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This episode, Stu Kedwell, Co-Head of North American Equities, discusses his views on the current market landscape and how investors can navigate this period. He notes that short-term changes in markets, while notable in the present, may not ultimately impact the long-term intentions to resolve them. Stu also talks about the waiting game of monetary policy changes, and what to expect when we begin to see their impact. [18 minutes, 19 seconds] (Recorded: March 7, 2023)


Hello, and welcome to the Download. I'm your host, Dave Richardson and it is Stu’s days, as they say over here in the UK. Stu, I'm in London today. Where are you?

I am at my post in Toronto. Not nearly as exciting as you.

Yeah, I guess so. Actually, you know what I did today? Because it was Stu’s days, I wanted to do something special, so I actually hopped on the train, and I went out to Richmond, and I wandered in around the area where they filmed Ted Lasso. And then I had a beer in the pub that they go to on the show and I had everybody yell out «dollar cost averaging» and then I took a sip of my beer. It was all in honor of you, Stu, on a Stu’s days in London.

Did you take the Stube?

The Stube? Yeah, I've been purposely calling things the wrong way here just to aggravate my UK colleagues. Leicester and the subway, things like that. That nice truck. The elevator. Those kinds of things. So, it’s nice over here. But markets continue to be— I think the word you were using as we were having our conversation— a bit of a conundrum, in terms of determining where we're going. Again, we're taping this on Tuesday afternoon. We’ve got chairman Powell testifying and of course he's jawboning about how they're going to do everything they can to kill inflation, and no one will be able to stop them until they've stopped inflation. But markets are kind of going «hmmm». We got a big jobs report coming on Friday that a lot of people are focused on because the last two or three job reports have been a little bit hotter than people would have expected. You'd think that inflation would have shown a little bit more signs of coming down. We talked last week about ten-year rates in the US that popped up over 4%. The two-year rate is creeping up on 5%. So, Stu, what do we make of all of this? Or do we not make anything of it? I guess we keep coming each week asking: is anything that's happening really changing your view of the direction that we're headed?

Not really. It is, but it's not. You have to be watching the tea leaves, so to speak, like trying to gather information from a lot of daily economic reports and conversations. You're always looking to see if something is changing underneath the surface that we have to really take note of. And it's always possible, but generally speaking, this is the longer roadmap of inflation that peaks. Maybe a year later, interest rates peak and earnings bottom. I don't think there's a ton of change in that longer-term roadmap. We had inflation peak last summer, but it's not coming right back to 2%. But it is declining. It's not declining at the pace that some would like to see. Part of that is because there's a lag in monetary policy. Part of it is that companies and individuals financed a lot of their mortgages and debt, and they've locked in some interest rates for a period of time. So even though they know that they may have to pay more in the future, they haven't had to do it yet. The unemployment has remained very low. There's a handful of things that, in all likelihood, will change. They just haven't changed yet. And as a result, you're not getting this near-term resolution in inflation, even though the conviction to deal with it remains the same. And it is progressing in the right ways. You're always worried when you see this because that's where you might get a policy mistake. Will there be just too much tightening that causes a more severe earnings decline, and then that severe earnings decline will lead to some liquidity squeezes in areas of markets that you might not have imagined, which leads to greater price change than just the earnings decline might warrant, and that creates this crunch period for markets. As a long-term investor, you know you're going to see those. As a very short-term investor, the thing to watch, really, is the long end of the yield curve, which has bounced around. But if we were really worried about inflation ballooning and being under control, the yield curve would tell you something about that. So, you know, we’re watchful. The part that we have to focus on, if it's a little bit higher interest rates and a little bit longer, what does that mean for earnings? Because earnings growth has kind of stalled— it's in the zero to 5% range—, and that's what we have to think about.

I was talking to a gentleman here in London yesterday, about this monetary policy and this lag. And you think of individuals. We generally focus on Canada when we're having discussions, because that's where we live and where we're based and where a lot of our listeners are. And you think of the way that we do mortgages in Canada. We've got variable rate mortgages. We've got terms from six months generally to about five years, with typically 25-year amortizations on the loan. And we've already seen in the system that there were some people coming into this that had variable rates. For 40 years basically in Canada, betting on variable rates was a pretty good bet. Over the long haul, rates were in a constant trend down. We've seen that reverse. So people who are in variable rates have had their payment adjusted or their effective amortization adjusted. But you've got to have some people with some mortgages starting to come due this year, next year, and that's got to start to impact. But it doesn't seem to be. Is it a little bit of a different scenario this time because of what we went through with COVID where rates just dropped to virtually zero. And that changed the way businesses and individuals set up their financing, this cycle versus other cycles?

Definitely, at the margin. People and corporations extended term and took advantage of low interest rates. And even on the individual front, there's alternative mortgages in Canada, outside of the banking system, that often have a term of one year. So they will reprice and that will impact some degree of consumption, but it's not the lion's share of consumption. And then the rest of the mortgages, because such significant volumes were done during the COVID period, even if you're on a variable rate mortgage in Canada, there are classic variable rate mortgages where the payment changes immediately in response to interest rates. And then there's fixed payment variable rate mortgages, which means as rates rise, you pay less principal down out of each payment, but your payment itself may not change. Because so many of those mortgages were written in 2020 and 2021, people may not feel the impact of higher interest rates until 2024 or 2025, when the terms of those mortgages start to renew. Again, that's a classic lag. You're sitting there and you're saying, boy, I know in four or five years my payment is going to change, but it's not getting me right today.

Yeah, the usual lag on a change in monetary policy. This is a much more pronounced shift and tightening cycle than really we've seen in 40 years— arguably ever, actually—, but it doesn't seem to be having really a ton of effect. Is it just going to be a little bit longer before we see it kick in? Does that increase the chance that they make a mistake?

Well, right now, it's been significant, but it's been measured and telegraphed. So that raises the question of do they need to do something that shocks behavior? You go back in time when the Federal Reserve used to raise interest rates on a Saturday. It used to raise them, then cut them. There wasn't this forward guidance that kept you off guard a little bit. And some people will say that while the rate increase in this cycle has been significant, it's been so telegraphed that it hasn't had that same jarring impact on behavior. The benefit of hindsight— you can debate this ten ways till Sunday—, what we do know is that higher interest rates have been loaded into the system and eventually that's going to have a slowdown. What they're really discussing now and what they don't want is inflation to be embedded in people's thinking, so they don't want it to be embedded before the real meat of monetary policy really kicks in. And that's the ongoing discussion that they've had today, and they'll continue to have. I think what they keep outlining is that they have the tools to slow inflation and stop it— which is higher interest rates, tighter monetary conditions—, and they have the tools to undo that if they slow the economy too much. So we know which way they're likely to err on. They've been pretty consistent on that front. And from a longer-term standpoint, there's movements in short-term interest rates and there's movements in longer-term interest rates, and the longer-term interest rate is much more important to signaling inflation expectations, valuation, all sorts of things. Even today, where we've had a fairly hawkish commentary from chairman Powell, the ten-year bond has not moved around as much as the commentary might lead you to believe.

In fact, we were just commenting, as we were talking before we started taping, that as we sit here right now, the ten-year in the US is down 15 basis points from where it was last week, even with the job owning that you're seeing from the Federal Reserve chairman today. We’ll just go down one more alleyway before we finish up today, Stu, with the companies that you're talking to. One of the real big concerns for longer-term inflation is the job market and the fact that the job market has remained very tight. In the companies that you're talking to, or that you're investing in, are you hearing anything from them about seeing a difference in the job market over the last month or so, as you start to see some traction around the tighter interest rate policy?

Yeah, that goes a little bit to rate-of-change type of investing as well. By and large, when we talk to a lot of companies, they're still feeling some wage pressure, but the majority of the «I can't fill the vacancy» is passed. The leading indicator of slowing jobs is positive, which is saying: I can actually now find people, I'm still having to pay them a little bit higher than I used to. Before the problem was twofold— I can't find them even if I could pay them—, now, I'm starting to fill vacancies still with elevated wages. We're seeing some businesses adjust the amount of labor that they're using so that eventually will lead to some softening as well. So again, when you look backwards and you say, this happened, then that happened, then that happened, over a three-year period of time, we don't want to ignore short-term events, but we need to be careful in the short term that we're re-altering or rewriting longer-term scripts because of daily activity, when we know that these things take some time to progress.

I guess the big thing is, even as powerful as some of these tools are, this is a big ship they're trying to turn. It's not dipping and darting around in traffic the way a little delivery scooter, a Uber eats scooter, is zipping around in the tight streets of London. This is like the Titanic. Hopefully they've seen the iceberg and they turned in time to avoid it. That's more what it's like.

Yeah. I think it's not just turning the ship. Because it's been so long since we’ve had high interest rates, there's so many nuances that present themselves. Kind of offshoots of policy. Even the way that interest rates might work from a traditional standpoint, you're also at a period of time where you put a ton of money in people's accounts from COVID and all of a sudden that money which you thought was going to draw down, is now making 4 or 5%. So higher interest rates are leading to a little bit more of a problem because they're creating a little bit more interest than they used to as well. So there's just a lot of dynamics going on. That's why I think it's important to really focus on what they are telling you. Is the messaging changing? Is the likely outcome changing a whole lot? There'll be lots of volatility in between but trying to get those things squared away.

Like I say when I do my speeches, a lot of the stuff I've learned from you over the years is that I don't know what the market's going to do today. I don't have much of a guess on next week. I don't know where it's going to be a year from now. Probably up, in most years. But by the time I get out to ten years, though, I got a pretty good idea of where it's going to be relative to where it is right now. And I'd rather bet on that than try and figure out what's going on in the short term. Because you can see, even as I talk to about as smart a person as I know who's tracking this stuff every minute of every day— that's his job—, it's tough to do because so much stuff is going on. From an investment perspective, fundamentally, you want to focus on the things that you can control and know, and that's the basics of investing. And then you leave it to an expert like Stu to worry about the small stuff and I'll go and hop on the tube and go somewhere interesting instead of worrying about it today.

Along those lines, one of our analysts— he’s now a portfolio manager, but when he was an analyst— we were talking about a stock ten years ago and I said I'm convinced that dividend will double in the next ten years, which would have been a 7% compound growth in the dividend. He put it in his calendar, and he walked by my office the other day and he said, it actually doubled last year. So, there's lots of noise, but there's the longer term as well.

But still, please come back and tune in for next week's Stu’s days, where we will zoom in and focus on the near term and help you make some decisions around your investments, or at the very least, try to develop some kind of an understanding of what's going on. I’d like to finish with where we started; I guess the key thing for people to do is believe.

That’s a good way of saying it, Dave. The thing I always remember is that there's a lot of people focused on an outcome that benefits the most people, and that outcome is, in this case, getting inflation down, preserving longer-term interest rates, creating the environment for businesses to invest. Maybe earnings are going through a bit of a struggling period right now, but they can then reaccelerate off that, and that's what longer-term investors are focused on.

Excellent. Well, Stu, thanks as always, and we'll catch up with you next week.

Great. Thanks, Dave.


Recorded: Mar 7, 2023

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