Transcript
Hello and welcome to The Download. I'm your host, Dave Richardson, and it is mid-year here, so it’s time for a special appearance from one of our favorites, Scott Lysakowski. Scott, how are you doing?
I'm good, Dave. Good to see you. Today is actually the last day of school, at least for my kids. It might be a mid-year check-in on the markets, but the final report cards came home earlier this week and it’s the last day of school. No more teachers, no more pencils, no more books.
I imagine the children of the head of Canadian Equities at Philips, Hager & North. We should establish your credibility here. There's no doubt you're likable, but we should also make sure they know there's a lot of substance behind that lovability. But I imagine those report cards are pretty good.
Yeah. Kids did well this year. They love school. They're enjoying it, but I think they're ready for summer, and so am I.
Big plans for the summer? You're always active. You're all over the place, right?
Yeah. The kids have a lot of plans, and I'm going to be shuttling them around, camps, etc. And we'll spend some time up in the mountains and get some fresh air. We have not had much of a summer yet. It's been pretty cool. We've had some nice sunny days, but not the heat. I was actually in Ontario visiting my family last week, and it was steamy. I know I grew up there, but I do not miss the humidity of Southern Ontario. It was a bit much for me.
Well, let's establish the credibility for my intelligence. While you flew from BC to Ontario, I flew from Ontario to BC and enjoyed a lovely sunny week with moderate temperatures.
Wasn't it nice?
It was beautiful. I loved it. That's why, again, for the final straw — this is where you're going to go up two to one on smartness early in the podcast — because you moved out there. And that's all we have to say. That was smart.
Yeah. I always say I traded three hours of time for ocean and mountains, so I'm okay with it.
Good on you. Everything in between is the rest of Canada. Well, I guess we got the out East, too. And the Canadian market. Well, actually, we like to check up first before we get into Canada, specifically, just mid-year. Let's take a look at the first half of the year. And if we go back and listen to your podcast right at the front end of January when we had you on, we thought this was the way the year would play out. It's been a pretty good year. You've got some very specific leadership in the US that creates a different dynamic in that market. But how do you reflect on the first half of the year and what it's been like for investors?
I would say, generally speaking: so far, so good. It's hard to have a clear view on the economic. The macro factors of the market are really hard to predict. But we thought, as long as nothing bad happened from the economic outlook perspective, then equity markets could actually have a fairly constructive year in delivering returns that would be in line with their longer-term averages. In Canada, the long-term average is about 7 or 8%. For the US, you're looking at 8 or 9%. They certainly done better than that in the US. So if we look year to date — and we're almost at the midpoint here — Canada is up about 4.5% year to date, or just over 4%. So that's pretty good, actually. I know markets don't move in straight lines, but if you took that on an annualized basis, you're looking at 8%, which would be in line, if not slightly above the long-term average. We're up 4%, and that's after June has been a bit of a rough month for Canada, and we're down a couple of points. At the beginning of June, we're up 6% for the year. So that's actually pretty good getting almost a full year's return in the first five months. But we're in a bit of a choppy period here. But I would say the returns have been pretty good. And if you said to me, hey, Scott, oil is up 12%, copper is up 12%, gold is up 12%, silver is up 20%. So commodity backdrop is looking pretty good. You have material stocks up double digit, energy stocks up just over 10% year to date. I would say, that's great for Canada. Canada is probably one of the leading markets out there. However, it is not. So I think one of the things that we've been discussing internally — and I've been reminding people and maybe sounding a bit like a broken record — is that when people look at equity markets, whether it's the financial press, people look at the biggest market, they look at the S&P 500. It is the biggest market. It's got the most news exposure. It's got the biggest companies. And so it should be focused on. But I think what happens is people look at the S&P 500, it's up. In Canadian dollars, it's up 18% year to date. Nasdaq is up over 20%. And the TSX is up only 4%, as I said. You'd say it's trading at close to all-time highs. And if you just look at the headline P/E multiple of the S&P 500, it's north of 20 times. So I think a lot of times, and sometimes we even find it internally, people say, how can you be constructive on equities here, given that the S&P 500 looks so stretched? And I would say that's an interesting observation, but I think it's really important to dig below the surface a little bit. There's an old saying, it's not a stock market, it's a market of stocks. And so if you treated the S&P 500 as a broad representation of broader equity markets, I think you'd probably miss some really important data points, and there's some nuance there. We've talked about the narrowness of the market and the concentration in the US at extremes. And whether you want to call it Mag Seven — or just even as you said, the top ten — the S&P 500 is up 18%. But the top ten stocks have contributed over 75% of those returns. That's great for those stocks, and it's great for those who own the index. But it's important to understand that as you draw conclusions of how equity markets look expensive. If you took the equal weighted S&P — so you take away that weighting and that bias of the concentration of the largest companies — the equal weighted S&P is up 4%. Similar to what we see in Canada. So when people say, how could you be constructive on equity markets? It's not so much I'm constructive on the S&P 500. I'm constructed on everything except that top ten. And that could just be going to an equal weighted S&P. That could be going down cap in the US. That could be buying Canada. But I'm sure if you had a PM from the European team or the UK, they would come and say the same thing. Their market looks pretty reasonably valued, and there's some interesting opportunities there. So what we're really trying to do is share the message of certain markets look stretched or may appear to look stretched, but you got to go below the surface to understand what's really going on there.
Yeah. Well, you've got the benefit of visual, not just audio like we are here. So people can't see your fabulous looking hair today, which is a shame, too. But they can't see these charts. But basically, I put up a chart of the S&P 500 with a valuation model. And I say, okay, well, look, here's where the S&P 500 is. But if I took out the ten top stocks, then it would look like this. And I flip the slide, and then I've got the same valuation model for the TSX. So the rest of the US market, other than those big stocks — and whether it's seven or ten or twenty stocks, but it's a very small number of stocks — if you just took out those top performers, it looks exactly like the Canadian market. It looks like Europe, and it looks like the UK, and it looks like emerging markets. Japan is a little expensive, too. And we won't tap into your Japanese expertise on this podcast. Maybe we'll let you do a few years of prep on that before we start talking about Japan. But other than that, markets look pretty reasonably valued despite the fact that they've had a nice run. They're at or near highs, but the valuation is pretty good. And then, as you were talking about before, if we take Canada, for example, you look at the underlying commodities — and like you say, they're all up double-digit percentage in the first half of the year — then you go, wow, Canada should be great. Well, those earnings are eventually going to come, aren't they, in those companies?
If I were to make the case for Canada, I would make it in three points. The first would be earnings. And notice that I didn't go to valuation because Canada has traded at a discount valuation. And I'll get to that in a second. But there's an old saying — I'm bringing up all these old sayings I learned over the course of my career — cheap stocks are cheap for a reason. Valuation is not a thesis. You need to have earnings. And you need to have earnings growth. That's what the market is searching for. And in Canada, if you look out over two years — and I use the two-year time frame because the shorter term is really hard; there's some economic variables that are out there that are hard to predict over the short term — but if we just closed our eyes and said, I'm a long-term investor, and over the course of the next two years, what's my outcome going to be if I just look at the TSX? And so not for the first time, but when you're looking at earnings in the TSX, I'd say you have two things. You have a fairly normal set of assumptions that are driving the earnings forecast. And I've talked about it many times in this podcast that the Canadian market is very cyclical and very economically sensitive. If we do start to see a material deterioration in the economic data in Canada or the economic outlook, this earnings forecast will be revised lower. But as of right now, on a base case scenario, which is probably more of a muddle-through economic growth — I hate to use the word soft landing, but it's just a moderate growth scenario — over two years, you actually see decent earnings growth in Canada. You're probably looking at close to 20% earnings growth. I don't know how it presents itself over two years. Is it 5% this year, 15% next? Is it 10-10? The way that the analysts forecast it right now, they're showing it pretty even: a 10%-and-10%-type of environment. But we could see something quite different. But if you think about over two years, we're going to get 20% earnings growth. So that's interesting. What is required for that to happen? Well, if we think about the big components of the Canadian market — energy, financials, materials, industrials — that's 75% of the market. You think about the energy sector. The analysts are forecasting 18 to 20% earnings growth over the next two years in the energy sector. And that's not requiring significantly higher oil prices. We need to acknowledge that if oil prices deteriorated materially, that earnings growth would disappear. But in a fairly flat oil environment, we get 18 to 20% earnings growth. You might say, how do you get that? Well, we've talked about it. These companies are growing production a little bit. They're focusing on getting their costs down. They're buying back shares, which makes their earnings go higher. They're paying down debt. So you're getting a decent amount of earnings growth without a lot of oil price requirement. One other thing I'd say on the commodities. We talk about the Bank of Canada and raising rates ahead of the Fed and the impact on the Canadian dollar. And that is a challenge for many aspects of what we do in our economy. But what it is actually really good for is for Canadian commodity producers. We know that commodity prices are priced globally, and they're priced in US dollars. But for Canadian producers, cost structure is in Canadian dollars. So a little bit of an economics lesson here is that if your cost structure is going down in Canadian dollars and the price of the thing you're selling is going up in US dollars, that's a really good outcome for Canadian companies. So that's something I think people probably underestimate, the benefit of commodity producers of a weak currency. So that sets up the 18 to 20% earnings growth for energy. In financials, fairly modest assumptions. We all know there's risks of credit and interest rates and mortgages and all that stuff. We're looking at 8 to 10% earnings growth in the forecast over two years. Typically, financials, banks, would try to deliver that on a one-year basis. So a fairly conservative assumptions around credit and the earnings power of banks and financials, but particularly in the banks. And then if we were to see banks actually return to their targeted earnings power — a lot of banks, when they talk about their forecast for earnings, they talk about an ROE, return on equity. And they target a 15 to 16% ROE. It may sound ambitious. The current forecast that analysts are using is probably something in the 13 or 14% because of the concern around credit. So you have a modest assumptions for earnings power and profitability and credit, if you get 8 to 10% earnings growth over two years. If they return to historic ROEs and earnings power, you're going to get something significantly more. The other big bucket is materials. Those are expecting to see pretty material earnings growth from those sectors. So that would be the copper stocks and the base metals and gold in particular. The thing that we always follow is where is the spot price of the commodity relative to where the analyst forecasts are? Because we can't predict the future, neither can the analysts. Right now, the spot prices for copper and gold are significantly higher than what the analysts are forecasting. So that's going to provide a positive tailwind for their earnings forecast. And for those company's earnings growth. And then finally, you have industrials. You're expecting to see some decent earnings growth out of those companies over the next two years as well. So you build this picture of, I'm going to get 20% earnings growth in the TSX, and not a lot has to work out to the upside. Now, like I always say, there is a downside scenario that if we see economic weakness, that's going to have an impact on all of those sectors I just talked about. If we keep that in the back of our mind, but as a base case, if we just keep muddling through here, there are some decent earnings growth. That's the first point. That's a long winded first point. The second piece is valuation. If you thought about today, similar to that exercise you did, where if you backed out the top ten stocks, the S&P 500 looks fairly valued. Or I often look at the equal weighted S&P. On average, the average stock in the US is trading at fifteen times earnings. It's well within its fair value range, similar to Canada. Canada would be trading fifteen times forward. If you thought about, what am I paying for those two years of earnings growth? You're paying a pretty low multiple. You're probably looking at twelve to thirteen times earnings. Where I say valuation is not a thesis, but we do have to think about it relative to other things you can do. If I go back to the beginning when people say, how can you be bullish on equities when the S&P 500 is trading at north of twenty times earnings, and you compare that with US ten-year bond at roughly 4.5%. Wouldn't we be better off owning bonds? I think I've talked about the equity risk premium or the difference between the earnings yield, which is the inverse of the P/E multiple. So, again, we're getting right into the math here, Dave. Hopefully everyone's had their coffee. And then you back away the ten-year bond, a low-risk asset. That's the premium you're getting for taking equity risk. So in the US, if you did that math, the equity risk premium is pretty small. It might even be close to zero or less than 1%. Do that math Canada, whereas if you take that two-year earnings growth forecast and the market is trading at twelve to thirteen times that number, that's an 8-ish% earnings yield. And then you back out a Canadian ten year, which is more like 3.5%, you're getting 500 basis points of equity risk premium. You are being compensated by 5% by taking some risk of moving away from a government Canada bond and buying the TSX, which has got this earnings stream that I just walked you through. Those are two really important features. If you have earnings growth and the valuation is expensive, you might not get a good outcome. But if you have decent earnings growth and a cheap valuation or a relatively attractive valuation, that's actually a pretty good set up for Canada. So we're constructive. Sometimes you have to go through that mathematical exercise. There's probably too many bits and pieces that I went through there, but that's really important to dispel the rumors that equities are stretched and look expensive. Some are, but a lot of the parts of the equity markets are not.
Now, to get the Canadian market really firing, though, we've got to get foreign investors to start to get a little more excited and interested about Canada. Some of that's around currency. Some of that is just what's going on in the US around AI and a couple of similar things in Europe on the drug side. That's drawing all the foreign investment. But what do you think ultimately gets people to start to pay attention to Canada on a global level? Not just Canadians investing in Canada, because we do.
Yeah, I'd say there's a couple of things. Historically, the most important one is the banks. And so I'd like to make it more elaborate and complicated at that. But when banks are outperforming the non-domestic investment into Canada, there's a positive correlation between those two things. And I'd say from the bank's point of view, there's still risk out there. The banks recently reported their second quarter. There's commentary around the provisions for credit losses. And so credit is still a concern. But we also have at the same time, the Bank of Canada started to cut rates. I know 25 basis points doesn't do a lot on a prime rate that was north of 7%. But on the margin, I like Stu's line, the markets are relentlessly forward-looking. So we're not just thinking about what is the absolute, it's more of what is the rate of change. And this would be not my prediction. This is the bond market's prediction that we could see 100 basis points of rate cuts by the Bank of Canada. And that's just going to make life a little bit easier. We'd always talk about Canadians are over levered or there's a lot of debt in the Canadian consumers capital structure — mortgages and lines of credit, etc. — and that's not going to make that problem go away, but on the margin, one year from now, life is going to get a little bit easier for most Canadians in terms of their cost of borrowing. On the margin, that's going to be helpful. Does that send people to Canadian Tire every weekend and buying jet skis and all kinds of discretionary spending? I'm not entirely sure, but the good news is it's incrementally positive. And that's what the market really is seeking. So to answer your question, what brings them back is I think some strong performance from the banks. And while we need to be concerned about credit and concerned about the sensitivity of bank earnings to credit, we need to focus on a couple of things. One, life is getting a little bit easier for the Canadian consumer, so that's great. And the other thing that we look at — and everyone focuses on the provision for credit losses, but that's what's coming out the back end of the credit cycle inside of a bank — what you want to look at is, are the things on the front-end getting worse? And I would say what we observed in the second quarter is that things on the front end, they're not maybe getting materially better, but they're actually not getting worse. So when you think about the credit machine, the big meat grinder of credit that sits inside every large Canadian bank, the things that are going in on the front end aren't getting worse, as of now. Everything can change in real-time, but that's a really important point. And then the second point I was making is that the bank's earnings power has been impaired by these provisions for credit losses. And a few other things like the market impact on the wealth businesses and the capital markets businesses. But on the margin, all those things are getting slightly better, or at least not getting worse. And so, if the banks were to return to what they believe is actually their internally forecasted earnings power, that 15 to 16% ROE, there's a materially higher earnings potential in Canadian banks, which people, I don't think, fully understand. And there's another rub that comes in when I say I'm constructive on Canada here. People say, well, Royal Bank, these things are trading at their all-time highs. They don't look beaten up and cheap, which is true. So you'd really like to buy them when they're down and out. But there is a scenario where the earnings power returns and things get a little bit better on credit. I think the market is very concerned about the downside to bank earnings in the face of credit and economic conditions. And I think we're underestimating the potential for upside in the earnings power if we return to more normalized conditions. So that will actually help bring some of the non-domestic investment back. Finally — and this would be my third point on making the case for Canada — it's cycle timing. So we have not seen non-Canadian investors piling back into bank stocks, but we have seen them pile into other parts of the market or have seen them more present. And one is in energy, which maybe comes as a surprise because the energy sector is a bit controversial, as we've talked about in the past. But we're seeing US investors, whether it's in trade flow or as they show up in the holdings report, as having a very meaningful presence in the large cap Canadian energy names. And part of it is that idea that, from a Canadian point, you don't need the oil price to go up for Canadian energy stocks to do well because they're doing just little things into their business that adds up to 10 to 20% earnings growth over two years. And so we're starting to see that come back. So you are seeing some pockets of non-domestic interest in our market. But the big one to watch would be banks and to bringing those flows back into Canada and seeing some of that normalization balance out between Canada and the US.
Yeah. And I think, as you say, maybe it's not looking a ton better, but it's not looking worse. That Canadian interest rate cut, for me anyways, is the idea that rates are no longer going up and they're no longer going sideways. There's your signal that rates are going down. And that first rate cut is important in terms of sending that signal. Now, as you say, markets — and I think you would expect it as well — expect rates are going to come down even more. And that creates some opportunity there in the banking sector, just in terms of that relief. And relief across the Canadian economy because of those debt levels and those mortgage rates that are maturing — mortgages that were locked in in 2021-2022, and are starting to come due this year, next year, and particularly in 2026 — to have those rates down lower, that just takes a whole lot of pressure off a whole lot of people.
Yeah, there was a lot of concern. If we thought maybe a year or a little bit more than a year ago, when we wouldn't have this clarity on interest rates going down. We thought there was still concern that they were going to continue to go higher. And there was some research done and talking about this mortgage rate reset being a shock. And you could do the math that if you had a certain set of circumstances, that you could see Canadian mortgage payments going up 50 to 75%. And that would probably be in the context of a 6% mortgage rate. And if we were to update that math today, it wouldn't look as much of a shock. So you have a couple of things. One, you're probably resetting in the 4%. I I'd have no idea where these things are going to settle out. But if you just mark to market today, you'd be at a 4% on a mortgage rate reset. And that takes that 50 to 70% mortgage payment increase down to maybe 30 or 40%. Still a significant increase for probably one of the biggest expense lines for most Canadians. So still pretty big. And then the other thing that we probably underestimate — and this one is maybe more of a question for Eric Lascelles — the rate resets are coming up this year, but also next year and the year after. We're looking at three years of earnings growth for the individual. People's incomes are going up — not everyone's; we do have a 6% or close to 6% unemployment rate here in Canada — but for the most part, if you thought about, we have a good inflation pass through. We've seen a lot of labor disputes in Canada ending up in higher wages. So the people's incomes are going higher. And so, if you don't have a 50 to 75% mortgage payment increase coming, but more like 30 and 40%, here's the great news: your income is up 30% over three years. And so that takes a little bit of the angst out of this big mortgage reset. Like I said, anything can happen, particularly in the short term. But we're getting some comfort around those two components. And we talked about the earnings growth. Energy needing to grow earnings 20% over two years, you don't need a big oil price, but that's still a hurdle that needs to be achieved. It's reasonable what's required for that to happen. And then the material stocks having a 30 to 40% earnings growth forecast, you need those commodity prices to stay higher and drag them up. But in the banks, which is 30% of our market and the financials, you don't need a lot to surprise on the upside. So I think we're remaining reasonably optimistic in that part of the earnings algorithm for the TSX.
Well, you have, as always, played your role as Captain Canada. And that's good. No, I'm joking. It sets up the key message here.
I think so. And Canada doesn't have the drivers of those top ten stocks. I do not want to dismiss any of it because it is significant and spectacular what is going on inside those top ten stocks in the US. So we are very respectful and pay a close attention to what's going on there. But what I observe in terms of people's attitudes towards Canadian equities is we're into the apathy stage. So my three points for Canada: earnings growth, valuation — not only just on its own, but relative to US and relative to bonds look fairly attractive — and cycle timing, which partly feeds into that commodity and just where we are in the economic cycle. So things getting slightly better and the commodity backdrop could play a meaningful role for Canada's relative outperformance over the more of a longer term. Sentiment is pretty washed out. Canada does not have exposure to these things. It's a bunch of cyclical stocks. We could just ignore it for now. So the apathy meter is quite high, which I actually take as a as a positive signal for a decent opportunity to take a closer look at Canada. We could not bring the Stanley Cup to Canada. The least we could do is earn 500 basis points of equity risk premium in the TSX. It's a nice consolation prize, isn't it?
We didn't get into that. By coincidence, I ended up in downtown Edmonton on Monday night. And it was lots of excitement, and then not so much excitement. Exciting and then a sad thing to experience. But Scott, always great to catch up with you. Lots of great stuff. And hopefully you have a great summer with you and the family. You get out, you get some better weather out there, and we'll catch up with you as we go into that really important stretch down through the fall in markets for the year.
Great. Thanks, Dave. Thanks for having me.