Hello, and welcome to the Download. Today we are joined by our favorite Canadian equity guy, Head of Canadian Equity at Phillips, Hager & North Investments in Vancouver. Scott, we haven't had you on for a while. You've been world traveling?

Thanks, Dave. I wouldn’t say world traveling, but I have been back on the road. It's good to be able to do the client events in person. I haven't done those in a while. I was reminded about how uninterested I am in business travel. That's one of my least favorite things. It's been nice to be at home, but it was good to get back on the road and see people in person and do some group events, which we haven't been able to do for a while.

Yeah. Did you find some good coffee?

I did, although I was surprised how hard it is to get a decent cup of coffee near the Toronto office. A couple of good coffee shops, but they open at 9:30 a.m. But I got a hot tip from Stu Kedwell. He's more than just a stock picker. He sent me to a place near the Toronto office, which was quite good.

Yeah. Downtown Toronto is one of the tougher coffee places for the types of coffee that we like, in the country. The power of the big brand in the Toronto market is tough. But we're going to stay home with the investment conversation today. One of the things that I recall from a podcast that we taped early in the year, I think back in January, you highlighted how low the volatility was in the Canadian market last year— one of the lowest volatility years on record. It was also a very strong year from a performance standpoint. And one of the things that you talked about was that typically these low volatility years were followed by years where there's significantly more volatility. You couldn't have been more prescient looking forward in terms of what happened, but you had a ton of success this year in terms of managing money in Canada, so why don't you walk us through the year? Because it's been a tale of two halves and there's maybe some misunderstanding; the Canadian market has done pretty well, but not as much recently. Why don't you talk about where we've been through this year as you see it?

Yeah, you're right, Dave. You're referring to one of our favorite slides that we were sharing with some clients when we were out on the road last couple of weeks. 2021 was really a lucky year for us because we had a north-of-20% return for the TSX and we really didn't have a lot of volatility throughout the year. The one thing that's interesting to note is that on average, the intra-year volatility for the TSX is 15%. So at some point during the year, you're going to get an event that takes you from peak to trough down 10 or 15%. So that's something to keep in mind as we go through volatile periods. That is somewhat normal. It doesn't feel great at the time. 2021 was quite different. We only had a 6% drawdown from peak to trough. So we did look at the numbers— I like to do the forward looking after these types of events— and the next year performance is not as great, where you have the average forward year performance is about 4% or just under, and the entry-year drawdown is close to 20%. That's sort of playing out this year. And this year you're right, it's been an interesting year where you have, I call it the tale of two markets, because if you just pull up the year-to-date numbers, the TSX looks pretty good. It's down 12%, which doesn't feel great, but when you compare it to the S&P 500 or the Nasdaq that are down 20 or 30%, the TSX does look like a relative outperformer. But really, that come in two parts. If you think about the period of June— there's probably a more specific date around a Fed announcement around mid-June— but if we just go back to the beginning of that month, the TSX is down 10%. That locksteps with what we would have seen from the Nasdaq and the S&P 500. So the first half of the year, we got the benefit of having that commodity exposure, very cyclical market. The energy sector did incredibly well, but we've given some of that back in the second half of the year. So, when I think about where are we now? It's a bit challenging because while we have seen the TSX correct over the last couple of months, the risk reward has gotten better, but there's still some risk to the downside. The features of the Canadian market that helped us at the beginning of the year may cost us at the back end of the year. Some of those cyclical exposures, commodities energy, were very helpful to start the year, but if we are going to go down the path of a recession or some economic slowdown, I would expect— and history would tell us that— those sectors, commodities and energy, will get impacted. So that cyclical exposure actually could fare negatively as we move through an economic slowdown. I would say, the other thing that pops up is that if you just look at the valuation of the TSX, it appears to be quite cheap. We've shown a chart in the past, or talked about it on this podcast, that the TSX does trade in a fairly significant discount to the U.S. That still holds true. We did say that when we're at these extremes at the beginning of the year, we're close to a two standard deviation discount, which if you're typically one standard deviation discount, the forward returns for the TSX are on average, in the 6, 7, and maybe even 800 basis point, 0.8% of relative outperformance, which we've seen; we've seen that already. But I think there's some risks to that valuation. If you looked at forward earnings, the TSX, I think, would trade at maybe 11- or 12-times earnings, which looks pretty cheap, but I think there's some risk to the earnings. So the P part of the P/E multiple has come down, but the E has yet to come down. I think that's been talked about quite a bit in the US. In the US, the estimates for the S&P 500 are coming down, particularly when you look at 2023. But for Canada, they really haven't moved. And there's two pieces. The big drivers of the Canadian earnings, the TSX earnings, are energy and financials. If you look at the energy estimates for energy stocks, they've actually gone up over the last three months. In the last week or so, we started seeing them come down. But as the consensus, the analysts are using an oil price that's well north of the curve, whether you're looking at spot or the futures curve as well. They typically chase the commodity price on the way up, and then they'll be forced to chase it on the way back down. So they've taken their numbers down slightly, but they're still using 90 to 100 oil for next year. So that's actually really driven the earnings forecast higher. Then for the financials, bank stocks have come down with recession and credit concerns, but the estimates really haven't moved because the impact of higher interest rates far outweighs the impact of credit risk at this point in time. But the stock market, I think, as Stu would say, is relentlessly forward looking, and they're looking through that near term benefit of higher interest rates and starting to get a little bit more concerned about credit going forward. So the market, especially the TSX, may not be as cheap as it appears. So we're waiting for some of these estimate revisions to normalize before we can get really excited about the risk reward for Canada.

I've just got my computer up here and I'm looking at various commodity prices. So oil, down from 125 to $85 as we're recording this today. Copper, from 5 down to $3,40. Natural gas that peaked at around $10 towards the end of August, is sitting under $5— that's 50% down. Even before we hit those high prices on all those commodities, energy companies and mining companies are able to do very well even at an $85 oil price or a $5 natural gas price, a $3.50 copper. But I guess that takes a lot of that upside out of it. Have we really seen the worst of the downside in the commodity prices if we are heading into a recession?

Yeah, it's a good point. Predicting where commodity prices are going, that's a very difficult exercise. We have to be very aware of commodity prices and markets because that's a big part of the Canadian equity backdrop. But that's not a skill set that we would claim to have. The direction of oil is a really difficult thing to predict. So a couple of things that we take into consideration— I think we've talked about our processes to build scenarios. We can't predict, so we prepare. We think about what a bad case looks like and what a good case looks like. For commodities, it's tricky, so I'll zero in on the energy companies; these companies are actually, while we're concerned about what happens to the oil price and recession, the companies themselves— and this is more than this year dynamic that's played out, it’s something that's taken place over the last number of years— they're in much better shape than they've ever been in terms of balance sheet. Just the discipline around how they're spending cash flow. We had a chart that we were sharing with clients showing that the last time oil was in the 80 to $100 range, the oil companies were spending and allocating a majority of that cash flow towards building new assets, growing production. That would have been in the 2008-09 timeframe, or the 2012-14 timeframe, and you would have been building oil sands mines, adding shale production, etc., and they would have been allocating very small amounts of their cash flow towards things like dividends or share buybacks. Dividends would have been small, share buybacks would have been minuscule, if not zero. Fast forward to today when we have 80 or $100 oil, the allocation of that cash flow going towards building new production is quite small. And instead, what they're doing is they're allocating that cash flow towards shareholder returns, giving it back to shareholders, getting their balance sheets in shape and returning that cash to shareholders. Dividends, share buybacks, special dividends, variable dividends—, really just trying to show that discipline. So it's sort of a tricky thing to predict how things will play out because, on one hand, these companies are in a fantastic financial shape. If the oil price does correct in the face of a recession, they've put themselves in a really good position to not get hurt by it too much. On the other hand, if oil prices stay high, I think they're going to continue to return to shareholders and then actually that adds an extra wrinkle that you've probably heard— people talk about it—, the significant amount of underinvestment that's going towards replacing oil production. So that's what's causing the price to be high— I think I talked about it in a previous podcast where the price was sending a signal to suppliers or producers to add more supply and they just weren't going to. Then, when you had the Russian-Ukraine event and you're potentially taking even more supply out of the market, that caused that price to spike and that actually would be a very early clue or sign of a recession risk because you're spiking prices to destroy demand. And so while they're in a really good position today, if we were to go down to an economic recession or slowdown to some extent, that will impact oil demand and impact price. Hard to say whether 80 is the new 50, or 60 is the new 40. Those are things that are too hard for us to predict. But you do have the supply, demand and balance is very tight and so if you have a recessionary event, you will impact demand, but you're not seeing the supply come on. So in a recession there is downside to the oil price for sure and I think these stocks could come under pressure, but they're in much better shape to withstand that pressure than they have in the past.

So the Canadian market in essence, particularly in the first part of the year, benefited from that overexposure to energy and material sectors, those cyclical sectors, as those prices have fallen off in the second half of the year, as interest rates rise, anticipation of an economic slowdown. Now we've started to move with the US market. I know in your portfolios, you've benefited greatly from having that exposure to those cyclicals through the first half of the year and then again, they're just acting in line with everything else, so you've continued to do really well. How do you have the portfolio positioned now as it becomes more and more likely that we see that significant economic slowdown? And how do you anticipate going through the last part of 2022 and into early 2023 in Canadian equities?

Yes, it's tricky. We've moved, I would call it fairly neutral. It's not an exciting position to be in, but we're in that sort of in-between phase. If I were to go back to the beginning of the year— I know it's only October, but if I think about January and February, it feels like a long time ago, so this is perhaps one of the longest years on record, I call it a dog year— but our base case would have been a normal economic recovery from the pandemic. Our bear case would have been maybe a slower than expected economic recovery. The bull case would have been wide open reopening type trade. We've had to revise those forecasts a bit as we think the facts have changed throughout the year. So our bear case is a recession— not a severe one, but a fairly mild one. Our base case is maybe not a soft landing— it feels like that's a little bit off the table— but it's more of a skate-through-get-by without a major bad, and nothing happens, but we do slow down. Our bull case is what we would refer to as the recovery scenario. Not something that we're really calling for in the near term but if we do go down the path of an economic slowdown, in our bear case, you need to leave that recovery scenario up there to remind ourselves that there is a prize on the other side. So we're kind of neutral. Earlier in the year we shifted some of our cyclical exposure in some of those sectors that you talked about, closer to neutral, and just in response to the worry of a recession. What's great about the stock market is that you don't have to be able to predict the future but you just have to understand the scenarios that are being discounted. We felt earlier in the year, there wasn't enough respect being paid to the recession scenario and now we're starting to discount it more, so things are becoming more interesting, but the challenge is to find the sectors that are looking more attractive to us from a risk-reward perspective. One, they still have downside and two, they're typically those sectors that we talked about. So we reduced our exposure to energy and financials earlier in the year. They're looking more attractive but those aren't typically the sectors you want to be buying as you head into an economic slowdown, as we move through it and get deeper into it. The risk-reward is potentially very attractive in those sectors but it seems a bit early to be looking at them. So I've probably talked about our skill which is not so much in predicting these macro type things— recession or not, oil up or down—, we're really in security selection, stock picking. So every day we're continuously looking at the portfolio for attractive risk-reward opportunities in company specific outcomes which we have at least a better shot of getting right and then just managing our exposure to the macro factors just to make sure that we don't get caught offside on it. So I wish I had a more crystal clear answer but the future is not that clear. So we're fairly neutral from those macro factors but always looking for stock opportunities to take advantage of.

It's typically what differentiates a professional investor from a retail investor in approach and that stock picking capability across a broad range of sectors. But I think I'd be remiss if I didn't talk about something I've been reading a lot about this week— and for those who have been listening to the podcast, I spent a lot of time over the last two or three months with realtors across Canada— the impact of the overinflated Canadian housing market. So even if you look at other housing markets around the world, a lot of people from outside Canada would suggest that the Canadian market is perhaps the most extremely valued housing market. And again, as you've already said, you're not going to have a base prediction that housing prices drop 10%, 15%, 20% through this, but clearly housing is going to come under pressure. What does that do to the financial sector, as we look into 2023? Rates are going up, but housing is tough.

Yeah, it's my least favorite subject, but we have to be aware of it, given that it's a big part of our economy. For a lot of Canadians, it's probably your most valuable asset. It's the biggest part of your net-worth portfolio. So it's very near, it's where you live. So it always tugs on people's emotions, which is always dangerous when you're trying to make pragmatic investment decisions. It's challenging because the change in the rate environment has severely impacted buying power, your ability to borrow and what you can afford to borrow. So that really impacted the price at which people can afford in most basic terms. So that's one piece. From selling, if you're a seller of a house, you're still anchored towards some of these more recent transactions— when I say recent, the transactions of six to twelve months—, which haven't reflected that change in buying power or purchasing power from the buying side. So you have a disconnect there. So you've seen some price correct. You've seen a significant drop off in volumes and you’re in this waiting period. What is risky is, if you wanted to sell your house and you were able to get a price within what you saw in the last six to twelve months, you may do it. If you don't see that price and you don't have to sell, you won't sell your house. So that's why you've seen the volumes drop off. What I worry about is the scenario where you get into an economic situation— a recession, job loss, those types of things that tie into economic slowdowns, and if people are forced to sell their house— now, you're going to have to go to with the buyers and that's where the spread collapses and the selling price will actually have to go. You'll see price and volume, which is not going to be good for a number of participants. That's one scenario that we're worried about, where you have distressed selling and that has a knock-on effect. I guess the other thing too is just the service costs of variable rate mortgages. I don't need to go over this but there's a lag effect of these variable rate mortgages. So the bank of Canada's raise rates, and the rubber has hit the road in a few places but not fully. So we have to factor that into the equation and how much debt do people have and how much variable debt, lines of credit, etc. If you're looking at bank balance sheets, the loan books are quite robust and the capital positions are very strong, but directionally, if there is stress, that's not going to work out well both for the earnings profile as you have to take reserves, and if they're just going to get worried about it and the stock market will express that worry through lower prices. So you have a couple of things to offset it. One, people have built up quite a bit of savings through the pandemic so you're able to withstand some of that. But we're chewing through that with higher interest rates, higher inflation, gas prices, food prices, a lot of those savings, those excess savings— we're chewing through that rather rapidly. So that's going to hit the road at some point. And we have not seen any job loss. The unemployment rates are still fairly low. So if we start to see those typical markers of economic slowdown or recession— unemployment starts to go up, we've worked through the savings, job losses, etc., people may be forced to sell their homes or the carrying costs are a lot harder— that is going to cause a lot of stress. That stress will show up in a number of places in our economy. The banks will be one because you will see credit risk rising, loan growth slowing, etc. That's a scenario that I don't think is reflected. Bank stocks are off from their highs and they're trading at very cheap multiples, but the estimates haven't come down and we haven't started to discount a stressful scenario for the banks in a big way. So that's what I mean. That's a great example of some of these more cyclical parts of the market, economically sensitive parts of the market, they have some downside risk still to more fully reflect that scenario, which I'm not predicting as an outcome, but it is a potential outcome that we need to be mindful of.

You said it's your least favorite topic, but that's probably the best explanation that I've heard of what's going on in the housing market and the impact that it has, particularly on Canadian bank stocks. So once again, you blew it away. So when I'm out in Vancouver next week, I'll buy you a coffee and of course a sausage roll at our favorite bakery. I'll bring the HP sauce and we'll have a lovely coffee and snack together in the rain. Is the weather turning there?

The rain is back here in Vancouver. So, coffee and sausage roll, I couldn't think of a better combo for a rainy day.

Excellent, Scott. Thanks. Great catching up with you. I know you've had a tremendous year on a relative perspective in terms of the portfolios you're running. So congrats on that and we'll see you next week.

Thanks, Dave.