steve's going to give us sort of the landscape across the remainder of the bond market. So, that's one of the reasons to subscribe. Make sure you're following the podcast wherever you download your podcasts. Or subscribe on YouTube. And of course, we love to get reviews and comments from people. But a few things just in there that I think are really important. If we just look in the US, what we were talking about with Andrzej, off of the inflation numbers and the Fed meeting. And of course, a new head, the Chairman of the Federal Reserve in the US, and a lot of people paying attention to his first meeting and what came out of it. And again, it was perceived initially as being quite hawkish. And what do we mean by hawkish? We mean that means more of a bent to raising interest rates and more of a concern about inflation and a desire to beat down that inflation. That's that hawkishness. So we saw the 10-year move back up over 4.5%, which is an important level within relation to stocks. We'll have a couple of people on the equity market side to talk about that over the next few days and next couple of weeks. But now we've seen that 10-year settle back down to around 4.4%. It's been below 4.4%. One of the real big concerns in the longer-term bond market. Although not a long-term bond, the 2-year US Treasury moved from 4.13% to well above 4.20%. I think it was 4.18% or 4.19%, an important resistant point for yield. So you broke through that, but it's since fallen down back below 4.1%. One of the things Andrzej was saying, which you reiterated, is we quite likely are at or have seen peak inflation through this. It's not that surprising that inflation expectations, as you look out farther, and if you've seen how quickly the price of a barrel of oil has fallen, that inflation expectations are going down. Now, for those of us who fill up the gas tank at the gas station, we realize that gasoline prices, which of course play a role in inflation and are measured in CPI, they go up like a rocket and fall like a feather, I believe is the term that people use. So as we're driving around this long weekend, whereas oil prices are down 80%, why is my gas price not down, it seems, almost at all? And that's the reality of that. But the trend is lower. If we look at wholesale gasoline prices, they're down from a peak of around $4 to about $2.80 US a gallon. Still using the gallon on that. So if we do have an end to the war, we're starting to see things. And maybe even that war was finished quickly enough that you're not going to see an overhang. And you're starting to see some of that in the bond market. And then we're just waiting for data to see exactly what these central banks are going to do.

Yeah, I think that's fair. And I think the market and the reality too is the central banks would look through that and that's why they focus on the core. They understand oil is volatile, moves up and down, and you can't really control oil to the same extent with monetary policy. But where they are concerned, the longer oil stays elevated, for example, the more likely you are to get those secondary elements where it flows through to other parts of the economy and becomes more embedded in expectations. To the extent we continue to see relatively low oil prices, I do think it bodes well overall for the inflation picture. Our own forecasts are that inflation for 2027 is back to that just-over-2%-type level. I think that's certainly a fair comment. Oil certainly seems to be what the bond market has traded off because of that. Again, I would say as oil fades into the background, the other comp is that you still have this very strong growth profile, especially in the US market. A lot of that being AI-driven, but that's again another difference you're seeing between the Canadian and the US economy, where the US economy perhaps is buoyed more so by some of that AI build-out.

Since bond markets almost like bad news, since Canadian growth is not as robust, or perhaps just disappointing— the way it's lagging behind the US and has for a while— the Canadian bond market is doing just fine, right?

Yeah, it's interesting because the Canadian bond market has actually been one of the best performers. If you want to do a World Cup analogy, it's been the winner of the World Cup of bonds. So if you look, say over the last year, it's interesting because the 10-year in Canada is about 3.40% today. It started the year at about 3.40%, and a year ago it was like 3.30%. So it certainly has bounced around a bit, but it’s been in this range fairly for a period of time here. If you look at the 1-year return on Canadian bonds, it's about 4%. If you think about your return from bonds would come from both the coupon and the movement in price, and so there hasn't been a big movement in price in the Canadian bond market, just in terms of start to finish. You've got essentially a coupon-type returns. If you look at global bond markets, like a global bond index over the last year is only up maybe 1%. We've seen yields rise more so in areas like Japan and Europe, and US to a lesser extent. But I think greater concerns in Japan and Europe, number one, around inflation. So the blockage in the Strait of Hormuz has a bigger impact on those markets. They're bigger importers of oil. But also, they've taken bigger steps in terms of expanding fiscal expansion and debt as well. That has been especially affecting the longer-term end of the market in areas like Japan, in particular, where we've seen a pretty big rise in the longer end of the market. Also, I think more of a need, again, for Japan, which has been still raising interest rates to fight inflation, and the US as well, which has pushed up the shorter end of the curve. Yeah, in the context of the world, the Canadian bond market's actually been a pretty strong performer. Good for Canadians. For us, within a lot of our portfolios, we actually do diversify into global strategies. So that hasn't necessarily helped us from a return perspective, but we do see that over time does end up being beneficial more from a risk perspective.

Yeah, so I guess the downside from a Canadian perspective— and from my initial comment as I fed it to you— that's just reflective of weak growth. We have relatively high unemployment. Then, okay, well, you say the fiscal situation is better, which would come to a surprise, I think, to most Canadians given the amount of debt that Canadian governments carry, whether it's federal, provincial, municipal. We're just the best of a bad lot. It's not like we've got a spectacular track record, but the US, Japan, and Europe have just done a worse job in terms of managing their fiscal situation, so we stand out there, and that stability is nice. And again, we get a little bit of the benefit of not needing to source a whole bunch of oil from the Middle East. So we're not affected like Europe is, or Japan is, around the Middle East as a source for oil. That helps us a little bit on the inflation front. Again, as usual, as we talk about how dour our bond friends are, and you have to deal with most of the bond people, which is a good thing. You're more pleasant than most bond people. They're always looking for the next disaster. We're not saying Canada is a disaster, but again, the stronger performance is a little bit a case of it's an underperforming economy with some pluses that are only pluses.

Yeah, there's certainly been this narrative recently: is Canada in a recession? We've had two negative quarters of GDP, but if you look through it, especially the last quarter, I think it was a minus 0.1%, and it was really more due to a shrinking population because per capita GDP actually grew by 0.9% annualized. Broadly, you're generally seeing unemployment declining, consumer spending holding up. Estimates for Q2, I think, are pretty strong. I think our latest forecast is around 1.4% for Canadian GDP. It's good, but again, there are some headwinds, uncertainty around CUSMA and how that's going to play out. We're obviously one of the bigger exporters into the US market and have been impacted to some extent by tariffs. I think all those have come into play in terms of the slower growth profile in Canada. Canada was perhaps a bit ahead of the others as well in terms of cutting interest rates. The fact that we've been more on hold, I guess, over most of the last year, that can be part of the story there too, I think.

We've talked with a lot of the guests around the potential for Canada coming out of this war. There's some really nice things in place that should help the Canadian economy. Nice to have that performance in the near term, but perhaps we see a big turn in the Canadian economy, again, on a relative basis, with a little bit more stimulus as well, so a little bit more spending. And that creates a bond market in Canada that's not as attractive as some other places in the world. So if we're talking about that, are there any areas right now that the bond managers that you're talking to are looking at as a really big opportunity? And that could be within government bonds or anywhere across the credit spectrum.

Yeah, so maybe first in terms of thinking about diversifying globally, I mentioned that within a lot of our balanced portfolios our bond portfolios are diversified globally. And I think as an industry, we talk quite a bit about diversifying the equity part, maybe less so about bonds. But I think the main advantage to having a global bond portfolio is really diversifying your interest rate risk because your return ends up being pretty similar. You get some years, like recently, where Canada is better, some years, like 2019, where Canada was the worst performer, but over time, you get a similar return experience across developed markets, at least. That rate diversification really helps reduce the volatility. It also gives more opportunities for active managers, such as ourselves, to look and see where there are better opportunities. And the caveat for all that is that you need to hedge the currency exposure for it to make sense. Otherwise, you end up just getting a currency fund with a bit of an interest rate kicker. But in terms of the global landscape, probably one of the areas where we've seen some opportunities in— I mentioned Japan, we have seen a rise in yields there and the 30-year Japan bond is just under 4%, something like 3.8% now. I think it's probably a bit excessive in terms of the market perhaps overestimating the inflation and growth opportunity there in Japan. That's an area where we have a bit of a trade-on to overweight Japan within some of our portfolios. And then broadly I would say on the credit side, credit's still pretty expensive for the most part, but you are getting a fairly attractive yield. And so we are where we like, the short end of the curve on in Canada. And I would say our non-core credit in terms of high yield EM, we're at the lower end of the tactical range, if you will, and positioned to take advantage if you do get some better opportunities within credit overall.

Yeah, and I think with what you're talking about and the nature of the bond market, it's been like that for a bit now where if Canadian government bonds are where the performance is and it's more on the short term than the long term, a relatively unsophisticated bond portfolio has been working pretty well. But as you highlight, just like in the stock market, that does not persist over the long term. The same reason you want to have diversification in your equity portfolio, you've also got to have diversification in your fixed-income portfolio, and that's across geographies and across risk levels in debt. And we're sitting down where, again, «short and safe» has been a really good place to be because there's not a whole lot of difference or there's record lows in terms of the distance between what you pay for government versus high-grade corporate bonds versus riskier high-yield bonds. But that is not something that persists over the long term. So that diversification is important. And something not to be missed because the market now is a little unusual compared to other types of markets. We say the same thing with equities, right? The S&P 500 a couple of weeks ago hit an all-time high with only 20 stocks hitting an all-time high on the same day. Which tells you that there's a concentration and it's a small number of stocks pushing the index higher. The last time that happened was in 2000. We all know what happened there. So these are some of these unusual things. I think the human mind has that recency bias. This works in the near term, so this is what I should do. But what really works over the long term is that diversification, and it's the same in bonds as it is in stocks.

And it's a similar story, I would say, for credit. Credit's been a really easy place to invest in the last 3 years because we've generally seen those spreads narrow consistently, other than some small blips around Liberation Day and around the beginning of the war, but nothing really significant there. You've had the benefit of that spread narrowing, which has provided some extra performance, if you will, for credit, whether it be investment grade or high yield credit, but we're at a point where it's very difficult for that spread to continue narrowing. So you can still have some outperformance, but it's probably just more going to be from that coupon pickup as opposed to that spread narrowing. And it is also, I think, a part of the cycle where active management is important and just doing your credit work. It's been a period where it doesn't really matter what you've owned from a credit perspective. There hasn't been a lot of defaults, a lot of distress in the market, but where our credit team earns their money is when things start to turn the other way, if and when that happens, which we don't know when it's going to happen, but at some point it will. And so you want to be prepared and ready for that and understand that the market environment in the last few years might not be the same over the next few years.

Yeah, now something completely unexpected is happening at my house. I don't know if you can hear it in the background. One of my daughters is actually vacuuming. It's just outside my office here, so I hope she's not making noise. So again, along the lines of somewhat unexpected, but good news, I think, is the amount of corporate issuance and just bond issuance in general that we've been seeing. So lots of supply coming to market. We talked about that with Andrzej the other day. You had SpaceX, you had Google, not just holding the handout for $20, but coming out with $85 billion. You add in what's coming to market because of rising debt levels in countries all around the world. There's a lot of supply coming out. Yet, the bond market seems to be absorbing it pretty well. Do you have any thoughts on what's going on around issuance and what that says about the bond market and just the economy and what's going on around the world in general?

Yeah, to your point, like we've seen the hyperscalers issuing billions of dollars of bond, looking to raise money essentially for this AI buildout. They've tapped the US market pretty heavily, but interesting, more recently, they've actually tapped the Canadian market and European markets. And it started in May where Alphabet came and issued $8.5 billion worth of bonds in May, which was the largest corporate bond issue ever in Canada from a single issuer. The previous record I think was $7 billion, a couple years before that, Coastal Energy. And that record lasted for about a month because then Amazon came to market in June and issued $14 billion, across multiple tranches from 3 years, 5 years, 10 years, 30 years. And it was interesting because both of those issues were very well received in the Canadian market. Demand was well above the actual issue size. So they had for the Alphabet one, I think there was $20 billion of demand for the $8.5 billion issue. So we've seen a lot of interest there is a lot of demand for the corporate issue and a couple reasons for that. I think first of all, from a sector perspective, you think about the Canadian bond market, there isn't really any other tech issuers in Canada. It's banks, it's insurance companies, it's telecoms, its pipelines. So there is an interest if you're an investor from a diversification perspective to hold some of these. The other factor is they're AA rated and there's very little in Canada in that AA ratings bucket. And so it's high quality. And to give you a sense, I think the latest estimates I've seen is those two issuers are now, I think, about 45% of the AA bucket in the Canadian index. And especially in the long end of the curve, there was a lot of demand from pension plans and insurance companies who prefer some of that longer issuance. So these are called Maple Bonds. So they're foreign issuers who issue in Canadian dollars. So they're fairly new. They've been around for a while. Maple Bonds though, it's only been as of last year that they were actually included as part of our benchmark, the FTSE Canada Universe Index. And I think that helped support the issue because you had passive investors, index investors also looking to participate as well. So we've seen a lot of supply both in the US and Canadian market, but it's really been met with high demand. To your point earlier, we haven't seen spreads really widen out significantly as a result of that. The feeling is we actually could see some more of these type of issues coming later this year to the Canadian market. I think it’s pretty interesting. I think one of the benefits for Canadian investors certainly is it does give some better diversification to our bond market, to be honest with you, relative to, like I said, banks, insurance companies, and telecom companies, and pipelines that were really most of our bond market here in Canada.

Yeah, a tip of the cap to the Canadian market and how much wealth and opportunity there is for these companies or governments to raise money in Canada. Canadian dollar is also very low on a relative basis. But just to set the table on that, one of the concerns you have when you have a lot of supply coming to market, basic supply demand, if the supply is up and the demand doesn't meet it, that's going to create a drop in prices, and a drop in price on bonds means yields go higher, and that's not what we want to see. So when the demand is there. And we also got to watch on the equity side— and we'll talk about this with some of the equity folks that we have on the podcast as guests— but you had the big SpaceX IPO come out, and there was thoughts that some other IPOs were going to come later this year, and now there's talk that they're going to push off because I think they're a little bit worried about the demand on the equity side. Given pricing levels versus the much more reasonable prices— and then we're talking about all relative pricing in fixed income markets—than where we sit in some areas of the equity market.

It's true. And that SpaceX, they did, I think, a $25 billion US bond issue as well in addition to that. So they're in their top of the market. And Amazon did a $37 billion issue and then did something in Europe as well. So again, all these hyperscalers are just really looking to raise cash where they can. And the reality is that they are in good shape. They've funded all this stuff in the past from equity and from operations. And so their debt levels aren't that high. And so that's why they get actually a AA rating in the market, because they are actually high quality. Even with these debt levels, they're fairly reasonable. And so it is something that certainly you're seeing in terms of lots of issuance to fund this AI buildout.

Yeah, it's quite remarkable. And I think what I'm most excited about is we're going to Mars, Steve. Maybe not us, maybe our kids, but yeah, we're going to get there. So let's just finish it off. I know one of the things you wanted to talk about, and I think this is just fundamental, this is table stakes. It's one of the reasons why I went back and did the old supply demand and pricing on bonds and where yields go is just coming back to the reason why you want to own bonds in the first place, which is that diversification against your stock holdings. And you're seeing stuff that's going on right now that just emphasizes the value of that diversification. And you had some comments on that.

Yeah, well, if you think about why you own bonds in your portfolio there's 3 main reasons. Income is a big part of it. You're getting a yield on this, and we talked about that in terms of the return profile. It has more stability relative to equities. But also there's this equity diversification element. And ideally what you like to see is bond prices go up. When, for example, equities are going down, bond prices go up. So to help offset that from a portfolio perspective. One of the notable things we've seen in the last few years, prior to 2020, for the decade prior to that, we generally saw this negative correlation between stocks and bonds, and that's what you want to see. So when equities are down, bonds go up, and that really helps you from an overall portfolio perspective. But the last few years, we've actually seen those asset classes move more in sync. So 2022 was a great example where equities were down and bonds were down. And so I think that's been certainly a disappointment from a portfolio construction perspective. So there's been this talk: do bonds still make sense in a portfolio? But one of the things we did a couple years ago was just look at that stock-bond correlation and how it relates to inflation over time because I think that's an important linkage. And what you tend to see is during periods where inflation is high and when inflation is really what's driving the market, that correlation goes positive. Inflation, when it goes up, is not good for bonds and it's not good for stocks. When it comes down, it's good for stocks, good for bonds. When inflation is what's driving the market, back to 2022, inflation was the only economic indicator anyone was looking at. That was really what was driving the market. In those environments where the inflation narrative is what's driving the market, that's where you see that positive correlation, so they move in sync together. However, as inflation gets down below 2 or 2.5%, what you tend to see is that correlation tends to go negative. And so it's interesting, we did start to see more of that negative correlation. So that traditional risk-on, risk-off type relationship, where if it's a risk-on environment, equities do well, bonds less so, and vice versa. But then it's interesting because when the Iran war broke out, oil prices, as I mentioned, were what was driving the market. And those correlations went positive again, pretty heavily and they spiked up. I followed it on a rolling 90-day basis, and it's gone really as high as it's been in the last little while. But again, overall, what does this mean? I do think that once we get back to a more normal inflationary environment, or at least where inflation starts to fade into the backdrop and you get more a 2 or 2.5%— which we're heading towards later this year, early next year— I think you'll see that more traditional relationship between stocks and bonds, and bonds provide that better ballast for your portfolio. They still do provide a ballast even if that correlation is positive because they do better, you get the income, but that negative correlation really helps in terms of that portfolio construction element. I do think, again, as we see a return to a more normal, call it a 2 or 2.5% inflationary environment, we'll get that better relationship returning.

Excellent. Well, Steve, that was a fantastic update. As you could see from the time we spent today, a lot is going on in the bond markets, lots going on with inflation. It's a reflection of what's going on all around the world. And the bond market is bigger than the stock market when you look on a global level, and that is always important to remember. Canadians tend to own more bonds than stocks. So that's why fixed income is so important. And it's always great to have you on to do that. Although in the Canada-Switzerland game, it was the strength of the currency that won out over the strength of the bond market. So I think we got an edge on South Africa in both respects when it comes to the game on Sunday, which we'll all be watching. And Steve, have a great weekend. Hopefully you get a little bit of extra time with at least a day off around Canada Day. And we'll look forward to having you on over the next few weeks.

Sounds great. Thanks, Dave. Thanks, everyone.