Recorded on April 3, 2020

In Episode 6, Bryden Teich and Bill Harris discuss the impact that COVID-19 has had on the markets and the global economy through the first quarter of 2020. They discuss some of the policy reaction from governments and central banks around the world as well as recent moves in the US Dollar and the dynamics that are causing it. They also touch on the movement in gold prices so far in 2020 and the broader outlook for stocks for the coming months.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Bill Harris (BH) | Bryden Teich (BT)

BT: For today’s conversation, I thought it would be good to go through and summarize a lot of things that we’ve seen now, given that it’s quarter end. It’s been obviously a very busy first three months of the year. The view we had at the beginning of the year coming in was that we were going to be in a low-interest-rate world for longer. I think in some ways it’s just been even further confirmed but maybe walk through some of that outlook and then what you’ve seen really the last couple of months.

BH: Yeah, I think even what we’re here today just to talk about specifically, you know on this Friday, of what’s happening, what are we doing about it? But it still requires some context in terms of how quickly we got here and how much is changed – not even in the last month, in last three weeks – which has been extraordinary. So the battle that we were fighting was that we’ve come from a market that was at all-time highs with the US Federal Reserve and central banking system injecting just incredible amount of money in the system and interest rates were incredibly low; and valuations were high. So, we were getting in a position – and we had been in position for several months – of trying to get as defensive as we could, and then you’ve got hit with shutting down, and now we’re at the point of shutting down the planet, we’re shutting down continents. It’s not just a recession, where recession is 10% of the economy will slow down or 20%. You’re just taking the consumer out.

BT: Totally offline.

BH: Yeah and understanding that. So really, all the issues that we were dealing with before -and I think this is our main message- is that the problem of the virus in the economy being shut down is the incredible injection of money into the banking system, in the economy, actually makes the previous problem that we were dealing with even worse.

BT: Yeah, I think the other thing that’s happened too, really in the last three weeks -the latter half March- is given that you now move to a point where you’re shutting down the world economy for an extended period of time to try and fight the virus, you then have this sudden flight to cash across all assets. So, what happens is the correlation or the relationship between all kinds of different asset classes spikes higher and basically what it means is that everyone is trying to rush to the exits, to get their cash as quickly as possible. And when you have stress on the financial system, the cash that people run to first is the US dollar.

BH: Just to explain that so an individual can understand, that’s saying “I’m dealing with my mother who’s older and she’s got to make sure she’s got money to pay the woman that comes in and helps her with food and cleaning.” But that’s just in a microcosm and then you see how that affects businesses; getting people to really understand -when you’re running for cash- the scale of the problem.

BT: Yeah, I think the important thing to keep in mind is in a global economy both on a trade front and a capital market front, the flow of capital all over the world has been really magnified the last decade. Absolutely. And so, what’s happened is you have a record amount of US dollar denominated debt that is offshore -so in other parts of the world- I think the number that we’ve looked at is somewhere between 13 and 15 trillion. So, if you’re a company in Asia or Africa or South America, you probably have at least half, if not more than that of your capital structure in US dollar-based debt. And so what happens is you have shut down big parts of the global economy, which means that a lot of companies, and businesses, and even governments for that matter, revenue goes to zero but the debt doesn’t go to zero. So you have this funding problem on the very short term and you have this rush to say “Oh I need to make sure I have enough US dollars for the next six months, so I can pay my debt, rent, employees. What was interesting is in the midst of the storm in March you saw stocks getting hit but bonds got hit too. There’s a lot of liquidation in bonds, both government and corporate; other asset classes like commodities or gold were also being sold. It was really saying “I don’t care what my longer-term view is. I just need cash over the next three months to make sure I can keep the lights on with my government or my business or my global company.” So, you had that initial rush into the dollar that put that upward pressure on it. The central bank in the US, the Federal Reserve, then tried to decrease some of that pressure with some of these swap lines. So basically it means they swap currencies with other global central banks and you try to flood the system with US dollars to alleviate some of that pressure but the problem is it doesn’t fix the bigger issue that a lot of the revenues for these companies have gone to zero. So, you can lend dollars to another central bank, but if a company in Asia has revenue that just went to zero how are they going to be able to pay their debt? So, you’re in the midst of this cash shortage in the system as long as the economy remains shut down.

BH: Right now as we said, we’ve seen the incredible three week panic, we put in a low that was on the 23rd of March and we see this incredible policy response -we can talk a little bit about that in a minute as a sort of breather- but as I said the work you’ve been doing and showing us is that there’s still this other whole part of the world, it needs dollars in their hands and that might not have happened yet.

BT: Yeah we talked about this earlier in the week saying there’s actually some great reporting on this both on The Wall Street Journal side and Financial Times starting to highlight a lot of the international countries – I guess you’d say developing countries – that were really starting to have debt problems and that need for dollars. But I think a lot of this comes back to: how long is the economy going to remain shut down? And I think that the initial thought was that this is maybe two weeks to a month; we’re now almost three weeks into this so we probably are at least another month, and then there’s even scenarios where it goes longer than that and I think that these debt issues become much more prominent the longer that this lasts. So, there’s the immediate desire to get the health situation under control, but a lot of the economy globally needs to get back to work or else these issues are going to remain now for the next several months. I think in a lot of our meetings and in communicating with clients, our view is still similar and hasn’t changed that the longer term pressure on the US dollar is going to be much lower but you’re now in this very short term period where there’s a rush to fund your liabilities that are based in US dollars and so you’re getting a little bit of a push higher. One of the charts that we like to look at in the office and our meetings is the relationship between the budget deficit in the US and trade deficit combined and overlay that with the US dollar with a six-month to a year lag. You have mentioned the stimulus package of two trillion for this one; I think the Federal Reserve now is going to end up to six trillion dollars; I think the Federal Reserve balance sheet increased by almost one and a half trillion in the last three weeks. So, these huge levels of fiscal spending in the US but they were already running a five percent of GDP deficit; it’s going to fifteen really easily, it might even go to twenty. So our view on that basis is still the longer-term pressure on the dollar is going to be lower but you’re in the middle of this storm right now where until these funding issues get settled, there’s still going to be some of this pressure in the system.

BH: Clearly, we were in a world a month ago where I’ve got my stock investments, I’ve got my bond investments, and then what I need right now is cash in my pocket. Specifically, as you’ve just pointed out, is the world uses the US dollar. So, we can even say, what’s the strength of the Canadian economy we’re in? It’s kind of irrelevant. The US dollar gets stronger because we’re thinking if you’re going to flood the system with money, but the need for dollars overwhelms that in the short term. So first I have to sell my bonds, but a week ago there was nobody to sell the bonds to; so then the central bank has to come in to buy the bond so that you can get dollars in your pocket; also if you have stocks, it doesn’t matter. A lot of times it’s just that you have an investment, “Great, I was owning this for the long term. Oh, but I actually need the money now.” So, the money comes from being invested in bonds and stocks. So much trading has gone on and we put sort of levels on these things. Going forward, once everybody has this money and it gets distributed, it solves that problem but the central bank is doing its damndest  right now to actually devalue the dollar to get themselves out of it; and we’re right back where we started this conversation, which is saying why we want to own hard assets, dependable businesses, essential businesses, so the money goes sweeping into the US dollar but at some point the money has to come back into the stock market, and buy hard assets because there’s a big potential that the dollar could be devalued over time.

BT: Yeah, I think the amazing thing sitting here, watching this, talking about it, thinking about it every day, is really just the speed and the ferocity of how quickly this is all coming together and so we put a lot of thought into where our view is at the beginning of the year, and how we’re going to prepare for what this outlook is going to be now. Our view always is a much longer-term view of saying what are the next two to five years going to look like, and how do we want to invest around that? But then you have these very short-term intermittent periods where it’s just storm and all these clouds are brewing and everything breaks loose, and it’s just saying the long-term view and outlook hasn’t changed, it’s just that you’re right in the middle of the storm. I think the unique nature about this is that everything got sold in those particular bad days.

BH: Oh, we could talk about gold then, specifically. So, we own gold because we want to own a hard asset. We think this devaluation is finally this thing that’s probably coming around but in the last two weeks, just run through how did gold actually behave as a defensive strategy.

BT: Yeah so the amazing thing is that right up to the end of February, gold was actually outperforming almost everything, maybe other than some parts of the longer term bonds that had done well for the first two months of the year. But gold had done well and then all of a sudden you got into first two weeks of March where everything got sold. Everything got liquidated from both gold in the futures markets or the price that you look at on the screen, gold miners got sold, the gold ETF’s got blown out, which then created other liquidity issues. I think the other problem that happened -and it was very clear a couple of those days where we just had mass liquidation of everything- is we’ve moved into such a financialized world and there’s just so much money sloshing around that a lot of bigger market participants will take their positions and lever them to three four or five X and so that works when the market’s moving in your favor, but as soon as that train stops you instantly have to de-risk. It doesn’t matter what you’re selling it’s just as instantly that these computerized trading programs are set up to just de-risk everything and what’s going to happen in six months, or a year or two years doesn’t matter. It’s just what’s going to happen the next six hours. Just sell everything.

BH: So, another way of saying this in stock market terms is this is the largest margin call in history and with interest rates being so low which means you can borrow money so cheaply. Which means, I bought the Canadian gold company and I borrowed money because it didn’t cost me any money to own it yeah because it was absolutely going up until this cash thing happened, which means I need cash more than I need my gold stock. Gold stocks collapsed along with everything else but when they went up, I mean it was just stunning to watch how fast they recovered. I think it was two or three days.

BT: Oh, you can always feel the margin call because it’s just indiscriminate selling, pause, and then you instantly bounce back to where it was before. I think to your earlier point of saying we’ve now set a couple of different ranges in the market where the initial force liquidation margin selling panic low. There was a low put in a week and a half ago, rallied off that low pretty hard, both in Canada and the US and now we’ve kind of set up a tradeable range going forward and then going back to what the outlook looks for the on the health side going forward but maybe talk about that from a perspective of what we see over the next couple of months in terms of what the market may or may not do.

BH: I think one of our big takeaways today – to make sure we hit our conclusion – is that we think we’re in much better shape for where we think the world is going to be going forward and we’ve had a number of transitions, and all our conversations, our research, in the last three weeks has been around transitioning the portfolio as fast as you can to these essential businesses in the economy. I think you can make the immediate assumption that this wouldn’t be a great time to own a cruise ship. That’s the simple conclusion but the other one, if this goes longer and we’ll make sure we touch base on this, is the length of time of this because that is the unknown. Everybody’s saying that it started out with an impression that this might be two-three weeks, but this is longer and which case, as it gets longer it’s just the consumer is where the problem is. So, we’re making sure we’ve transitioning the portfolio into much more essential businesses. You always think about Bell telephone going through 2008-2009, we just watched how Bell telephones business grew. There are certain businesses that we can own that just don’t get shut down – actually can nobody function without them. So, transitioning the portfolio into those sorts of things, but we still own businesses we just don’t run to US dollars and run back; it’s just something we don’t do. We can protect at the margin but really, we have to find these businesses that are going to do well in the next one, two, to three years.

BT: And you’ve done a lot of work on just putting a certain percentage number on what you would consider to be essential businesses within what we’re doing outside of our cash or gold position. Was it almost 65 percent of the portfolio?

BH: Our quarterly report – which is going to come out shortly and will be on the website as well – shows that there’s almost two-thirds of what we own which is in cash, gold, bonds, and mortgages, and then essential businesses. And when we’re talking about the stock market, we’re sweating it every minute every day, but it’s really a much smaller percentage of the portfolio. And the essential business is what we’re talking about – Bell is an easy one. But things like CP Rail – nothing gets around without it. It’s the guts of the economy, the transportation, the essential businesses, and these are not being shut down as opposed to it’s really hard to understand where you’re going to be when you come back. It’s just such an unprecedented event to shut everything down.

BT: Yeah, I think the other side on that respect is now with what the market has done the last couple weeks. I think the difficult part is that our view and how we approach it is as business owners is, we like to invest in long-term businesses, things that we think can protect and grow capital over long periods of time. But then there’s also you get into this short-term period where all everyone thinks is what the technicals are saying, how much have you retraced of the previous low. This is why our view is that it’s so important to own a portion of the portfolio in these essential businesses because to try and take a fundamental view or predict what earnings are going to be like over the next year, or even close to the next two years, is really difficult. So, then a lot of these shorter term technicals and ranges become more important at least as a ring-fence where the markets are likely to trade. So maybe talk to that a little bit, about this idea of we put in a low, a couple weeks ago now, and that there’s likely still to be another test of that, and then what the outlook might be for the next few months on beyond that.

BH: Okay I’ll set that up by touching on the first point which is really what we’ve been doing here is that you’re trying to analyze your business normal and say okay how probable can it be? Is there any growth? Now it’s actually completely flipped on its head. You still read the newspaper during the day but you’re not making investment decisions off the newspaper; you’re making investment decisions off solvency. So, we’re going through all our companies and saying okay, actually a number them are net cash. All of our businesses have been great about getting that information out to us. And then the question is do we think our dividends are safe? Because really what we’re hoping to do is we’re still collecting our dividends, and we’re able to keep investing our way through this. Instead we’ve got a strong portfolio and we just keep picking away as we go along patiently, and we’ll talk about the levels because that’s exactly what the question is in today’s call. But really, there’s no way to know -if this goes longer- are your dividends safe? A company might just say “It’s better for me to have that money in my pocket than it is to dividend-it” but you also know your company is stronger because it’s made that decision. So far other than a couple companies that we’re watching closely, we actually think that with most of our dividends, we should be able to get through this, and we’ve touched on the length of time, but the stock market always looks out six to nine months. So, everything we’re doing today is looking into the Fall; and the stock market looks into the Fall. That’s the hardest part about investing: you can just be incredibly uncertain about today, but the stock market is always judging how the Fall is going to be. But the problem is how much business goes on in the Fall really depends how deep we go, and then can we get back to work, can the consumer get back, and all the people in the hospitality industry pay their rent, and get back to work. So that that sets up the context. Specifically talking about today -that was a long-winded set up- So we’ve had that incredible steep severe pullback and depending on the market -the Dow Jones industrial average was at 30,000 and fell just below 20,000, so it was down a third- what we found was almost everything across the board, if it was a financial asset, it went down about a third. We’ve had a recovery since then so what’s really important about this is we’ve now set that bottom a week and a half ago, we have that low point in the market then we had sort of a relief rally which came to a technical resistance line. You’re not telling anybody this, everybody’s looking at the same point on the chart. So now you have a rebound rally in a high and you’ve got low from a week a half ago and we’re just sort of trading in that band. Right now, we actually don’t have to do anything we have to watch and see how this resolves itself. If we gradually break up, and everybody hates the market, and it’s over and the market can see through the Fall, or if we fall to a new low, then we’re going to be more patient sit on our hands and again we’ve got 12 to 13 percent cash. We’ve got our list of things we’re waiting for to buy and this is our playbook. We’ve got the market setup that’s going to tell us what we’re going to do going forward. I would say the next time we have this conversation we’re going to know where we tested those two points.

BT: There’s more clarity, yeah. It’s amazing how much is happening, and how much news flow, and how much market action two weeks will tell you. I think the other thing I’m adding is that one of the things that’s really blown out the last couple weeks is the volatility index (VIX) which examines the level of panic in the market based on…

BH: I want you to talk about the VIX because you’ve done all the work on this but having followed this, it measures the amount of volatility in the stock market, and we’d actually gone for a period incredibly low volatility. In 30 days’ time, what is the probability that 30 days will be the same as today? And so, the amazing thing was that we spent three years of most days, a month from now is going to be the same as today. Like almost the same. There was no volatility in the market and then you have almost zero probability that a month from now is going to be the same. So, you go from an it’s a unit of volatility of 10 and we had it almost as high as it’s ever been which sort of it ramps up around 80 or 90.

BT: Yeah so that’s exactly the point. When you look at the volatility index and how high we got in the middle of March up to 85-90, which is really just an incredible level to be up there and to be sustained but now that we’re starting to put in lower highs, there’s a little bit of a calming effect going on -instead of being at that panic level- but with a volatility index at 45 it’s still an incredibly high level. And I think the one chart that we looked at earlier this week that I thought was really interesting is if you put up how the volatility index looked in 2008-2009, it peaked in November of ’08, but the market didn’t bottom until March of ’09. So in our playbook for what we expect over the next couple of months is, the best thing would be to see the market try to make a new low, whether it fails or not, you know, as long as it’s kind of within that range of where it bottomed but then to see that happen with a much lower volatility index, then I think confirms that you’ve wiped a lot of that anxiety out of the market. Then at least you put in another sort of tradable bottom which you’re probably going to have a pretty significant bounce on at least into the Fall. I think I totally agree with you that the outlook beyond there is still a little bit uncertain with how deep this recession is going to be and how quick people can get back to work but at least it gives a bit of a framework for making decisions of saying, “There’s a technical way to look at really good buying opportunities” but also still having our list of companies that we’re looking at and saying “Okay this is the day we’ve been waiting for in the week” and now it’s just a matter of saying “What are we going to buy here at this level?”

BH: Okay I just want to make sure we touch on these two other key points since we did this last podcast and we wrote about it in a note that went out to clients, but really we’ve now had an extraordinary stimulus. So, this is the first time we would talk about it. Again, the problem is that we know we’re in this contraction, we know the economy’s incredibly shut down, and usually you will wait for the government to react except it looks like the government has fully reacted over and above anything that has ever happened before. The problem is we when we look at the Fall, you’ve doubled your stimulus. You were – just this afternoon – putting numbers together to put in context for people the size of what the deficit was now, what we think it’s going to be, and what is the size of the debt coming out of this. And then Canada is sort of a mirror of what’s happening in the US.

BT: Yeah, the way we thought about it this – and Matt and I talked about this on a podcast about a month and a half ago – at the end of 2019, the simple numbers are the US economy’s about 21 trillion dollars in size and they were already running a deficit of around 1 trillion dollars so debt or deficit to GDP in the US at in December was about 5% which is just that 1 divided by 21. And so the package that we saw from Congress two weeks ago is 2 trillion, but in a recession what happens is that the government revenue also collapses and you have unemployment go up, and unemployment insurance and stabilizers kick in. So, the simple way to take it is the 1 trillion dollars which was the runway from before, add 2 trillion – I would even say, generously add another half trillion is probably going to be another trillion on top of that with how low revenue is going to come down – so you’re very quickly at 3.5 trillion or 4 trillion just this year in net new borrowing in the US which is 20 percent of GDP, which is just a staggering number. It’s a number that you see in emerging markets or impoverished developing countries where they’ve got some kind of a corrupt government and they’re just spending like crazy. So the US is now faced with this situation of saying, “How do we get ourselves out of it?” Well, of course the government’s going to respond, but the level of stimulus being thrown at this is so significant and I think coming out of this, the national debt in the US is going to be somewhere around 27 trillion by the end of this year, and your economy is probably still going to be around say 20 or 21 trillion because on a full-year-basis, it’ll contract a bit, and the numbers just start to spiral out of control from here. I think that this is actually the most difficult thing about the period of time we’re in, where you have this one or two months where everyone wants to rush to cash because they just need it to get through the next six months. But then you have a government that’s going to issue trillions of dollars of debt and spending, and not even talking about what the Federal Reserve is doing. And so, through this period currencies – and just dollars – will hold in well, but then in a few months to a year probably the last thing you want to own is paper money because governments are going to do everything they can to inflate it away. And that’s the most difficult thing about the period we’re in, is that the government spending numbers just start to get so out of control, and at what point do you lose faith in that money to maintain purchasing power, and the governments are going to desperately try to create inflation or the central banks are. I just think it’s definitely a very complicated mix looking out a year or two years from here.

BH: Yeah absolutely, just how extraordinary this time is, and how you know the world is not going to look the same going forward. We keep on saying that some things would be the same and some things would be consistent but just you can’t “get that genie back in the bottle” to use that term. We’ve had discussions over the last couple days on inflation in the near term and what that looks like. I think just to share a couple of those ideas because it’s such an extreme inflation. It really helped me to visualize what this might be different about it.

BT: Yeah, it’s actually not that hard to create inflation. I mean the government can just say “wire ten thousand dollars to everyone’s bank account tomorrow or a million dollars.” There’s no amount of money that will impact it and I think in the US they’re doing what we would call helicopter money – basically mailing checks out to people and that’s good for the next month or two to get you through but now everyone’s going to expect a cheque from the government every couple months. The mental effect or that the psychological effect that this has on people’s behavior going forward, I think it’s going to be significant but to that point, it’s not that hard for a central bank or a government to create inflation. Once you do that, it’s incredibly hard to slow it down, but at the same time you can’t just create growth overnight. So, if you’re ever moving into an environment where you create inflation and there’s no growth, it’s actually the worst environment out of all – which is stagflation.

BH: Well even just to walk through this: you’ve got money in your pocket, you’re going to the store, but the problem is there’s only a few things in the store.

BT: Yeah there’s a shortage. It becomes a shortage of goods. You can create as much money as you want – paper money or in people’s bank accounts – but there’s a fixed amount of goods and you have supply chains breaking down and you have all these issues now of getting goods across the world. So, there’s a shortage of everything and what happens when you create more money is everything gets more expensive.

BH: Yeah even shutting down the economy is an extraordinary thing and we talk – having been a base commodity investor for most of my career – extraordinary situation we’re in now which I’ve never seen before. And you might get positive on the commodities because you’ve shut down all the mines and it looks like now oils in its own very much its own universe – that’s a whole other day going into that. Just in terms of copper, uranium, or you’re talking even about gold, you’re shutting down all the mines, but there’s a need for the actual product. And you’ve created all this money so that the money chases all the products that have already been created but people aren’t in business creating new supply. So, it’s this short-term inflation that we have never seen in our generation.

BT: I think a lot of that comes down to: how quickly can the health situation get under control, and how quickly can people get back to work, and how structurally are you changing people’s psychology and behavior once they go back to work? And I think that there’s a short-term period that you keep reiterating that is a rush to cash but then cash is probably the last thing you want to own in that inflationary or stagflationary environment because the purchasing power of currency gets eroded very quickly.

BH: So, let’s just conclude on that then. We still envision that we’re in it now – this rush to cash – we believe that you still have to come back to the stock market and we’re trying to invest for where the world is going to be six months to two years from now.

BT: Yeah and I think the idea too is: you still got dividends coming in all the time, every month, we have 12-13% cash positions in the accounts, and to be buying things through this, I think there’s another you know couple maybe a couple weeks to a couple months where the market chops around, probably put in a low, and then you probably bounce significantly higher into the Fall, but there’s still this outlook going forward, and saying “with interest rates going to be low, if you’re going to have a more inflation, you absolutely want to own gold, you absolutely want to own real estate.” I mean, we’re very light right now in the commodity side. There’s an argument to be made that you actually want to be more into commodities and that kind of environment, but we’re not quite there yet but I still think these essential businesses – utilities, infrastructure companies that we own – all of them are still vital in that kind of a period of time. It’ll be fascinating to see how we move through these next three months. We’re now at the end of the quarter so we’ll have a quarterly report out in the next couple of weeks, and then look forward to the next conversation from there.

BH: Yeah, most of our business is hard asset type investing and we like doing tangible businesses – bricks and mortar is sort of the way it is historically – but again maybe we’ll touch on this because this would be for another podcast… The way the economy is evolving is that – especially going through this – an essential business is your health insurance, an essential business is your software provider, not your product, not your consumer technology device. It’s much more the systems that we have to run our business that are actually becoming essential. We can shut an off a lot of our business down but there’s somethings that we just cannot shut down.

BT: Yeah, it’s the same for most businesses that your critical software and infrastructure aren’t going to get shut down. So, really the focus remains trying to find these certain parts of the economy that we think will actually become even more crucial through this period and bouncing out of it.

BH: There you go. Thoughts to talk about next time.

BT: Look forward to it.

Recorded on March 13, 2020

In Episode 5, Bill Harris and Matt Manara discuss the incredible events in the global stock markets for the second week of March 2020.

Topics discussed include Avenue’s positioning in the equity portfolio and some of the opportunities that we were taking advantage of this week. Bill and Matt also discussed some of the signs of stress they are seeing in the high yield bond market and also how the illiquidity of certain Exchange Traded Funds (ETFs) exacerbated the volatility in stocks this week.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Recorded on February 28, 2020

In Episode 4, Bryden Teich and Bill Harris discuss the events in the stock market for the last week of February 2020 and how Avenue has been positioned for this.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Bryden Teich (BT) | Bill Harris (BH)

BT: So if we were to start off, we originally had a different topic that we were going to discuss in this week’s podcast but I think with what’s happened in the market and sort of the extreme week that we’ve had, we thought it would be a great time to sit down and have a conversation about what’s happening out there and what we’re doing about it. And so, if you were to take a look at what the week has been, how would you sum up how we got here and what has led to this kind of period of volatility in the market?

BH: Yeah, it’s as exactly as you framed. This has been an extraordinary week and so it’s actually interesting; I’ll even frame it to the point of view that most people in their daily lives really don’t pay attention to the stock market that much. Then you can even have an economy slowdown and you’ll look at the market on the weekend or a couple days later and say, “oh wow, I didn’t really know this was all happening.” But because you’ve got the virus, and the story of the global proportions, and then the stock market reaction, this is really an extraordinary week. So again, as you introduced we were going to have a different talk today, but thought that this was important to touch on, and certainly in the last 48 hours we’ve had lots of calls and emails, so this is absolutely top of everybody’s mind.

BT: Yeah and it’s a great medium to discuss what’s on our mind and what we’re doing about it. The last conversation we had was almost a month ago now, we talked about this idea of really low interest rates, a lot of money in the financial system, a lot of the money had gone into stocks, and this indexing effect that we hadn’t really seen how it was going to shake out. Our view had been, you would probably hit a wall and the market was going straight down because of this cascading effective indexing and leverage in the system. And so, if you were to sum up that index effect: how big of an impact do you think that has had on what this week has been like?

BH: Yes really standing back and saying over the last couple years, what’s really happened that’s changed the stock market is that there are no longer individual people, individual stock brokers, making individual ideas, or even portfolio managers at insurance companies, pension plans, sitting in a chair saying I want to buy this sell this. More than 50% of participants are participating in the stock market using indexes. So when you make buying decisions, you’ll be making them gradually, how do you feel each day, the market will then work its way up gradually but we’ve always felt over the last two, three years that “oh this indexing thing is really going to change the nature and tone of the market.” When you have an event or a crack, our expectation would be it’s going to go straight down. This is really the first time we’ve tested it, and so going back to where we were just this time last week, we were at all-time highs, incredible ounce of liquidity -jargon [that] just means the central banks can create money, there’s no real place for the money to go but into hard assets like houses or into the stock market, so it gets pushed into the stock market and it just goes into the index and drives the stock market up, and the biggest names get the most money. When it rolls over, there’s just there’s nobody to buy it – everybody is just an incremental seller, and we’ve seen this week -just five days in a row- absolutely straight down.

BT: I think the remarkable thing is sitting at the screens all week, and this and looking at the gapping down of markets to that effect. That’s sort of the technical way of saying there’s just at lower and lower levels there haven’t been buyers, and so you used to have the shock absorbers which were the banking system which would take on positions on the trading desks. The shock absorbers for the market have long been gone with a lot of the regulations that’s happened in the last decade, and then you’ve amplified this with indexing, and you’re just get to a point where there’s just no buyers at certain levels and this idea of when you get it in an overvalued market or extreme valuation market you have sentiment at all-time highs or close to all-time highs, and you hit a wall and the market goes down really fast, really quickly. So, if we take a step back and say, these are things that we’ve been preparing for, for months and how we’ve positioned our strategy. What would be some of the key points that you would touch on in terms of how at Avenue we’ve surgically been preparing for this for quite a while?

BH: Yeah, I’ll absolutely hit that one and I’ll throw it back to you because of the work you’ve been doing. Even though we’re at all-time highs, and sentiment was positive for the stock market, we’d actually seen things that were eroding inside. This is laying out that case that the indexing was going to change the nature of the markets means that you actually have to do it ahead of time. We then as a strategy say we want to own stable income producing companies, but you have to be really careful in valuation that you don’t own anything that’s really expensive. So we’ve spent, certainly last year, that’s where something like Microsoft that we had owned for 10 years, and then coming into this year, we’ve sold Apple, look at trying to move the money into less expensive stocks, but our hit list in the last few weeks of taking off technology, taking about down energy, we’re in a position of being 22% cash and gold ahead of this, which this time last week was actually quite an uncomfortable position, but defending it saying I don’t know what’s going to happen but we have to be ahead. I’ll just comment that first thing on Monday morning, we came in and said, “okay, this is very real and let’s tear the portfolio apart, what is it that you want to do?” – Paul Gardner participating in that meeting. There wasn’t anything that was an obvious air pocket under the valuation. So it’s interesting coming into this week: there wasn’t anything else we were going to do, except then you’re starting -which is very different mental mindset- saying actually let’s spend all week trying to figure out where we want to put this money when we get an opportunity.

BT: Yeah, I think the other thing too is that when you get to periods like this, or weeks like this, where if you look at it on a shorter-term indicator, we were oversold three days ago; cascading down Monday, Tuesday, Wednesday, and then to have Thursday and Friday, this capitulation pushed down. I think if you look at one of the indicators we’d like to look at which is how many stocks are above their 200-day moving average, and overlay that with the index, when you get to these extreme levels -I think yesterday was about 32% –  as uncomfortable as it is, we know we have to be doing something because with the volatility index -the VIX- at close to 42, with stocks now significantly below their moving averages, as painful as this is, this is actually where, surgically, we go through and implement our plan. I would say we always have a list of stocks that we’re looking at, and we’re always having levels in each one, where we can be buying but you have to methodically have that planned out, you know kind of months and months in advance and now this week has been a great opportunity to start executing on that. The other thing too is when you look at having a bigger plan like this, sometimes it’s easy to sit in a meeting and talk about what you want to do and then all of a sudden that the decision-making process gets accelerated very quickly. So, us having the ability to react on our feet, be quick, execute our plan, know what we’re doing ahead of time, you have to have a Zen-like feel to what we’re doing. I think what was interesting is a lot of market participants the last number of months felt like there was a laundry list of reasons to explain why things were so great, and from an economy perspective, manufacturing, employment, we’ve been watching that a lot of these things have been soft now for months. So, the nature of this virus and the longer tail impact on the global economy is still far from certain -what this looks like even out six months- and so that’s very different than what previous sell-offs had been, where it was a tweet and the market would go down 8%, and there’d be another tweet and the market would go back up; this is very different. In our preparation we’ve been ready for this for a while, and it’s just been a matter of going through and implementing our strategy.

BH: I think this is the one of the harder points about doing this. As you said, we’re at our desks, we’re watching what we own, why we own it, looking at the numbers come in, and from a client’s point of view, I empathize. This is probably the hardest part: you’re seeing the headlines, you’re anxious, and so we know the businesses and say, “we own great businesses. There are fantastic amounts of dividends that are coming into the portfolio. We’re already defensive ahead of time” and so even though there’s this nervousness, it seems counterintuitive that we’ve had an extraordinarily bad week, and today we actually spent this morning -already an hour and a half- saying where we going to spend 2-4% of our money by the end of the day even then knowing it’s still might be worse by the beginning of the summer. And so how can we know that we have a good valuation, make sure we’re getting a dividend, and which case we can ride through, and we’re still going to be constantly be able to add to the portfolio if this does continue. Certainly, our impression today is that it’s the nature of it; [it’s] probably not over.

BT: I think the other thing too is that, as long-term investors like we are for clients, as counterintuitive as it is -as you mentioned- you have to actually embrace periods like this because they create fantastic opportunities, and so what we’ve done is we’ve taken profits on certain positions over the last several months, we’ve reloaded the cash position with those profits, and now we have levels on certain stocks where you start deploying that over time, but I think the best way to describe it is this surgical process that we try to execute with selling it levels that we like, and then having it taking profits, and you’re constantly reloading the portfolio. At the same time, you have all of the high yield portions of the portfolio spitting an income every month, and then there’s more money to deploy over time. The other one -I’ll just push back onto you- is just to square up that the last comment, we discussed about the economic outlook, and what’s your view on the timeframe for this global slowdown to push through? And if we were to look at a chart of 30 year interest rates, you’re at now historical low levels, and so what does that mean for what the Fed likely has to do to this and also the outlook for equities versus bonds now over the longer term?

BH: Yeah wow, we’ve got another 45 minutes.

BT: Yeah, we could talk for hours but we don’t want to bore people.

BH: Interest rates now look like they’re at an extraordinary low. It was just at Christmas time; we were talking about the 10-year because it’s about businesses and how businesses can borrow money. The most important interest rate is the US 10-year rate, which is where a corporation funds -not about us and buying our houses. The stock market is based on businesses and that’s the important number. So, two months ago that was roughly 2%, 1.9 but going to 2%. Now it’s almost 1%, it is down 50% in two months but from an absolute level, 1% is what you’re going to get in the bond market, which is just not a great rate of return for how much risk you’re taking. What’s implied in this for us is that we are equity investors, you’re getting a great deal owning a big stable business that throws off money. A situation like this creates a buying opportunity, knowing again that this is what we do, we’re in the business of buying businesses. We’ve got dividends, we accumulate them, and we keep buying, and buying, and buying stuff so this by definition has to be -ironically- a good thing but it’s just like you don’t want to buy the falling knife. That’s the probably the biggest issue we’re dealing with today and this week is that: is this falling knife? Are we just about to buy it a month from now saying “oh that was a bad idea.” So can we protect ourselves and buying the businesses we’re comfortable with? We know are comfortable at this level anyway. I think the point that I probably would have brought up earlier was that you don’t have to fly into the eye of the storm. This was just last quarterly letter to discussing Microsoft and how expensive it is, and a 1.3 trillion dollar company, and how on earth is it going to double in size, and the answer is well the numbers really were ahead of itself, but that doesn’t mean we have to go right back into Microsoft or Apple. So, we can actually say that this was the eye of the storm, all that money went into these stocks. When it’s going up you have to be over-weighted when you know for an investor that’s trying to beat the market, when the stock is going down you have to be underweight so everybody has to get underweight fast, in which case you don’t really know where Apple or Microsoft is going to settle out. So, let that go to somebody else and we can focus on things that other people aren’t looking at.

BT: So if we were to wrap up on this point of saying so as we discussed, as painful as it is in weeks like this, today is the day we’re actually putting money to work some of the money that we have been storing up for months now -which is a great time to be deploying a little bit. But having cash, having income, having these other different yield sectors, whether it’s real estate, or infrastructure, utilities, generating a lot of a lot of cash in the portfolio, how would you sum up the strategy now for the next six months as we go through this period of what will be slower global economic growth?

BH: We’re in a position now to pick away at things, and so today’s the day, might be two weeks from now where we see things again. We certainly would like to focus on those key parts of the economy which is: health care, technology; these are great businesses, but they’re quite often expensive and so this might be a chance for us to actually get them, or they’ve got these other industrial businesses that are beaten up but they’re very solvent, great long-term, core the economy businesses with dividends, and we can buy them and sit on it, and just accumulate income over time which is really the core of the strategy.

BT: Why don’t we wrap it up there. Thanks for the conversation and look forward to the next one.

BH: Yeah exactly and it will be interesting.

Recorded on February 7, 2020

In Episode 3, Matt Manara and Bryden Teich discuss the U.S. Federal deficit and how it is impacting the direction of monetary policy. They also discuss the reach-for-yield going on in corporate and high yield bond markets and discuss other risks they are seeing in the market.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Bryden Teich (BT) | Bill Harris (BH)

BT: So if we were to start off, we originally had a different topic that we were going to discuss in this week’s podcast but I think with what’s happened in the market and sort of the extreme week that we’ve had, we thought it would be a great time to sit down and have a conversation about what’s happening out there and what we’re doing about it. And so, if you were to take a look at what the week has been, how would you sum up how we got here and what has led to this kind of period of volatility in the market?

BH: Yeah, it’s as exactly as you framed. This has been an extraordinary week and so it’s actually interesting; I’ll even frame it to the point of view that most people in their daily lives really don’t pay attention to the stock market that much. Then you can even have an economy slowdown and you’ll look at the market on the weekend or a couple days later and say, “oh wow, I didn’t really know this was all happening.” But because you’ve got the virus, and the story of the global proportions, and then the stock market reaction, this is really an extraordinary week. So again, as you introduced we were going to have a different talk today, but thought that this was important to touch on, and certainly in the last 48 hours we’ve had lots of calls and emails, so this is absolutely top of everybody’s mind.

BT: Yeah and it’s a great medium to discuss what’s on our mind and what we’re doing about it. The last conversation we had was almost a month ago now, we talked about this idea of really low interest rates, a lot of money in the financial system, a lot of the money had gone into stocks, and this indexing effect that we hadn’t really seen how it was going to shake out. Our view had been, you would probably hit a wall and the market was going straight down because of this cascading effective indexing and leverage in the system. And so, if you were to sum up that index effect: how big of an impact do you think that has had on what this week has been like?

BH: Yes really standing back and saying over the last couple years, what’s really happened that’s changed the stock market is that there are no longer individual people, individual stock brokers, making individual ideas, or even portfolio managers at insurance companies, pension plans, sitting in a chair saying I want to buy this sell this. More than 50% of participants are participating in the stock market using indexes. So when you make buying decisions, you’ll be making them gradually, how do you feel each day, the market will then work its way up gradually but we’ve always felt over the last two, three years that “oh this indexing thing is really going to change the nature and tone of the market.” When you have an event or a crack, our expectation would be it’s going to go straight down. This is really the first time we’ve tested it, and so going back to where we were just this time last week, we were at all-time highs, incredible ounce of liquidity -jargon [that] just means the central banks can create money, there’s no real place for the money to go but into hard assets like houses or into the stock market, so it gets pushed into the stock market and it just goes into the index and drives the stock market up, and the biggest names get the most money. When it rolls over, there’s just there’s nobody to buy it – everybody is just an incremental seller, and we’ve seen this week -just five days in a row- absolutely straight down.

BT: I think the remarkable thing is sitting at the screens all week, and this and looking at the gapping down of markets to that effect. That’s sort of the technical way of saying there’s just at lower and lower levels there haven’t been buyers, and so you used to have the shock absorbers which were the banking system which would take on positions on the trading desks. The shock absorbers for the market have long been gone with a lot of the regulations that’s happened in the last decade, and then you’ve amplified this with indexing, and you’re just get to a point where there’s just no buyers at certain levels and this idea of when you get it in an overvalued market or extreme valuation market you have sentiment at all-time highs or close to all-time highs, and you hit a wall and the market goes down really fast, really quickly. So, if we take a step back and say, these are things that we’ve been preparing for, for months and how we’ve positioned our strategy. What would be some of the key points that you would touch on in terms of how at Avenue we’ve surgically been preparing for this for quite a while?

BH: Yeah, I’ll absolutely hit that one and I’ll throw it back to you because of the work you’ve been doing. Even though we’re at all-time highs, and sentiment was positive for the stock market, we’d actually seen things that were eroding inside. This is laying out that case that the indexing was going to change the nature of the markets means that you actually have to do it ahead of time. We then as a strategy say we want to own stable income producing companies, but you have to be really careful in valuation that you don’t own anything that’s really expensive. So we’ve spent, certainly last year, that’s where something like Microsoft that we had owned for 10 years, and then coming into this year, we’ve sold Apple, look at trying to move the money into less expensive stocks, but our hit list in the last few weeks of taking off technology, taking about down energy, we’re in a position of being 22% cash and gold ahead of this, which this time last week was actually quite an uncomfortable position, but defending it saying I don’t know what’s going to happen but we have to be ahead. I’ll just comment that first thing on Monday morning, we came in and said, “okay, this is very real and let’s tear the portfolio apart, what is it that you want to do?” – Paul Gardner participating in that meeting. There wasn’t anything that was an obvious air pocket under the valuation. So it’s interesting coming into this week: there wasn’t anything else we were going to do, except then you’re starting -which is very different mental mindset- saying actually let’s spend all week trying to figure out where we want to put this money when we get an opportunity.

BT: Yeah, I think the other thing too is that when you get to periods like this, or weeks like this, where if you look at it on a shorter-term indicator, we were oversold three days ago; cascading down Monday, Tuesday, Wednesday, and then to have Thursday and Friday, this capitulation pushed down. I think if you look at one of the indicators we’d like to look at which is how many stocks are above their 200-day moving average, and overlay that with the index, when you get to these extreme levels -I think yesterday was about 32% –  as uncomfortable as it is, we know we have to be doing something because with the volatility index -the VIX- at close to 42, with stocks now significantly below their moving averages, as painful as this is, this is actually where, surgically, we go through and implement our plan. I would say we always have a list of stocks that we’re looking at, and we’re always having levels in each one, where we can be buying but you have to methodically have that planned out, you know kind of months and months in advance and now this week has been a great opportunity to start executing on that. The other thing too is when you look at having a bigger plan like this, sometimes it’s easy to sit in a meeting and talk about what you want to do and then all of a sudden that the decision-making process gets accelerated very quickly. So, us having the ability to react on our feet, be quick, execute our plan, know what we’re doing ahead of time, you have to have a Zen-like feel to what we’re doing. I think what was interesting is a lot of market participants the last number of months felt like there was a laundry list of reasons to explain why things were so great, and from an economy perspective, manufacturing, employment, we’ve been watching that a lot of these things have been soft now for months. So, the nature of this virus and the longer tail impact on the global economy is still far from certain -what this looks like even out six months- and so that’s very different than what previous sell-offs had been, where it was a tweet and the market would go down 8%, and there’d be another tweet and the market would go back up; this is very different. In our preparation we’ve been ready for this for a while, and it’s just been a matter of going through and implementing our strategy.

BH: I think this is the one of the harder points about doing this. As you said, we’re at our desks, we’re watching what we own, why we own it, looking at the numbers come in, and from a client’s point of view, I empathize. This is probably the hardest part: you’re seeing the headlines, you’re anxious, and so we know the businesses and say, “we own great businesses. There are fantastic amounts of dividends that are coming into the portfolio. We’re already defensive ahead of time” and so even though there’s this nervousness, it seems counterintuitive that we’ve had an extraordinarily bad week, and today we actually spent this morning -already an hour and a half- saying where we going to spend 2-4% of our money by the end of the day even then knowing it’s still might be worse by the beginning of the summer. And so how can we know that we have a good valuation, make sure we’re getting a dividend, and which case we can ride through, and we’re still going to be constantly be able to add to the portfolio if this does continue. Certainly, our impression today is that it’s the nature of it; [it’s] probably not over.

BT: I think the other thing too is that, as long-term investors like we are for clients, as counterintuitive as it is -as you mentioned- you have to actually embrace periods like this because they create fantastic opportunities, and so what we’ve done is we’ve taken profits on certain positions over the last several months, we’ve reloaded the cash position with those profits, and now we have levels on certain stocks where you start deploying that over time, but I think the best way to describe it is this surgical process that we try to execute with selling it levels that we like, and then having it taking profits, and you’re constantly reloading the portfolio. At the same time, you have all of the high yield portions of the portfolio spitting an income every month, and then there’s more money to deploy over time. The other one -I’ll just push back onto you- is just to square up that the last comment, we discussed about the economic outlook, and what’s your view on the timeframe for this global slowdown to push through? And if we were to look at a chart of 30 year interest rates, you’re at now historical low levels, and so what does that mean for what the Fed likely has to do to this and also the outlook for equities versus bonds now over the longer term?

BH: Yeah wow, we’ve got another 45 minutes.

BT: Yeah, we could talk for hours but we don’t want to bore people.

BH: Interest rates now look like they’re at an extraordinary low. It was just at Christmas time; we were talking about the 10-year because it’s about businesses and how businesses can borrow money. The most important interest rate is the US 10-year rate, which is where a corporation funds -not about us and buying our houses. The stock market is based on businesses and that’s the important number. So, two months ago that was roughly 2%, 1.9 but going to 2%. Now it’s almost 1%, it is down 50% in two months but from an absolute level, 1% is what you’re going to get in the bond market, which is just not a great rate of return for how much risk you’re taking. What’s implied in this for us is that we are equity investors, you’re getting a great deal owning a big stable business that throws off money. A situation like this creates a buying opportunity, knowing again that this is what we do, we’re in the business of buying businesses. We’ve got dividends, we accumulate them, and we keep buying, and buying, and buying stuff so this by definition has to be -ironically- a good thing but it’s just like you don’t want to buy the falling knife. That’s the probably the biggest issue we’re dealing with today and this week is that: is this falling knife? Are we just about to buy it a month from now saying “oh that was a bad idea.” So can we protect ourselves and buying the businesses we’re comfortable with? We know are comfortable at this level anyway. I think the point that I probably would have brought up earlier was that you don’t have to fly into the eye of the storm. This was just last quarterly letter to discussing Microsoft and how expensive it is, and a 1.3 trillion dollar company, and how on earth is it going to double in size, and the answer is well the numbers really were ahead of itself, but that doesn’t mean we have to go right back into Microsoft or Apple. So, we can actually say that this was the eye of the storm, all that money went into these stocks. When it’s going up you have to be over-weighted when you know for an investor that’s trying to beat the market, when the stock is going down you have to be underweight so everybody has to get underweight fast, in which case you don’t really know where Apple or Microsoft is going to settle out. So, let that go to somebody else and we can focus on things that other people aren’t looking at.

BT: So if we were to wrap up on this point of saying so as we discussed, as painful as it is in weeks like this, today is the day we’re actually putting money to work some of the money that we have been storing up for months now -which is a great time to be deploying a little bit. But having cash, having income, having these other different yield sectors, whether it’s real estate, or infrastructure, utilities, generating a lot of a lot of cash in the portfolio, how would you sum up the strategy now for the next six months as we go through this period of what will be slower global economic growth?

BH: We’re in a position now to pick away at things, and so today’s the day, might be two weeks from now where we see things again. We certainly would like to focus on those key parts of the economy which is: health care, technology; these are great businesses, but they’re quite often expensive and so this might be a chance for us to actually get them, or they’ve got these other industrial businesses that are beaten up but they’re very solvent, great long-term, core the economy businesses with dividends, and we can buy them and sit on it, and just accumulate income over time which is really the core of the strategy.

BT: Why don’t we wrap it up there. Thanks for the conversation and look forward to the next one.

BH: Yeah exactly and it will be interesting.

Recorded on January 23, 2020

In Episode 2, Bill Harris and Bryden Teich discuss how global stock markets are currently being impacted by central bank liquidity and relate that to previous periods of market exuberance. They also discuss the signal that the underlying economy is sending at the outset of 2020, and they discuss the outlook for the Canadian energy sector.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

Bryden Teich (BT) | Bill Harris (BH)

BT: So if we were to start off, we originally had a different topic that we were going to discuss in this week’s podcast but I think with what’s happened in the market and sort of the extreme week that we’ve had, we thought it would be a great time to sit down and have a conversation about what’s happening out there and what we’re doing about it. And so, if you were to take a look at what the week has been, how would you sum up how we got here and what has led to this kind of period of volatility in the market?

BH: Yeah, it’s as exactly as you framed. This has been an extraordinary week and so it’s actually interesting; I’ll even frame it to the point of view that most people in their daily lives really don’t pay attention to the stock market that much. Then you can even have an economy slowdown and you’ll look at the market on the weekend or a couple days later and say, “oh wow, I didn’t really know this was all happening.” But because you’ve got the virus, and the story of the global proportions, and then the stock market reaction, this is really an extraordinary week. So again, as you introduced we were going to have a different talk today, but thought that this was important to touch on, and certainly in the last 48 hours we’ve had lots of calls and emails, so this is absolutely top of everybody’s mind.

BT: Yeah and it’s a great medium to discuss what’s on our mind and what we’re doing about it. The last conversation we had was almost a month ago now, we talked about this idea of really low interest rates, a lot of money in the financial system, a lot of the money had gone into stocks, and this indexing effect that we hadn’t really seen how it was going to shake out. Our view had been, you would probably hit a wall and the market was going straight down because of this cascading effective indexing and leverage in the system. And so, if you were to sum up that index effect: how big of an impact do you think that has had on what this week has been like?

BH: Yes really standing back and saying over the last couple years, what’s really happened that’s changed the stock market is that there are no longer individual people, individual stock brokers, making individual ideas, or even portfolio managers at insurance companies, pension plans, sitting in a chair saying I want to buy this sell this. More than 50% of participants are participating in the stock market using indexes. So when you make buying decisions, you’ll be making them gradually, how do you feel each day, the market will then work its way up gradually but we’ve always felt over the last two, three years that “oh this indexing thing is really going to change the nature and tone of the market.” When you have an event or a crack, our expectation would be it’s going to go straight down. This is really the first time we’ve tested it, and so going back to where we were just this time last week, we were at all-time highs, incredible ounce of liquidity -jargon [that] just means the central banks can create money, there’s no real place for the money to go but into hard assets like houses or into the stock market, so it gets pushed into the stock market and it just goes into the index and drives the stock market up, and the biggest names get the most money. When it rolls over, there’s just there’s nobody to buy it – everybody is just an incremental seller, and we’ve seen this week -just five days in a row- absolutely straight down.

BT: I think the remarkable thing is sitting at the screens all week, and this and looking at the gapping down of markets to that effect. That’s sort of the technical way of saying there’s just at lower and lower levels there haven’t been buyers, and so you used to have the shock absorbers which were the banking system which would take on positions on the trading desks. The shock absorbers for the market have long been gone with a lot of the regulations that’s happened in the last decade, and then you’ve amplified this with indexing, and you’re just get to a point where there’s just no buyers at certain levels and this idea of when you get it in an overvalued market or extreme valuation market you have sentiment at all-time highs or close to all-time highs, and you hit a wall and the market goes down really fast, really quickly. So, if we take a step back and say, these are things that we’ve been preparing for, for months and how we’ve positioned our strategy. What would be some of the key points that you would touch on in terms of how at Avenue we’ve surgically been preparing for this for quite a while?

BH: Yeah, I’ll absolutely hit that one and I’ll throw it back to you because of the work you’ve been doing. Even though we’re at all-time highs, and sentiment was positive for the stock market, we’d actually seen things that were eroding inside. This is laying out that case that the indexing was going to change the nature of the markets means that you actually have to do it ahead of time. We then as a strategy say we want to own stable income producing companies, but you have to be really careful in valuation that you don’t own anything that’s really expensive. So we’ve spent, certainly last year, that’s where something like Microsoft that we had owned for 10 years, and then coming into this year, we’ve sold Apple, look at trying to move the money into less expensive stocks, but our hit list in the last few weeks of taking off technology, taking about down energy, we’re in a position of being 22% cash and gold ahead of this, which this time last week was actually quite an uncomfortable position, but defending it saying I don’t know what’s going to happen but we have to be ahead. I’ll just comment that first thing on Monday morning, we came in and said, “okay, this is very real and let’s tear the portfolio apart, what is it that you want to do?” – Paul Gardner participating in that meeting. There wasn’t anything that was an obvious air pocket under the valuation. So it’s interesting coming into this week: there wasn’t anything else we were going to do, except then you’re starting -which is very different mental mindset- saying actually let’s spend all week trying to figure out where we want to put this money when we get an opportunity.

BT: Yeah, I think the other thing too is that when you get to periods like this, or weeks like this, where if you look at it on a shorter-term indicator, we were oversold three days ago; cascading down Monday, Tuesday, Wednesday, and then to have Thursday and Friday, this capitulation pushed down. I think if you look at one of the indicators we’d like to look at which is how many stocks are above their 200-day moving average, and overlay that with the index, when you get to these extreme levels -I think yesterday was about 32% –  as uncomfortable as it is, we know we have to be doing something because with the volatility index -the VIX- at close to 42, with stocks now significantly below their moving averages, as painful as this is, this is actually where, surgically, we go through and implement our plan. I would say we always have a list of stocks that we’re looking at, and we’re always having levels in each one, where we can be buying but you have to methodically have that planned out, you know kind of months and months in advance and now this week has been a great opportunity to start executing on that. The other thing too is when you look at having a bigger plan like this, sometimes it’s easy to sit in a meeting and talk about what you want to do and then all of a sudden that the decision-making process gets accelerated very quickly. So, us having the ability to react on our feet, be quick, execute our plan, know what we’re doing ahead of time, you have to have a Zen-like feel to what we’re doing. I think what was interesting is a lot of market participants the last number of months felt like there was a laundry list of reasons to explain why things were so great, and from an economy perspective, manufacturing, employment, we’ve been watching that a lot of these things have been soft now for months. So, the nature of this virus and the longer tail impact on the global economy is still far from certain -what this looks like even out six months- and so that’s very different than what previous sell-offs had been, where it was a tweet and the market would go down 8%, and there’d be another tweet and the market would go back up; this is very different. In our preparation we’ve been ready for this for a while, and it’s just been a matter of going through and implementing our strategy.

BH: I think this is the one of the harder points about doing this. As you said, we’re at our desks, we’re watching what we own, why we own it, looking at the numbers come in, and from a client’s point of view, I empathize. This is probably the hardest part: you’re seeing the headlines, you’re anxious, and so we know the businesses and say, “we own great businesses. There are fantastic amounts of dividends that are coming into the portfolio. We’re already defensive ahead of time” and so even though there’s this nervousness, it seems counterintuitive that we’ve had an extraordinarily bad week, and today we actually spent this morning -already an hour and a half- saying where we going to spend 2-4% of our money by the end of the day even then knowing it’s still might be worse by the beginning of the summer. And so how can we know that we have a good valuation, make sure we’re getting a dividend, and which case we can ride through, and we’re still going to be constantly be able to add to the portfolio if this does continue. Certainly, our impression today is that it’s the nature of it; [it’s] probably not over.

BT: I think the other thing too is that, as long-term investors like we are for clients, as counterintuitive as it is -as you mentioned- you have to actually embrace periods like this because they create fantastic opportunities, and so what we’ve done is we’ve taken profits on certain positions over the last several months, we’ve reloaded the cash position with those profits, and now we have levels on certain stocks where you start deploying that over time, but I think the best way to describe it is this surgical process that we try to execute with selling it levels that we like, and then having it taking profits, and you’re constantly reloading the portfolio. At the same time, you have all of the high yield portions of the portfolio spitting an income every month, and then there’s more money to deploy over time. The other one -I’ll just push back onto you- is just to square up that the last comment, we discussed about the economic outlook, and what’s your view on the timeframe for this global slowdown to push through? And if we were to look at a chart of 30 year interest rates, you’re at now historical low levels, and so what does that mean for what the Fed likely has to do to this and also the outlook for equities versus bonds now over the longer term?

BH: Yeah wow, we’ve got another 45 minutes.

BT: Yeah, we could talk for hours but we don’t want to bore people.

BH: Interest rates now look like they’re at an extraordinary low. It was just at Christmas time; we were talking about the 10-year because it’s about businesses and how businesses can borrow money. The most important interest rate is the US 10-year rate, which is where a corporation funds -not about us and buying our houses. The stock market is based on businesses and that’s the important number. So, two months ago that was roughly 2%, 1.9 but going to 2%. Now it’s almost 1%, it is down 50% in two months but from an absolute level, 1% is what you’re going to get in the bond market, which is just not a great rate of return for how much risk you’re taking. What’s implied in this for us is that we are equity investors, you’re getting a great deal owning a big stable business that throws off money. A situation like this creates a buying opportunity, knowing again that this is what we do, we’re in the business of buying businesses. We’ve got dividends, we accumulate them, and we keep buying, and buying, and buying stuff so this by definition has to be -ironically- a good thing but it’s just like you don’t want to buy the falling knife. That’s the probably the biggest issue we’re dealing with today and this week is that: is this falling knife? Are we just about to buy it a month from now saying “oh that was a bad idea.” So can we protect ourselves and buying the businesses we’re comfortable with? We know are comfortable at this level anyway. I think the point that I probably would have brought up earlier was that you don’t have to fly into the eye of the storm. This was just last quarterly letter to discussing Microsoft and how expensive it is, and a 1.3 trillion dollar company, and how on earth is it going to double in size, and the answer is well the numbers really were ahead of itself, but that doesn’t mean we have to go right back into Microsoft or Apple. So, we can actually say that this was the eye of the storm, all that money went into these stocks. When it’s going up you have to be over-weighted when you know for an investor that’s trying to beat the market, when the stock is going down you have to be underweight so everybody has to get underweight fast, in which case you don’t really know where Apple or Microsoft is going to settle out. So, let that go to somebody else and we can focus on things that other people aren’t looking at.

BT: So if we were to wrap up on this point of saying so as we discussed, as painful as it is in weeks like this, today is the day we’re actually putting money to work some of the money that we have been storing up for months now -which is a great time to be deploying a little bit. But having cash, having income, having these other different yield sectors, whether it’s real estate, or infrastructure, utilities, generating a lot of a lot of cash in the portfolio, how would you sum up the strategy now for the next six months as we go through this period of what will be slower global economic growth?

BH: We’re in a position now to pick away at things, and so today’s the day, might be two weeks from now where we see things again. We certainly would like to focus on those key parts of the economy which is: health care, technology; these are great businesses, but they’re quite often expensive and so this might be a chance for us to actually get them, or they’ve got these other industrial businesses that are beaten up but they’re very solvent, great long-term, core the economy businesses with dividends, and we can buy them and sit on it, and just accumulate income over time which is really the core of the strategy.

BT: Why don’t we wrap it up there. Thanks for the conversation and look forward to the next one.

BH: Yeah exactly and it will be interesting.

Recorded on January 7, 2020

Bryden Teich and Paul Gardner discuss Avenue’s outlook for interest rates and Federal Reserve policy as we enter 2020. The past year saw a significant change in policy from the U.S. Federal Reserve with three interest rate cuts and a significant re-expansion of their balance sheet starting in September. The conversation touches on the economic outlook for both the United States and Canada and the impact on interest rates and stock prices.

Information relating to investment approaches or individual investments should not be construed as advice or endorsement. Any views expressed in this podcast are based on information available at the time and are subject to change without notice.

*Listen to the audio for the full conversation

Bryden Teich (BT) | Paul Gardner (PG)

BT: One of the things, obviously last year was such an incredible year for interest rates, where you had 2018 peaking at three-and-a-quarter on the 10-year in the US and the bias that has been felt for a couple years of saying, “Oh, we’re going into a higher rate world” finally felt like it was happening. And then 2019 just came back and more, and sort of the volatility of rates that are now collapsing and if you look at the long-term history of interest rates where we are historically you’re in this unprecedented low-level, and so what’s your view of that volatility last year, and what do you think the bond market is reflecting?

PG: Last year was a really interesting microcosm of the bond market because it was like a two-headed investment – it was two-headed snake in a way – because you had rates going up aggressively and everyone, everyone was saying, “The US is about to see three-and-a-half yield treasury or 4% treasury.” They always do this at beginning of the year. They always overestimate the yields, and they’re always mistaken, and then yields drop. Well, we saw what happened with the trade war; we saw what happened with the weakening global economy; and it just completely -on a dime- reversed itself; very nasty and very aggressively. And we were always kind of in that defensive mode for bonds just because the risk-return of being very aggressive wasn’t in our favor but at that time you still have to be invested and it’s still a relevant asset class too. So, in the end, there was a thought that the best you’re going to get is a coupon yield. You actually got capital gains. Whether it was our bond fund or the index, you’re talking roughly around 6-7% rates of return from the bond market where everyone hated it in the first quarter of 2019.

BT: It felt like there was a couple years of rates being low and inching up, and from a capital gain perspective there wasn’t much. There was just the yield; but it feels like that excess return for 3-years’ worth of it, all came in the last year on a capital gains side. I think the one that you said that was also is important is this importance of fixed income as an asset allocation tool, where you had a tougher stock market in 2018, but then having fixed income alleviated that sort of overall rate of return even in a tougher year.

PG: Even internally we had this discussion about how relevant are bonds for clients? Now we know that capital preservation is foremost important, but also you want to rate a return so we’re struggling with clients who kept pushing back on saying “Why do I got to be in the bond market if not going to make any money” or “It’s low-yield environment” but at the same time you have to balance two bonds just for that rainy day or that capital preservation. But what they what did change – and we had this internal discussion at Avenue – was that we always talked about theoretically everyone needs, at retirement, at least 6-7 years’ worth of bonds to cover the volatility from the equity market. So, everyone’s invested in the equity market. What you can’t do is pull money out of your investments if the equity markets down. So that’s why there’s a need for the bond market. So, the debate that went on internally was “Maybe that’s too conservative. Maybe we don’t need 6-7 years of bonds. Maybe it’s more like 4 or 5” and that’s how we left it, and that’s why we had thought over the last year there was a chance for lower exposure to fixed income even though it’s still a very relevant asset class. Of course, that depends on individual circumstances. But going into 2020, there’s been a lot of interesting stuff that you have looked through as well. I saw some charts that you showed me, and I’ll throw it back to you on 2020, but then I’ll give you my cut.

BT: So I think the most interesting thing – if you go back and really dial in on some of the things that the federal reserve has said the last couple meetings – is that you had this really aggressive about-turn by the Fed in early 2019, after they hiked in 2018, into a tough market, and then you had the three cuts this year and at each meeting it was very well-priced in that the Fed was going to cut. Then the last two meetings, they’ve now been on hold but the language around the Fed of finally realizing the difficulty in creating inflation and they have this aggressive view that they have to get inflation higher, and so this idea that they’re not going to cut unless you see sustained and persistent inflation. I mean to hear a Federal Reserve Chairman say that, that is extreme, and it didn’t really get as much [broad] play.

PG: No, that was a really big thing for me; a transformational kind of moment. It’s always very boring – this fed [speech] – you don’t get much from them, everything’s more or less obvious, but I thought it didn’t even really resonate with any of the investment community. I thought that speech where they basically said, they’re going to not raise rates until they see inflation sustainably above 2%, and then you overlay that with the Trump administration’s obsession with lower rates, and then you look at the global landscape where I think there’s a real possibility that not only the Fed doesn’t raise rates and they try to get inflation hotter – and the ingredients are there for it to get hotter – it’s just I’m a little suspect on if we ever can see high inflation because Japan has been running this model for 20 years to ramp up inflation. They had negative rates they’ve done everything possible. The problem with Japan [is that] it’s a society that doesn’t allow immigration. Its aging population is probably around 65, so there’s a natural structural deflation embedded into Japan. So that’s really not the greatest test case, so then we move over to Europe, and they’re more or less trying to do the same thing. The trouble is they’re policies are so archaic, and so behind, and they’re so structurally fixed; so with that, it’s also a hard example to kind of flow through so the US is finally probably going to enter into this zone of “How do we create more inflation?” because they have so much debt that they have to try to inflate their way out.

BT: Yeah, I think that’s the psychological thing that’s happened. I think they haven’t expressed it directly but I think they realize that you have to be at a point where you’re real yields or real interest rates are at or close to zero because that’s the only way that you’re slowly defacing the value of the currency. I think the view a couple years ago is that you’re in this better growth environment, you’re going to go to positive real yields. And it seems like the economy couldn’t take it for more than a couple quarters of actual positive real yields. Then all of a sudden, we come back down to what is basically a zero real yield but that’s a way that they can debase the massive amount of debt that they have

PG: If you look at the ingredients of inflation – like I said those couple of prior examples weren’t the best case scenarios because they had they had individual or they had country specific issues, but if you look at the US – we have full employment; we have easy monetary policy; and we have capital spending, our investment infrastructure spending; and most importantly the consumer is incredibly healthy. So generally, what happens in recessions is you’re trying to save the consumer because the consumer has high unemployment rate, the consumer is restructuring, they’re bankrupt, or they’re over-levered. Well that’s not happening in the US. We have savings rates of now 6-7% which is huge in the US; the consumer’s 70 percent of the economy, and now you’re juicing up the system. So, I have conviction on this idea but I’m not going to go all in and what I mean by that is I still don’t know if we can see structural inflation again. But this will be an interesting time because with the Fed on hold, you’re going to have this enhanced fire pushing onto the consumer because they’re already hot, so this might be the chance. Another thing is, this is the first year – I can remember that all the strategists and the economists – they’ve always said higher treasury rates every year at the beginning of the year – three percent, four percent, five percent – they’ve always talked about this and they always been wrong other than maybe one year in 2017. But what’s interesting is now everyone’s so used to that, they all think rates are going down, so that’s anecdotal proof to that, but you’re also given something on a contrarian view that this might be the year that they get it wrong, and then rates do climb higher. And when I say rates climbing higher, I don’t think it’ll be substantial but then at the same time, it might be big because if we do see inflation then what do you think the bond market is going to do? It’s going to react violently to that because the bond market has never believed in the equity markets inflation story. The bond market has always thought that there’s massive disinflation in the global economy, but if we did see a whiff of inflation then you actually might get the bond market to really adjust. And what does that mean? You see the yield curve go up and you also see the yield curve steepen. So, one of the biggest positives of the bond market of the last ten years have been is the long-term bond rates, you know, ten years and higher. Well that might reverse itself because you’re going to get a steepened yield curve and you’re going to suffer price losses. So, where do we end it? The question is then, what do we do with 2020? So, we go into it no different than last year; always trying to get duration up because we’re always struggling with duration. We tend to be short-term buyers of corporate credit -and we can kind of go into the credit markets after this because there’s a dynamic there that’s really strange that you’ve talked about a little bit- but the fact is that we’re going to be slightly conservative and slightly negative to duration in getting ready for that possibility of higher rates. I’m not going to like I said put all my money on black on this idea, but I just need a little more proof because the ingredients are there for this to play out. That being said, my forecast is this year, you’ll probably just get a coupon return of maybe 3%. I don’t think much more.

BT: I think it’s interesting -having worked with you for a number of years and always trying to see and feel what you’re thinking- the one thing you touched on which was for years everyone said rates were going higher. Every year it was at same drum beat in January, and I totally agree with you. To see it have reversed, of now everyone saying rates are going to be here or lower, it shows you the shift in market sentiment. I have not seen a year mis-positioned like this, where you do have the view that rates going higher as a contrarian call and/or slightly contrarian. It just shows you that if you do have -to your point- inflation expectations change a little bit, or you get oil higher, or you have this cyclical growth recovery, there’s no reason why in the long end [of the yield curve] you can’t steepen 50 basis points or 1%. At that point, a lot of the views that are being expressed now that are offside about, “you know rates are going to collapse lower” because the other thing we didn’t really touch on yet is this idea that not only is the Fed easing and keeping rates low, you’re still pumping a trillion dollars of new deficit spending into the economy in the US this year. You’ve got the consumer that’s in good shape; you have the Fed that’s easing; and you’re still massively expanding on the fiscal side by 5% of GDP again; this year is going to be in deficit. This idea of, you’re running incredibly stimulative policy when you have inflation or you have unemployment at 3.5% and a basically full economy, you’d have to go back 50 years to see this kind of an aggressive policy and a lot of that speaks to also the sort of political, divide where everyone wants to take credit for all the good things, and the bad stuff is everyone else’s fault. But the Fed, this year, had to start re-expanding the balance sheet because all this excess issuance from the treasury was basically bloating the balance sheets of all the broker dealers and now the Fed has had to step into the T-bill market and repo market.

PG: So, can you talk to the audience about explaining that dynamic, what happened in September?

BT: So what happened in September 17th was that in the overnight rate market …

PG: Which is the funding market for all these US banks of the world…

BT: So basically, it’s the cash market for overnight lending and you had rates very quickly spike up to, I think they topped out around, 10% overnight; which means for one-day money, interest rates were 10%, which just shows you the Fed had been on this program of decreasing the size of their balance sheet, pulling liquidity from the system, quantitative tightening is what they call it, and you hit this mini crisis point in September where all of a sudden there wasn’t enough cash in the system, and so you had short rates spike because of that. The Fed was very quick on the case with regards to that, and a week later started doing a repo, started expanding their balance sheet with T-bill purchases. But the amount of liquidity that the Fed supplied, if you wanted to pick the day the S&P bottomed in October and was on a hockey stick into the end of the year, it was on the day that the Fed basically came out and said we’re going to be expanding our balance sheet again, and taking this liquidity…

PG: Yeah and that’s really telling because in regard to that overnight issue, it’s a technical issue, basically there’s just too many bonds chasing, and not enough dollar bills. I’ve seen this historically where, of course during the Fall of every year, there is liquidity issues but this only lasts for a week, for three days, for four days. This seems to be permanent and that leads me, once again another piece of the ingredient, is you have systemic debt issuance in the US that’s not turning around, and it’s probably going to get worse because if you do have a recession, the deficit is going to 2 trillion – which isn’t sustainable. It’s only sustainable until it isn’t, and we’ve always said that you can never pick the day that you don’t buy another US treasury bond but there will be a day if it keeps going like this -I don’t know if that’s two years, I don’t know if that’s five years or ten years- but there will be a day where you just go, “I’m bidding out.”

BT: I think the other thing that’s interesting that ties into this is that if you look at how the current administration has weaponized the US dollar in tariffs and globally, they’re running economic sanctions against the world and using the dollar’s strength to do that, but the one thing that’s really changed the last couple years [is] if you look at the issuance of T-bills or treasury bills that are being bought by foreigners -so foreign governments, foreign central banks- that’s now collapsed to really low levels. So, you have these massive deficits: foreign governments and foreign central banks aren’t buying your paper anymore and so that’s where the Fed has had to come step in and be buyers of T-bills. They said originally it was a year-end tax problem and it was going to be a week; they’ve been buying five billion of T-bills every day for three months. They’ve been caught in a situation.

PG: Yeah, I think we can talk about the dollar a bit right now because it flows through into the dollar conversation. That you have a Trump administration, you have the federal reserve, and you have the dynamic of the global economy which is: good growth, not great growth gives you the ingredients that the sundry currencies or the emerging markets or the non-US led currency such as Canada or Australia or Europe, all slightly doing better in December and they’re breaking technical levels that we haven’t seen for a while. It’s set up for a very bullish run in non-US currencies -well anything against the US seems to be doing better. Of course gold is another ingredient on why we think that -and we’ve talked about this over the last several weeks- that the US dollar is really vulnerable over the next two years.

BT: I think that for the last couple years it kind of felt like you were entering this period on the policy level, where things were setting up for a weaker US dollar but then you had this period where it was still a better growth environment in the US versus globally, you had the US stock market ripping, buybacks, all this stuff. So all of that forced dollars into the US system so you were strengthened with the US dollar because of that, but it feels like all of those things now are going back the other way: you’re having better global growth, Europe looks a little bit better, emerging markets look better, Asia looks better, you have at least a trade truce, whether this phase one deal is anything at all. But this risk on sentiment that’s changed -and at the same time the deficits exploding- the sustainability of the strength of the US dollar, I think is really starting to crack. And I think that all you need is the Fed to continue easing, or there to be more expansion of the balance sheet, things that aren’t priced in for that to change. I think the other thing that I think would be interesting to talk about is, you’ve now had 5 years of negative interest rates in Europe, so you had to change in the ECB recently with Christine Lagarde, and this negative Europe view and the negative Euro view for so long, that have really allowed the US dollar to maintain its strength. But the one thing that’s interesting is that, the Swedish central bank which was the first to go negative in 2014, now basically said “This isn’t working anymore. We’re going to take our rates back to zero and be done with it.” And you’ve had for the first time a really significant strengthening in the Swedish currency Krona against the US dollar and all of that is just saying, “We’re no longer negative, we’re going back to zero, but it shows you how much pessimism was built these other currencies. So what is your view now and what the euro looks like and this shifting winds of central banking in Europe? Do you think that there’s a chance that even if the ECB says “We’re going back to zero. Things aren’t great but we’re going back to zero because negative interest rates don’t work.” That you could have this kind of whiplash in a bond market maybe in Europe about where you have still all this debt that’s trading at negative yields.

PG: I have less conviction on the euro because the euro would generally go stronger and it probably will, but there’s so many structural issues in so many political issues in Europe; but if we take the same thought process and put it upon Canada -let’s use Canada because of course, we are way more exposed to Canada because that’s our portfolio and how we manage money but let’s talk Canada- and you could make the case that Canada could be really strong over the next two years, let’s go through this: oil prices have gone up recently, and they haven’t gone up as much as you would think they’ve gone up considering all the geopolitical events that’s happened over the last two years or sorry two weeks, so that that’s positive. Relative budget deficits as much as we can cry about the liberal deficits that are happening and that are about to happen, they’re still within the spectrum of normalcy or spectrum relative to other countries. You’re talking 1% deficit to GDP on Canada, you’re talking in the US at least 4%, if not 6%. Two, the economy’s generally decent here and never forget that immigration in Canada, which we generally like, adds about 1% of GDP growth just by all the immigrants coming in here so it’s a net positive to the economy because demographically we’re in the same situation as Japan or most other countries. We’re not having enough babies, so by that default, we need to have immigration come in because we have almost full employment.

BT: You know what’s funny? I think Canada is seen as a country in a world where a lot of people want to come to, if you’re coming from other countries, and it’s really been of a huge boost to growth the last number especially the GTA, in Ontario, and in Quebec.

PG: Right let’s now look at foreign investment which is stagnated for years because of the perception that we’re not business friendly and that hasn’t really changed too much. But the fact is when you go through the global investing world, if you’re not interested in investing in the US well, do you want to invest in Europe? There are so many problems there. Do you want to invest in Asia? You wouldn’t want to invest in China or even Japan. You start whittling down, you could say, “Canada’s not a bad spot and they have the gold, the oil, the pipelines” as much as we’re yelling about it, they’re still, I would assume, Trans Mountain and Enbridge Line Three is going to be completed in 2022. Then most importantly, no one’s really talking about this, the fracking revolution in the US is either slowing down because of bankruptcies and capital destruction, or the depletion rates of these wells which are inherently very quick unlike in the oilsands which are more manufacturing, the decline rates are much lower, where decline rates in fracking are in 40-60%, and we haven’t seen that roll over. So for the moment we see 13 million barrels a day -up from 8 from five years ago- crazy. so if you start seeing it just slow down, stop, or reverse, then you start seeing a premium into Canadian oil.

BT: And then if you have the pipeline capacity coming on at the same time, and then all of that just changes the sentiment. I think the difference is that there’s an arguments to be made where Canada’s improving, but I think the current moves in the US dollar or the strength in the Canadian dollar which has been one of the better currencies of the G10. The other thing that’s interesting is if you look now at central banks around the world, so if you look at the Fed, ECB, the Bank of Japan, all of them are expanding their balance sheet, or basically manipulating overnight interest rates or the currency through their balance sheet. Canada is the only G10 central bank that actually isn’t manipulating its balance sheet – there is no balance sheet. You’ve got this almost tightening and one thing I thought that would be interesting to talk about is: in 2015, you had an opinion piece that you wrote for The Globe and Mail about those first few central bank cuts that Stephen Poloz has had. If you remember back [then], the oil prices had cratered, and Canada was very quick to come out and cut rates twice. I think it really hurt the currency at the time. The view was that, things aren’t that bad, that was maybe too aggressive, but I think the interesting thing is that the Bank of Canada was actually the only G10 bank last year to not cut rates and so to see how sort of the view of Stephen Poloz was that he was the former Head of Export for Canada. [He] was a very weak-dollar-person and pro-export and the way the central bankers can lower the currency you get more exports, that was a growth way. To see how sort of steadfast he was of saying “We’re not cutting rates, the economy’s okay, it’s improving,” I think did a really strong job stewarding.

PG: We had the free trade agreement signed in Europe, the CETA.

BT: Yeah and then the USMCA. But I think he did a really good job this last year, steadfast in the face of all these other cuts from central banks. What would be -evaluating the Bank of Canada, now that he’s retiring in the next month- what would be your view of central bank policy in Canada?

PG: It’s kind of alone globally, it’s really in a situation where they don’t need to lower rates. If you’re going to lower rates, you are going to spark the housing market which the Bank of Canada has been obsessed with -keeping consumer indebtedness at high level. I have issues with that stat but I don’t have time to go into that, but things are lining up where the Canadian economy is doing quite well. Quebec is doing amazing, we have the infrastructure, we have the immigration, and we have it seems like the tone in place for increase employment from the tech sectors, whether it’s Vancouver, [and] Calgary. We have really high value immigrants that are coming in whereas the US is basically shutting it down. So just as an aside, we have a building going up across from us and it’s going to be completed next year but I think Google’s taking the whole building, so it’s kind of crazy.

BT: I think a lot of the technology companies you have now that have moved to Toronto, or Vancouver, or this kind of Waterloo-Toronto corridor have a pool of talent. You have a highly educated workforce, you’re paying people less than you would in Boston or San Francisco, because obviously currency is lower, cost of your wages for employment high quality employees is lower, so there’s this huge attraction to Canada.

PG: Plus, we have the same rules of law, I would now make the case that we have higher rules of law than the US since they always seem to put tariffs on. One of the things that that’s really important is -because we have to get back to the investment side- is that global money managers mark Canada as a 2% weighting globally because that’s actually what it is, it’s 2% of the global GDP and so all you need is a global manager, a bunch of them, and they’ll have the same thought process. Coming into a new year, you look at rebalancing all your global weightings and go “You know what? Canada should probably go to 3% or 4%.” What’s crazy is going from 2-4%. Let’s say they do that, that is so massive towards this small economy that it’ll be so much money coming in that it could move the Canadian dollar, maybe five cents over a course of six months.

BT: I think if you look at where the dollar is, it’s really interesting because sentiment has been super negative for a number of years, positioning has been negative for a number of years, but really, I mean, if you look at a longer term chart of the US dollar and the CAD it really peaked out in January 2016 at just under 70 cents. That was kind of the capitulation moment where the view was that the Bank of Canada was going to cut again, and they didn’t, and that kind of put in the floor for the time being but Canadian dollars actually been in a pretty nice uptrend since then but because it’s still at a low relative level people look at it like “Oh…” but if you look at rate of change and the directional move you’ve actually been strengthening now for a couple of years.

PG: And it’s gone up by stealth because it’s a weak US dollar story, it’s not a strong Canadian dollar story, but in inherently the reverse is true. The Canadian dollar is strong as you mentioned, it was the strongest in 2019, and did you see any headlines on that? Very little. There’s this thing going on that I think the sentiment is so terrible for Canada globally from investing, that we know it’s turned around and it’s just a matter of time until they recognize it because the global investors are very scared about buying S&P at these levels, so it’s all relative when you have four stocks comprise of 80% of the gain last year. FAANG stocks created -just so you know- what, 80% of the NASDAQ return which is crazy. So that tells you that there’s real elevated levels and then when you look at Canada, there’s so many value stocks here whether it’s Enbridges or…

BT: Yeah, it’s kind of a cyclical, energy, materials, financials…

PG: We’re still noted as that, but I would say we’re less so but anyway, maybe we can tangent into the credit…

BT: The one thing I was going to ask about was the amazing thing that happened last year as rates were really collapsing in the US, and so bond prices going up, you had BB or BBB credit spreads at historically tight levels, but one of the views that’s been expressed by a few people -it’s kind of a contrarian view and I’ve seen a couple good articles about it recently- but it feels like the same issues are creeping in with the rating agencies where a lot of bonds on the credit side -both in the US and Canada- it feels like it’s being mis-traded again and you have this demand for more lucrative credit ratings, than the companies probably actually deserve, and some Moody’s, DBRS, S&P, Fitch, all of those that are now back being complicit in the huge blowout if you look at debt issuance on the corporate side in the US. Based on your historical experience and views, what are you sensing with regards to credit ratings, and do you see that kind of manifesting?

PG: Well first of all, it’s expensive. The credit market bonds with ratings, with corporate credit -not only was there a record issuance last year- but it’s an expensive category. So unlike what we just talked about on the bond side, interest rates side, and on the currency side where it’s a relative gain, I look at the credit market in the bond market as an absolute gain meaning that it’s hard for me on a BB or on a B+ or CCC whatever you want to use as high yield, to get excited about something that’s trading at Government of Canada’s plus 400 basis points over, when that used to be 700 basis points over. So an absolute level, the risk-reward is not in our favor in the bond portfolio, so for the last year -and it hasn’t helped or hurt us that much- we were very cautious on getting invested in the high-yield space because you’re just not being compensated to be in that high yield space even though we do have some exposure, where I consider us very defensive now. I’ve been waiting for yield spreads to back up, they have not. They have in the worst credits, the CCC’s but we don’t generally invest that. The BB’s that’s still not investment-grade has done quite well. I think the best sector, which we invested in, why we weren’t hurt by our conservative stance, was the BBB market had a great year and we generally invest 30-40% of our portfolio in BBB’s so that did quite well. Going forward, even though the investment side -just as an aside- the investment grade market did incredibly well last year, the high yield market had mixed results to the point where the last quarter I think there was a big sell-off in the high yield market. So, you take that and go, “Even though we’re invested in it, I’m not excited about that sector, you got to be invested in something…

BT: You try to find the highest qualities stuff you can…

PG: And the lowest duration as well. So, we’re still waiting for that moment where there’s a buyer strike in the credit market and the trouble is you need a down equity market which hasn’t happened for 18 months, so you’re waiting for that even though I don’t even know if that’s my view but that’s why from an absolute return basis, I don’t want to buy stuff that yields me 4-5% in the high yields spot and even in the investment-grade spot which only yields you 3-3.5, we do it because we got to buy something, but it’s not making me excited about it. So that’s why we have a lower exposure to it, even though we are exposed to it. I would say, I’m still waiting for this moment where credit markets deteriorate, and then at that point when you have the flexibility, and the money to spend on those markets, that’s where you really add value because in a crisis market or in a down market in the credit markets, if you have a dollar to spend, it’s price discovery when it gets really bad, so you can buy ridiculous yielded bonds at 7-10% sometimes or just because there’s no liquidity. I want that liquidity. I think the value is liquidity in the credit markets. There is not as much value in the high yield markets or credit market.