Hello and welcome to The Download. I'm your host, Dave Richardson. Really happy to be back with one of our favourite guests, Scott Lysakowski, head of Canadian equity at Phillips, Hager & North Investment Management in Vancouver. Actually, we got nice weather here in Toronto today, Scott, but I always like to catch up on your better weather out West. What kind of day are you looking at out in Vancouver today?

Oh, Dave, it's springtime in Vancouver, which is probably one of my favorite times of the year. We're 10 degrees and sunny. I don't want to rub it in because I know you guys have a little bit of wintry weather lately, but we've got the cherry blossoms in full bloom and spring is in the air in Vancouver. So I can't complain.

I already regret asking the question. We're going to get our typical early April last snowfall kicking ahead from winter and then we'll move on. But I'm glad things are nice out there. It's also been nice, though— to talk specifically about investments—, it's been a good time to be a Canadian investor or to be invested in Canada. And we were talking a little bit before we started rolling the tape here about the strength of the Canadian market this year, again, not just in real terms, but in relative terms, when you look at markets all around the world and you've got some really interesting stats on that.

Yes, Canada has been one of the best performing equity markets globally. I think it's the best in the developed markets. It's second to Brazil across all markets, so it's been a really good start to the year. Really not surprisingly, it's driven by that composition— I think we've talked about it almost every time I'm on the show here—, the high composition of cyclical sectors: energy, materials, industrials. The financials have not performed as well as some of the other cyclical sectors, but certainly the energy and materials have. If you look at some of the best performing markets globally, Brazil, Canada, the UK, there's a high correlation of their strong performance, not surprisingly, and the amount of exposure those indices would have to energy materials. So Brazil has the highest, it's about 42%, when you combine energy and materials. Canada is second at 28%. The UK is next with 22%. T would compare to the U.S. at 6.5%. So you can see why Canada has been one of the best performing markets due to this exposure. There was a moment— I think it was at the end of February— when the U.S. was down 12%, Nasdaq was down close to 20%, and Canada was flat on the year. So that spread was really wide. It's coming on a little bit lately, but it's been very strong.

Just once again, another example of why a Canadian investor is going to have Canadian holdings in their portfolio. Quite often it's a little bit of an overweight position. And again, depending on your investment objectives, that could be a good or bad thing, but the whole concept of diversification, that you're going to have that Canadian and some of those other markets that have performed well in your portfolio, is a good mix. I guess the big question then, Scott, is, do you think this is something that can continue? When we've seen this kind of significant outperformance in the past, is this something that continues through the year for an extended period of time? What's your outlook?

Those are tough things to predict. But as you know, I love to look back at history and see what we can learn from previous periods of strong relative performance. We went and looked back to the 1950s and a number of periods of strength where Canada has outperformed the U.S. like it has over the last three months. Canada, to start this year, has outperformed the U.S. by just over 7%, which is a fairly significant number. Surprisingly, it's not the highest it's ever been in the last fifty plus years, but it would be up there. It'd be in the 95th percentile in terms of relative performance. When we look at those periods where Canada has outperformed in the past and then look at the forward periods after those, periods in which, on a three-month basis, Canada has outperformed the U.S. by greater than 7%, what's the three-month, six-month, 12-month forward performance look like? On average, Canada still continues to outperform. So on a three-month basis, it's greater than zero. But on a six-month basis, it's almost 2%, and on a 12-month basis, it's almost 4%. That compares, as we know, over long periods of time, on a 12-month basis, Canada has underperformed the U.S. by about 1.5%. A significant data. And so that would lead us to think that while the period of strength has been very strong for Canada versus the U.S., history says that it could persist for some time.

That then speaks, at least that part of the Canadian market that's really been leading— as you say, materials, energies, cyclicals— that leads you back to higher commodity prices, whether it's oil or metals or agricultural products, fertilizer, all these things that are a big part of the Canadian market. What are your thoughts on pricing there? Are we going to continue to see elevated prices, and does that create any concerns for you moving forward?

Yes, I think it does. The one thing I would say is that commodity prices— and we've talked about it in the past— have been strong. Obviously, they've gotten really strong over the last several weeks, but for the prior year, commodity prices have been strong. There's a number of factors at play. We're talking about an economy coming out of a pandemic; you have economies recovering. Things like oil inventories are being drawn down as people are getting back out there and getting on airplanes again. We were starting to see all that tightness creep back into the commodity markets prior to even what we've seen so far this year. What I find most interesting is that, while the commodity prices were sending signals to producers that inventories are getting lower, the strength and commodity prices would say now is the time to bring on supply. But we weren't actually seeing that. There's a number of reasons that would drive that. Part of it is just capital discipline amongst the commodity producers and I'm not just talking about oil, but across the metals complex as well. You're just not seeing commodity producers commit to spending the big capital and making the big capital investments required to opening a new copper mine or bringing on large amounts of oil production. We haven't seen that in a while. I think the previous commodity super cycle has really stung these management teams and their shareholders have sent the message to these companies say, we want you to be disciplined. We want you to return some of these excess profits to shareholders. You're just not seeing a lot of the capex increases as you would have seen in the last big bold market that we saw for commodities. Then secondly, I just think you have a lot of uncertainty around demand, talking specifically about oil. If you're an oil producer today, or at least at the beginning of this year, you're in the $80 oil price. You were enjoying the excess returns, the profits you were getting at those commodity prices. You had managed your cost structure. You've been disciplined with your capital. You were using that excess free cash flow to pay down debt, give dividends to shareholders, buy back your own shares. You're quite comfortable with that. The idea of spending significant amounts of that excess free cash flow on new projects? While we're seeing an increase in demand in the near term, as we come out of a pandemic, the long-term demand for things like oil is very uncertain. If you're thinking about making a large-scale investment in bringing on new oil production, you're looking at at least a 10-year payback. No one really knows what the demand picture is going to look like in 10 years. So, they are really not willing to make those investments. And then of course, what's happened over the last several weeks is that now we've taken even more supply out of the market and that's caused a spike in prices and that actually becomes a little bit more worrisome as we go into a price-spike mode. Commodity strength that we saw earlier this year was just sending the signal to add supply. When you go into the spike mode, what it's actually doing is trying to destroy demand. It goes from inducing supply to destroying demand. That's when we saw oil spike to $130. That's what the market was trying to do. What worries me, to get to your outlook question, is that when you have these spikes in prices to destroy demand, they tend to be recession inducing. You're trying to tie all this together: you have this recovering economy and then you have this really tight environment for commodity prices causing prices to spike, adding to what is already a fairly inflationary environment. It's just hard to at least not assign some higher risk of recession if this type of environment persists. Now, there's a number of things at play in terms of bringing on new supply, whether it's temporary releasing of reserves. Those types of things would be helpful, but I still think we have this structural tightness which is great for commodity prices and producers, but it could be risky for a recession down the road.

Yes. I should mention a couple of things here, Scott, just not to leave them hanging. One is, you did a fantastic job for people who are regular listeners to the podcast and would have listened to Scott— I think it's two appearances ago— where he walked through the way energy companies are managing their balance sheets and how they're different from previous cycles in the way they're managing their balance sheet, for a lot of different reasons, and he goes into that in detail. And then obviously it's this tragic situation that we have in Ukraine with the Russian invasion, which has just created that additional tightness and that spike in prices. That's something that, again, the markets have to adjust to, to prevent those prices from persisting. Again, we've seen prices come from $130 a barrel back down to a little over $100 a barrel now. That adjustment seems to be taking place. It is a challenge. We had Stu Kedwell on yesterday and we were talking a little bit about the risk of a recession and the Federal Reserve and central banks around the world, along with these higher commodity prices, inflation, and the needle that you have to thread here to create the soft landing. It's funny that markets are kind of telling us to look at odds. The odds are still very low over recession, but it is something that you have to keep in mind as an investor and obviously an investment manager, Scott?

That's right. It's really hard to predict these types of large macro events. There's the running joke that even the economists have a tough time predicting recessions. But the stock market— and I'm sure, as Stu laid it out— thinks in scenarios and it assigns different weights to each scenario that affects the price. While we were, probably at the beginning of this year, at a fairly low risk of recession, just given that we were coming out of one that was in the pandemic, those odds have increased slightly and I think you're right that the central banks really have a tough task at hand to engineer the soft landing, as people say, to manage this rising inflation as well as not tip things too much into recession. It's going to be a delicate balance. What I worry about is that Canada has that high cyclical exposure, so if we do tip into a recession, some of the relative strengths that we've enjoyed over the last three months, to start this year, and 12 months, could be at risk so it's a bit of a delicate balance that we're walking here.

After many years of underperforming the U.S. it's nice to see Canada getting its time in the sun. I can see the weight off your shoulders a little bit. You're a little more chipper today.

It's our turn, for now.

For now. Okay. That was fantastic. Thanks for the update. Look forward to seeing you soon. We'll see you next week or in the next couple of weeks. Always appreciate you taking the time to visit with us.

Great. Thanks for having me, Dave.