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This episode, Stu Kedwell, Co-Head of North American Equities, takes a look at the recent movements in the U.S. Treasury yield curve, and discusses whether an inverted yield curve could signal a risk of recession in the near term. [11 minutes, 27 seconds] (Recorded March 30, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave “Woozy” Richardson, and it's a late (S)Tuesday. Stu Kedwell, Co-Head of North American Equities at RBC Global Asset Management, thanks, as always, for joining us.

Dave, how are you doing? Great to see you.

Well, my (S)Tuesday was a little rough. I shouldn't say that rough but I had a little bout with vertigo, and so the whole world was wobbling around for me. I couldn't walk a straight line. Something I've never experienced before. I'm sure some of the listeners have or know someone who's had a little bit of an issue with that little imbalance in the old years. But I'm feeling better today, and I apologize that we're a day late after being off for a couple of weeks to rest up with the podcast. But feeling better. You're doing well, Stu?

Doing great, Dave. You might say the markets have had a little bit of imbalance some days as well, so maybe it's par for the course.

Yes, it has been kind of a wobbly or random walk down Wall Street. One of the things yesterday, as I was lying down, watching the business channels and the headlines: a lot of talk around what's going on with the yield curve. Some of the concern that comes out of that is, when you get what they call an inverted yield curve. We look at the yield on a long-term bond, say a 10- or 30-year bond, then we look at a shorter-term yield, maybe two or five year. When one of those shorter-term yields goes above one of those longer-term yields, people go, wow, an inverted yield curve; that means maybe we're going to have a recession, or at least it gets some attention. When you see that and you hear that talk yesterday, how do you react as an investment manager?

Well, Dave, your point is a good one, because the bond market has been a pretty good predictor of things over time. It's a huge pool of capital, and it has generally been more right than wrong, although it doesn't have a hundred percent batting average either. We have to take that into consideration. Normally a bond investor says, I want to get paid more if I'm going to give you my money for a longer period of time, because I have to give it to you for longer, and there might be economic growth, there might be inflation, I want to get compensated for all these things. When those yields approach the short-term yields, it's the bond market's way of saying, I'm a little worried about some of those things out in the future, so I don't need to get compensated for them because I think they might actually be worse. Where we sit today, we have an uncertain macro picture with what's going on in Ukraine and the implications on economic growth. We have a Federal Reserve that has been very vocal about tightening interest rates. Those two things are combining to flatten the yield curve. Normally when the yield curve flattens, spreads widen out a little bit because that's the way the corporate bond investor tries to factor in some recession. Then we have the stock market. A couple of weeks ago, when we were down around 4100 on the S&P or what have you, you could say that you had factored in a slowdown to some degree. Then we've had a very significant rally for a variety of reasons. That cushion is not as big today as it was a couple of weeks ago. In the short term, what you can say about the stock market is that the odds of recession are not really factored in to the same degree that they might have a couple of weeks ago. We've covered this before, but from a long-term standpoint— and by that, I mean five to 10 years—, you would expect to experience one, if not two recessions. It's not derailing to the long-term investor, but it is something where you're thinking, well, this one market is saying the odds have increased, are all markets saying that? And that cushion is not quite the same at this level.

Stu, does that trigger you to go back and start to do some recalculations or do a really in-depth review of what you think is the most likely scenario to play out, shift your odds around which scenario you think is going to be the most likely scenario that plays out. Is it a time to revisit what you're thinking?

Well, there are three things that you do. The first is, as you always do, you go through the different cash-flow scenarios that you could envision for a business in a bull case and in a more pessimistic case. You have those discussions with management to say, what would you do if that took place? We had a discussion this morning with a company and we were talking about some of those priorities. We said, well, how would those priorities change if the economy slowed down? It gives us a good understanding of those different cash-flow scenarios. The second thing is, you look at the valuations that might present themselves on those cash flows. The big change there is that the Federal Reserve is not flushing liquidity into the system. If your investment case is based on an expanding valuation, you’d discount that. You'd say that's not likely to happen. We're going to be very dependent on cash-flow growth to drive a return here. The third thing is, you would look at businesses with maybe a little bit more debt on the balance sheet, and you might reconsider some of those investments, because if things get rocky, those can be more volatile share prices. Those are the three things. Not that you're not always doing them, but you're definitely making a more particular view of those things at this stage of the cycle.

Say we were heading towards a recession sometime over the next one to two years. How would we see that play out in the market that we're looking at right now? Would you first see that contraction around the multiples, or would you start to worry about earnings and where they're going, and start to see signs of that in earnings? How far out would that happen?

Well, the first thing you'll see is contraction in multiple, because the stock market will worry about it before it actually happens. The second thing— and we've seen this to a minor degree— you'll start to see consumer staples, some utility names, some things that are more defensive in the stock market, start to perform better. Then the third thing that you see is earnings start to degrade eventually if the slowdown takes place. A couple of things that I would highlight as offsets to this is that the central bank is very aware of all this as well. Jay Powell at the Fed, and the bank of Canada, they're not trying to put the economy into recession, they're trying to negotiate a period of elevated inflation; some of which is still transitory, and some of it they need to really address. But as they start tightening— and they talk about 50 basis point increases versus 25 basis point increases—, that's where the stock market is likely to worry about the adverse outcome. It doesn't mean it'll happen, but the stock market needs to worry about a little bit. Second thing is that, versus other recessions, some of the economically sensitive areas of the market are supported by lack of supply. You might worry about oil demand, you might worry about copper demand, but the supply chains have changed quite dramatically. The third thing is that the consumer, particularly the U.S. consumer, is in very good shape. They have delivered to some degree through this process. Their ability to deal with higher oil prices, higher inflation, things like this, is quite a bit better than it would have been in the past. There's pros and cons to any discussion. What we always need to do is position the portfolio in a manner where we think that the most options exist for our shareholders going forward.

I've got to say, I'm always reading a lot. I'm always watching markets. I've read a number of articles that suggest that it's very hard to look at the yield curve right now the way you would normally look at it— all the dislocations coming out of Covid and where we are in the global economy. It may not work in terms of a signal the way it's worked in the past because there's almost an anticipation that as we get through some of these supply chain issues, that a lot of this inflation stuff is going to wither away.

Different investors look at different things. Fixed income is not an area of specialty for me, obviously. But once you're talking about, is it going to be 11 tightenings? 12 tightenings? 13 tightenings? I don't want to bet on 15; we're already at 13. There is a fair amount of worry that has been factored in from a tightening standpoint. The question for the equity investor is, have we moved past that? Is that a source of concern or has it already been discounted and that's what the recent weakness and rebound reflects? I would say right here, when we look at it, call it 4600 on the S&P 500, it's not at a level that significantly impacts your long-term potential but it's also at a level that does not reflect a recession in likely the next 12 months.

Excellent. Well, Stu, as always, really interesting insights into the way that you, as a professional investment manager, interpret that news flow or interpret different signals that are being given by whatever market it might be. The bond market, of course, as you say, has very good track record. Not perfect, but good track record. Something you have to keep an eye on even as an equity investor. Some really good background for how investors can think of this as they follow the news, as we all do every day. So Stu, welcome back. Thanks for another great (S)Tuesday and we'll see you next week.

Great thanks, Dave.

Disclosure

Recorded: Mar 31, 2022

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