A Wave of Central Bank Liquidity

Bryden Teich (BT) | Bill Harris (BH)

BT: So, if we were to start off, one of the things I think that has been happening the last number of months now. The Fed has been expanding their balance sheet and you’ve seen global stock markets since September really take off. It feels like we’re in a momentum and liquidity-driven market and there’s no telling how long that can go for but what’s your view and feeling of being in the stock market for 30 years, what this last four months has been like in terms of liquidity and momentum?

BH: Yes, that’s one of our main conversations that we have each day. And it’s seeing how much liquidity was created halfway through last year and the number is just extraordinary as we’re rolling through the cycle and then always going back in other markets, and certainly we have a shock to the system and the market goes down dramatically in a short period of time. Everything will all move together and it’s usually for a short period of time, but what we’ve seen over the last two years with 2018 where almost everything was down and then with one central bank, the US Federal Reserve Bank, changing policy mid-year, and 2019 with the market anticipating ahead of time and then almost everything went up. So, getting the Fed right really is the most important thing to do at the moment, but it’s trying not to predict “we’re going to have to take a contrary bet” and say “we’re going to bet against it, that it’s too high, it’s all going to fall.”  When it’s happening and the Fed is committed to easy money, certainly through this year, almost sitting on their hands to the election cycle, it is happening, you’ve just got to go with it.

BT: I think the one thing, also on that point, is that now that you’re in an election cycle and the Fed almost has boxed themselves in because we’re in this unprecedented world where the Fed is now being politicized regularly in an election cycle, and regardless of what the economic data does or doesn’t do, they don’t want to make a big decision that could be interpreted politically. At the same time if the underlying economy gets either a lot better or gets a lot softer, they still have to do their job and be reacting to that. And so, how do you see that Fed decision now for the rest of the year or do you think that they’re going to be on hold, or do you think that they might be politicized in any kind of way?

BH: Yes certainly they’re trying to get out of the politics and I think what’s nice about it, is we like talking about this, and thinking about it, and reading about it, but really our job is here; and the strategy is to go where the valuations are. We already established that the market is going, it’s running, we are not trying to out-guess or out-smart ourselves. Now the question is always, where do we see the value and where can we get the income that we’re looking for? And so just make all those assumptions, this is true, and now bring it back to what are we going do about it, where are we going to find value, and really always coming from the point of view of where do we protect ourselves? How do we analyze what is the downside first and then make sure as we’re going through this year, if things get too expensive, recycle it back into something that’s not expensive.

BT: The other thing too is that with what central banks have done the last decade now, with interest rates being so low in both nominal terms, but also real terms -if you include inflation- you’re basically at a point where the returns on cash and the returns on bonds of multiple durations are now basically the same. So, this idea of money that was has been on the side, has been forced into owning assets whether that’s: arts, farmland, real estate, stocks, or global stocks. Now being in a zero real interest rate world, anything can be really funky very quickly, where Tesla goes up a hundred percent, just because at a zero real interest rate everything’s worth whatever you want it to be or whatever that last person was willing to pay for it. Going back to this idea of what the Fed has done and if you look at the money supply: M2 aggregates have really shot up in the last six months but at the same time it doesn’t seem like that money is making its way into the real economy. So you’re in this window having a momentum market, having all this extra liquidity, having money supply increased significantly but it’s not making its way into the real economy which then means you’re in an environment where anything can happen from a stock perspective.

BH: Yeah, it’s an extraordinary point in time. So, I mean, we throw around these ‘jargon-y’ terms about monetary policy, it’s one of these things you sort of study in university for a couple days, and then you really forget about it, and it doesn’t really affect most people’s lives until right now. It’s so extraordinary and we talk about liquidity, which means just cash into the system, but there’s nothing we really need to do with the cash at the moment; we have as many auto plants as we need. In the tangible world, there’s overcapacity and in the new economy, “the digital economy”, -we talked about this two quarters ago in the newsletter- that the old economy has these super-low interest rates; the new digital economy doesn’t borrow money.  We’ve got a Google office tower going in right across [from] us, so there’s a tangible office with people in it, but they don’t build things. Like if you want to repeat your software, you just hit a button, and you reproduce it. It’s an extraordinary change in the economy and so if you’re going to print more money, the only place it goes is into financial assets. So, whether that’s your house, or you mentioned art, and also just hitting on the point: it’s the size of the bond market and the size of the bond market globally. It’s just a huge tank of money, historically, that just sits there, and that was the bulk of the return for institutions, pension funds, insurance companies, and now as you rightly pointed out -no interest rates and them making it equivalent to cash- all that money is under incredible pressure to go somewhere. Now we’re seeing booms in private equity, venture capital, we’ve listed this other one, the US corporate bond market, and so what’s important for us is it coming back and saying, “we have an equity strategy where we each have ownership and businesses, where we try to capture the income stream” and now getting really nervous, “are those getting expensive?” So really our discipline is coming back and saying, “okay, we know there is this bubble in cash happening, how do we still capture our income stream and protect ourselves”

BT: And adding on to that is just the one specific thing that’s happened in the last, decade since ‘09 is you’ve had this huge boom into indexing too so ETFs, whether it’s stocks or bonds or liquid bonds that can now be traded liquidly. The one thing that we’ve talked about a number of times in the office is this idea of -let’s look at technology specifically- if you look at all of the major global technology firms, they’re all in the US. Any global money that is in any kind of equity strategy that needs technology or wants to invest in technology whether it’s a public company, venture capital or private equity. All of that money is getting funneled through this technology boom in Silicon Valley and some of the other tech hubs throughout the US. So, talk to that point of the concentration of not just having all this money and bonds that needs a rate of return, but then you’ve gone we got a handful of technology companies or private equity funds to put that into. You’ve had this huge move into these assets because that’s a place to have been.

BH: We’ve touched on this argument the other day, and I also want to come back to just straight valuation on say, take the broad index in the US like the S&P 500 where’s the valuation at, and the reality is the valuation is fair. It’s just a handful of companies out of the S&P 500, 50 them have these extreme valuations and the rest of them are actually relatively fairly valued. So anyway, the way we were setting up this premise, and going back again 30 years ago when I was interning in the business and saying, if you ran a German pension fund -and I was in the UK with a group that was running pension funds there- every portfolio sort of looked the same. You have: a bank, a utility, and you have a telecom company. Germany had their three, the UK had their three, if you’re in New York you had an AT&T, Wells Fargo, and then [in] Canada you had bank, telecom, [and] utility; but now when you say, “what’s the greatest, hottest thing in computing?” -and that’s cloud computing- there’s only three companies on the planet. So, the scale of that -that everybody from Dubai, to Hong Kong, to Frankfurt, to London, every single money manager in the world that wants cloud computing exposure has to go to the same three stocks, and magically Microsoft is 1.2 trillion market cap. Just coming back to that one point: 10 years ago, Exxon was the largest company in the history of capitalism at 400 billion. Now, Microsoft is 1.2 trillion, making forty billion a year in earnings.

BT: Yeah and Apple I think is 1.3, I think Google is now 1.1 as well. You can see this technology boom that’s happened, and layer over on top of that indexing -and it’s not that these companies aren’t doing fantastic things or making great technology advancements- but you’ve had this huge rush into anything that is super-high weight in any major index, and you’ve just had these valuations take off to nosebleed levels and our view is always coming back to saying “where can we find value and consistency?” And it’s not to say that some of these companies aren’t great companies, but the idea is always “how much are you paying for that asset?” and if you’re going to be an investor for 10 or 20 years, you have to really think about not just what you’re paying for in terms of where the stock is, but the actual value on a go-forward-basis. Can you get your rate of return in something that’s trading at one and a half trillion market cap?

BH: Well this is what we wrote in the last quarterly report and tried the phrasing of saying “the degree of confidence.” Maybe we’ll just touch on that for a second. So if Microsoft is trading over 30 times earnings and we want to double our principle as safely and conservatively as possible, Microsoft by that definition -which really doesn’t pay a big dividend now- has to double. It has to get to 2.4-2.5 trillion market cap in the next 10 years which is then, as we said, the size of the Canada in one company; and so their earnings have to go from 40 billion to 80 billion, but then that implies -and one of the hardest things about stock market math is the market multiple- for the stock price to double, the multiple still has to be the same. 30 times 80 billion, implying that Microsoft has doubled in size and is still growing at just as fast of a rate as it is today, or you would make the assumption that the growth is going to slow a bit, so it’s trading at multiple of 20 times earnings. So, for the stock to double, it means earnings have to go from 40 to 120 billion. It’s possible, but you’re asking a lot. Then the way we phrased it; is it has never happening human history before so you’re predicating saying “here’s my bet. I’m going to say that I’ve great deal of confidence that Microsoft is going to do something that has never happened before” or when we come back to our portfolio saying “can we find really highly profitable, consistent businesses that are trading at 10 times earnings and give us an income stream, we can double our money with way less risk going with a whole other group of businesses.”

BT: And to your point, a whole higher degree of confidence in what we’re doing.

BH: Yeah, what is the downside of risk? And can we do this and have a confidence? And we talk a lot about events [that] happen over the weekend and try to communicate with clients as clearly as possible [clients will say], “are you worried about the stock market?” and [we] just say “Well, we’re worried about a lot of things, but we’re really comfortable with the businesses that we own because we know we don’t have high valuations but that’s the hardest thing to communicate all the time because we do the work all the time on what we own and why we own it. Just making sure, we’re communicating that as best we can.”

BT: Right, so I think if we were to just switch gears a little bit, one of the things you and I often talk about, is [for] the last year [there] has been this ongoing trade war between the US and China. You got this phase one deal in December, and it looks like, at least for the time being, into the election there’s probably not going to be a ratcheting up, but you never know. From your view and from some of the things that you’re looking at, what do you feel the state of the underlying economy is in both Canada and the US? And I know people often conflate stock market and economy, and they’re quite different things; so, the stock market can be doing one thing, while the economy is doing something totally different. What’s your feel for what the underlying economy is now, if you think of both manufacturing and on the service side in light of having run a trade war now for over a year and a half?

BH: Right, it seems like the trade war effect is in the numbers. We really had a slowdown in the industrial economy but we come back to the point in a place like the US -our North American economy- manufacturing is in the 14-15% range, might even be slightly less than that and it’s definitely affected. It is in the middle of America that we would argue, last summer, was in recession and we actually think they’re coming out of recession, and this is where we’ve made a few investments in that area where there’s stable businesses that have been really beaten up in the stock market and the businesses are just fine. Whether it’s stable or hopefully recovering a bit but there is numbers -and we were looking at it this week- of saying this slowdown on the global economy actually might be rolling out. And so again, we just don’t want to get ahead of ourselves because the stock market really seems like it’s on fire at the moment, and just not to get caught because really the economy is quite slow. The most important thing is this word we keep using of “liquidity”. There’s way too much money in the system and that’s driving everything

BT: I think the one thing that I find interesting is that you’ve had this kind of rolling effect. If you look at CEO confidence a year and a half ago, [it] really started rolling over, right in the middle of the trade war issues between US and China. CEO confidence got weak but then it took six months for the manufacturing data to start getting soft, but then that rolled over. Then at the same time, if you look at the S&P 500 -yes earnings look good because you did a major tax cut and everyone’s buying back their own stock but if you look at the underlying aggregate profits in the US like your private individual businesses, all profits in aggregate have rolled over, so your profits have now started to get hit. The next thing to happen though is that traditionally companies try to protect their margins. Their profitability is obviously important so then you start cutting back on labor but that shoe hasn’t fallen yet because consumer confidence is still high, employment is still rated incredibly low, but it feels like if there were to be that next shoe to drop, that would be where it is. I think the next six months of employment data becomes very critically important because once the consumer gets that sniff of “I might get laid off” or “my neighbor got laid off” and “I’m just going to pull back on my consumer expectations,” then you could get into a recession because at 1-2% growth, it doesn’t take much for things to really roll over here. That’s what I think, going back to [how we] originally started this, is what do central banks do if you do get into that kind of period where you have a couple negative quarters of GDP growth because they’re already basically at zero?

BH: Oh yeah, you’ve hit a lot of topics there and introduced them all. I’ll refine it by saying that it really is about the employment numbers this year. And in terms of the overall earnings, you know North America and then using the S&P earnings, they’re actually unbelievably stable the last couple years, but that’s hidden by the fact that the top 50 companies are going gangbusters and then we have a deterioration that’s in the other part of the stock market. So certainly, that’s the hard data on the economy and then on soft stock market indicators we’re really looking at market sentiment going forward, and where we were incredibly low. Like this time last year, there was this idea that we were going into recession at least in some point the next six months. Our argument was “that’s fine but we’re already there in terms of sentiment numbers.” We’re at 45, using jargon or technical terms, 45% of market participants were positive; that market doesn’t go down, there’s nobody to sell it to, everybody’s already negative, and so going through this last 3-4 month period, sentiment is going up, gradually, start to get nervous around 70, absolutely at 80 percent, but we’re not there when everybody’s bought, then this is where you have to get nervous. But the other one we looked at this week which was extraordinary is stocks trading above their 200-day moving average. Again, it’s a technical term we’re not basing our decisions on technicals, but just noticing that these are one of those outlier things that only happens occasionally, but it shows in terms of long-term trends for stocks over the course of a year and a half almost every company is in an uptrend and that is highly unusual, and also something to make you nervous about. Which comes back to the valuation, we want to make sure that we are being as defensive as we can be now, whereas within our strategy we’re making sure we’re absolutely all in this time last year – when everybody’s negative. Now that everybody seems to be positive, we want to be bringing in an element of caution.

BT: I think the thing too on those two indicators, if you look at bullish and bear sentiment and then also percent above 200-day is that they’re both in that flashing yellow stage now where it’s not full stop, you got to get really defensive but it’s also not, “this is actually way too negative, you got to get really aggressive here.” You’re kind of in that neutral zone but it feels like you could have a thrust higher here if you have a strong first few months of the year, which then I think would be, for long term investors, signaling a little bit of caution of saying, “prices are high, and sentiment is very positive.” Generally, that’s a pretty good time to be thinking of raising some cash or creating some money for future opportunities from that perspective.

BH: Yeah, we went through all our businesses this week on Wednesday and would say [that] nothing has rolled over just in terms of price chart; and if they haven’t, you can’t say that we’ve had a correction because everything is still in the strong uptrend. We’re in a presidential election year and usually a neutral, sometimes slightly positive year; but not making a political call, this is purely a stock market call, [Trump] sort of messed up the whole cycle of trying to use a traditional timing. Traditional timing is: you get a Christmas rally, and relatively a light to upward market into April, and then you’ve got your sell in May, and go away that end of April to the to the beginning of summer as a time that, if you want to really just avoid the stock market that would be the standard thing we’re looking for. So, you would still get a push up in the next 2-3 months and then you want to sit on your hands for a bit. But our stock market seasonality seems to have been thrown out the window about two years ago.

BT: Yeah totally agree. I think I would be remiss if I didn’t ask you this but, you were out in Calgary last week and so having met with a lot of companies, and you go out to Calgary for a particular conference beginning of every January. What would be, being boots on the ground, having the time to meet with all these Canadian energy companies, what would you say is the sentiment like from both an investor perspective and then also maybe some of the things that the companies were relaying in those meetings?

BH: So, it’s coming back to August-September where these are extraordinary low valuations, and going back. It was 1998 in the Asia Crisis, and the Russian Bankruptcy that we had valuations like that. It had to go back that far to find a period that was similar to it and so we went as overweight as we could be within the sector and then we’ve had a nice little move, and we’ve actually gone back to what we would call a neutral weight in energy. “Okay, we have it, the companies are making money at this commodity price,” and if we come in and say, “is my business a good business? is it making money? and have I not paid too much for it?” and it ticks all those boxes, and then you say, “what’s the market sentiment towards it ?” and it’s still in the middle of, “I don’t care. Where’s that next dollar going to come in?” So you’re sitting in the conference room and asking the questions, “well are you getting calls from New York?” or “Are you getting calls from London?” and the answer is no; there are no calls; there’s no incremental dollar coming into Western Canada to invest. We still have this big stigma that [in] Canada [we] can’t get anything done, so we have to be really cautious.  We’re looking at our investments and saying can we clip our income off of these and I don’t care if nobody shows up ever.

BT: Right and you’re getting paid at this low valuation to just sit there as you’re still owning a profitable company waiting for things to get better.

BH: Yes, so more time has to go by so we either we fix our infrastructure issues or something else happens that energy is such a compelling investment that people have to come back to it because they’re making so much money.   It doesn’t seem like we’re there at the moment.

BT: But sentiment from some of the companies you spoke to all seem like they’re still profitable
at these levels, they’re moving ahead with their particular growth projects that each company has and  would you say there was a high attendance at this conference based on previous years and so it seemed like in general investors were coming back whereas three years ago you could throw a bowling ball right through the conference kind of the thing.

BH: Yes, that’s absolutely right.  There were big Toronto institutions there, the Calgary group of participants, everybody was there, everybody was very keen, about 50 companies in two days and they said it is busy, Western Canada is throwing off about four and a half million barrels a day, they’re doing it incredibly efficiently, except it’s not dynamic.  Ironically, getting to where we are now is incredibly unproductive because so much money got thrown at it so fast, importing people from everywhere to get stuff built.  That is a recipe for terrible productivity. Right now, everybody’s is complaining they can’t get anything done but there’s incredible productivity which means dollar for labor unit added, it’s an incredibly profitable, productive sector and everybody’s ignoring it.

BT: You mean versus going back 10-15 years ago where there was this kind of anecdotal boom in Alberta, and it was welders were getting paid a quarter million dollars a year so that kind of a frothy economic environment sucked so much costs out of the projects because you have to pay labor so much, you have to pay your transportation, but you’re saying now that cost of labor has come off these companies now and are just so much more profitable because you don’t have that same shortage of labor.

BH: And you’ve gone from increasing from 2 million barrels a day to 4.5 million barrels a day but now you’re doing it with a handful of people doing it really efficiently.

BT: Right, do you think the other thing you’re just touching on is that it seems like some of the things that I’ve read in the last couple weeks, where last year at this time it was supposed to be a very cold winter, we had this kind of record cold across the Midwest Prairies in Canada and the US, so obviously  natural gas prices were pretty strong as we entered the beginning of last year.  It feels like now you’ve kind of got this glut environment where the winter so far hasn’t been as cold as expected, inventories have been built up  Do have a view on the gas market in North America in general, just based on what prices have been of doing in the last couple weeks?

BH: Yes, it’s a really tough one, so it’s North American gas, a really NYMEX [issue], and it looks like there’s too much gas in the US for the first time. It’s not that there’s excess gas but they’ve been able to have a relatively healthy 2.5-3 dollars US gas price and that’s really come off.  Ironically, one of our main gas investments in Western Canada, have fixed a lot of the infrastructure and how the gas gets around, so we’re actually getting a much better price.

BT: Right and that would be AECO pricing.

BH: Yeah Alberta pricing. And then there’s actually all sorts of things being built now whether the potential of LNG but chemical plants and things like that. There’s uses for gas in Western Canada and they’ve fixed the infrastructure bottleneck, it’s still not a great price. As you said, we’ve got one bullet that we’ve spent there. It’s got a big income, and it’s making money, but [we’re] still watching that really closely.

BT: Is there anything else you’d like to talk about?

BH: I think we can touch on this, and it’s that Bill C69. This is that big test for Canada, Canadian infrastructure and really how Canada sits on the global map. The main one that’s in the newspaper is Teck Resources doing the Frontier Project. Big thing for the oil sand is just to say another project can go ahead, big thing for Teck, big thing for Alberta to sort of say, if you put the TMX pipeline in -this is the one from the oil sands to Burnaby BC- there will be room for another project with capacity; you’re overcapacity now. Roughly around 200,000 barrels have to go by rail at the moment but if you put in just TMX and then Enbridge has what’s called their Line Three Project and then there’s lots of capacity; you can actually bring on a new oil sands project.

BT: So, if productions got up to 4.5[%] and let’s just say, fingers crossed, TMX goes through, and Line Three goes through, does that 4.5[%] go to 5.5[%] or 6[%]? Does it go to 5[%]? What is that number?

BH: So the expectations of things -rough projects that are on the books but it’s so expensive to build a new oil sands from scratch- the whole world might change ahead and really, this is what it comes down to: there are projects on the books to go to 6 million barrels a day, but then they have to get approved and Bill C69 since the federal government has to approve big resource projects from the environmental side and then let’s go see if this happens. Now Premier Kenney has already gone to Ottawa and said, “we’re doing this because this is what’s important to us,” so it’s going to be a big test if something can get built. The fascinating one that came up in meetings last week, and I don’t think we’re saying anything that’s not publicly disclosed but Suncor was describing that it takes so long to permit a project in the course of 10 years, that one of their original mines is going to start rolling off in 2035. So, you’d say, “well that’s a long way out,” but they are going to start permitting it now because they know it takes so long to do it. When you look at the oil sands there’s two things you look at: the mine, and the mining activity -which [is when] they’re digging it out. You have all the tanks, and the pipes, and all that stuff so you’ve already built it; a lot of the capitals [invested] in the processing plant. So, the mine just feeds the raw material into the processing plant, which is already built. So, what they’re doing is: this mine has been mined out and we’d like to start at this other mine to feed the same plant. Suncor would say I’m just keeping my production flat, but I could probably go and get a new permit because I’m talking about 2 billion barrels of oil. So, they’re going to go into the permitting process. The C69 permitting process and say can they go to Ottawa and get a permit to keep their production flat, but then the Liberal government has to make a decision on the oil sands being in business in 2035, and they’re going to wear that.

BT: Right and it’s almost like a litmus test of saying, “do you actually want to get any projects done, ever, in Canada again” but it doesn’t actually affect Suncor because it’s such a long dated asset where it’s not going to affect anything they’re doing for the next decade. It’s just saying, “we know we have to do this in 15 years and we’re going to test you to see if you actually will allow us.” Suncor is a fantastically run company, great on all sides from both management, operations, safety, your stalwart Canadian energy company. If they can’t get something done on this size, keeping production basically flat, it’s basically saying “nothing’s getting done”

BH: Yes, so we don’t own Suncor, we have in the past, we don’t own it right now. And it’s at a slightly higher valuation than where the other producers are trading but it’s not going to affect Suncor as much as the overall tone in the whole industry and is Canada investable. Between Teck and Suncor over the course of this year, you might come out the other end just saying, you know, Canada is still dead to the world.

BT: So, I mean, if you go down the list of Canadian energy companies, and look at the sector as a whole you’re going back to levels that you haven’t seen since [1998]-[2000] both on valuation and sentiment. If you look at the S&P, for example, the weighting and energy has never been lower and predates back to ’98-’99. Being someone who’s was managing money back then, looking at the energy space, how does it feel today [or] the last couple years, versus what it was like 20 years ago when you anecdotally would say “no one even wants to look at any of these companies” even though it was 2x cash flow or 1x cash flow?

BH: Okay that’s actually a great analogy because we’ve already said that the way the stock market is exploding in this digital economy is starting to feel an awful lot like 1999 going into 2000. So that’s when the Asia Crisis and currency capital crisis happened in 1998, and then the oil and gas companies -the producers in Calgary- got down to 2x cash flow and they sat at 2x cash flow for 6 months while Nortel went to a 100x earnings. It was supposed to make a dollar. I remember I sat in meetings, you know, it’s sort of the enterprise ship, boardroom table at TD and we couldn’t talk about anything else. It made a $1 and was supposed to go to a $1.25. It was trading at a $100 and a peaked out about a $120 before it collapsed. It ended up being accounting fraud didn’t make any money that time but going around the table -and the conversation never even got to me- and I’m just sitting there pounding the table saying “my stocks are trading at 2x cash flow not a 100x future fraud earnings.” So that’s full circle, going right from there until the fall, where we had high quality companies. In September they were trading at 3x cash flow. So, we’ve bounced from that, and we’re in that 4-5x range at a low base but it’s hard to figure out where that push is going to come from. I’ll end on that there’s still a feeling that 10 years from now, we might be regulated out of business.

BT: The world is changing so quickly that, that’s the added layer of complexity today versus back then when it was none of these other things were on the table.

BH: I mean we even wrote this in one of the letters last year, which is: the original oil sands analysis that you know, [the] first time I did a spreadsheet was that you had a cost of capital, you have to borrow money, have to build plant and equipment, but nowhere did you value air and water.

BT: Right and now they’re priceless.

BH: And now it’s priceless! So, if suddenly you come in just say, “well I can’t even put a price on that” then “you shouldn’t be doing it”. Well then you just shut the whole thing down. Maybe we’ll leave on that happy note.

BT: That was great, thanks for the conversation.