Perspectives podcast: Making sense of the markets

Stephen Meurice: Hey folks, Stephen here. We have something extra for you this week. I was recently part of a live event where I interviewed Andy Nasr. Andy’s the Chief Investment Officer of Global Wealth Management at Scotiabank. You also might know him as a regular guest on this show. The event was a 2024 Market Outlook hosted by Scotia Wealth Management and the chat was so interesting I thought our podcast listeners would enjoy it as well. Andy gives his take on the current state of the economy, interest rates, inflation, geopolitical events, and all the ways those factors are affecting stock markets and investing. So here it is, my conversation with Andy Nasr. Hope you like it.

Andy, great to see you as always.

AN: Nice to see you too, Stephen.

SM: All right, here we go. We'll get into the meat of this shortly around investment opportunities and portfolios and all that good stuff. But I'd like to start with the bigger picture, sort of a macroeconomic lay of the land, if you would, which has been kind of hard to get a grasp of it seems to be over the last six months or so. Where you had towards the end of last year, people were still talking about the possibility, maybe even likelihood of a recession and then a whole bunch of economies proved to be more resilient maybe than expected. And so less talk about recession maybe than there used to be. People were also talking or hoping for some interest rate relief early in the year. And then that started getting pushed out and it was like, ‘Oh, maybe it's June, maybe it's July.’ And then on the inflation front, seemed to be pretty sticky. It wasn't going away as quickly as you wanted. And then at the last inflation report that came out from StatCan showed that it was actually going down, is heading in the right direction. And it was actually, I guess, just about within the Bank of Canada's target range, like around 3% or just under 3%. So, things just seem to be going back and forth. People are worried, then maybe they're less worried. And obviously, all of these different things are interrelated. They connect to one another and have an impact on one another. So maybe we'll just start there. What's your feeling about all of those different main sort of things that people are thinking about and looking at on the news and how that has evolved and what it looks like in the coming months?

AN: Yeah, there certainly is a lot of conflicting economic data. So, no question that policymakers are going to be data dependent, meaning taking a look at all of the information that they have and trying to understand how that can affect future policy. But you talked about the last couple of years. I'm just going to rewind it a little bit further back. So, if you think of the health crisis, when we came out of 2020, we responded to that with a combination of fiscal and monetary policy stimulus. Fiscal stimulus, meaning governments threw a bunch of money at the problem.

SM: Lots.

Lots of money. To the tune of $30 trillion, which is 35 times more money than we spent in the global financial crisis. And a lot of that money went directly to households. We saw savings rates get elevated. They were 5 to 6 times higher than the long-term average for households in a lot of different countries. And then we also had that monetary stimulus. We lowered interest rates to near zero in Canada, the United States and a lot of other places. And since then, the economies gradually opened, up so that stimulus was necessary because there were broad swaths of the economy that just weren't working, that weren't operational. And so, we rolled through 2020 and 2021 and 2022, and it looks like we're turning the corner that this demand/supply imbalance that was caused by the pandemic showed signs of improving then we had geopolitical conflict. Russia invades the Ukraine, we still have geopolitical conflict. And you think of what's happening with the economy right now and in large part it's the interest rate and inflation uncertainty that continues to weigh on the minds of policymakers and investors alike. When central banks increased interest rates quite significantly in the last couple of years and it was almost two years ago where they started pushing rates up, we really saw concern from investors because they weren't sure how far they were going to take interest rates up. They knew it was to address inflationary concerns. And maybe I'll just frame it this way. Central banks have one primary objective. They've got a couple of different objectives depending on the country. But their primary objective is to achieve economic stability, and they do that with by messaging price stability. So as an example, if, you know, we thought that prices were going to go up 10% a year and inflation was double digits in a lot of regions, it was at multi-decade highs in those regions. If we thought that inflation was going to remain there, then economic participants would rush out and buy everything today. If we thought inflation was going to decline by 10%, we wait till everything goes on sale. So, price stability is an important concept for central banks because it ensures that everybody in the economy doesn't defer or accelerate their purchase decisions. So, they wanted to get inflation back down to within their range, we'll call it, of 2-3% in Canada and in the U.S. And the primary mechanism that they used to do that was by pushing interest rates up. So, if you think about it from a financial institutions perspective, banks like the Bank of Nova Scotia and other financial institutions are the transmission mechanism for monetary policy. Meaning if interest rates go up a whole bunch, we got to be a little bit more careful about who we're lending money to. We've got to make sure that, you know, there's a strong likelihood that we get that money back. And that's generally how financial institutions pass through higher interest rates in the economy. And so right now, we've seen interest rates go up a lot, but I'm not sure we've really seen the full extent of it as it pertains to household consumption, the impact it's going to have on governments, the impact it's going to have on corporations. So, there's a lagged effect. And in many respects that lagged effect is causing this slowdown in moderation, in economic growth. So, where we stand today, some regions were teetering on the brink of recession. We hope we avoid it. That is always the hope, we avoid recession. And central banks are attuned to that. So, to the best of their ability, they're going to try to manage policy to make sure that the economy and inflation slow down just enough and that we get to a point where we could start to get back to normal. But we're certainly not at normal.

SM: So, it's a delicate dance that they do where, I mean, the whole point of it is to try to slow down economic activity, but without tipping into recession. Which often has been the case when interest rates go that high, it can be difficult to avoid. Looks like we're kind of avoiding it now. But do you see, is that lag effect because they say the increases in interest rates can take as much as 18 months really to start having an impact on the economy. The last increase was September or something like that. So, the slowing, you think, is going to continue?

AN: Well, you bring up a good point. There's this lag effect. And I think the tricky part, I think you said threading the needle. So, the whole premise of a soft landing is that the economy slows down just enough. We avoid recession and then we can take off at some point again. The challenge with all of this and what makes it very, very difficult to forecast is the global economy has never been this heavily indebted, public and private market debt to GDP is well over 300%. So, there's this big mountain of debt that sits on top of the global economy, and that debt gradually gets refinanced. As an example in Canada, our households are more vulnerable to higher interest rates. We've got about 40% of mortgages getting refinanced in the next couple of years. So, this lagged effect will show up in different parts of an economy. It could be households, it could be an impact to governments, it could be an impact to corporations. And that's what makes it tough, is you think of the extra money that's required to service debt at a much higher cost, and it has to come from somewhere. So generally, when you look at governments, governments are running deficits in a lot of places. Household finances aren't, I wouldn't say they're in the best shape in Canada, but they're probably going to come under a little bit more pressure over the course of the next couple of years. And when you think of the impact of where interest rates are today, the policy rates, the rates the central bank set, if you think of where they are today and what would happen if we refinanced debt at current rates. In Canada alone, we'd have to take an extra percent off GDP just to service the interest costs. If household debt was refinanced at current rates, it would be a lot more than that. And then you see signs of this in the U.S., too, where, you know, government debt getting refinanced at current rates would carve a couple of percent off of GDP. So current levels of interest rates aren't really sustainable on a go forward basis. And it is likely we get back down to something that's a lot more manageable or at least something that will support normal economic growth at a point in time and where policy rates are today, that's not the answer.

SM: Right. So, you mentioned during the during the pandemic period, people were actually accumulating a lot of money. There was lot of savings, more savings than Canadians had had generally for a very long time. Is that all gone or is that what is helping to keep the economies perhaps a little bit more vibrant than one would expect in this kind of rate environment?

AN: Yeah, it is. A lot of it is gone. Before I get to that, I just want to touch on one thing because for us, the risk is when we think of how markets have performed and how investors feel about things and most people's expectation of the economy, there has been this pivot a little bit where people were expecting many rate cuts in 2024 and now it seems to have been pushed out, maybe to the latter half of the year, into 2025. So the big challenge is if we keep interest rates elevated for a prolonged period of time, maybe we start to see some fissures and cracks. Maybe we start to see some pockets of the economy really struggle with where interest rates are, and that can show up in a whole bunch of different ways, in a whole bunch of different countries. Because while we look at Canada and the United States, other regions are still contending with the same issue. To answer your question about the savings rates, I said this at the beginning, but savings, household savings rates were 5 to 6 times higher than their long-term average in Canada and the U.S., now they're below average. So, in part, the way that we've responded to high prices, things costing more, the way that we've responded to high interest rates is that households have not only blown through savings, but they've dipped into credit. And if you look at credit card borrowing in Canada and the United States, it's up about 30% in the last couple of years since they started increasing interest rates. So, household finances are becoming a little bit more strained. You may not see it when you look at consumption, but you certainly start to see it when you look at some parts of the economy.

SM: From a household perspective. As you said, there's a lot of mortgages coming up for renewal. I think they say probably more ‘25, ‘26, but probably starting towards the back end of this year. Once rate starts coming down, then that becomes less of an issue, right?

AN: It does. And this is an important concept because when we talk about interest rates going up, whether it's the impact of interest rates on a mortgage or the impact of interest rates in the sense that you're lending money to a company or any other entity, the lender never really wants the asset back. We don't want the house back. You don't want whatever you've collateralized the loan against. You don't want to take possession of that asset. So, you always try to work out the debt. And the big issue in Canada is that I used to say we have 25-year amortization periods. Then I bumped that to 30. And now you could say that we've got 35-year amortization periods. And I say it a little bit tongue in cheek and in jest, but one of the ways to handle higher interest rates is by pushing out the term of the debt, the challenge is that we have in amortization period doesn't match the debt term. And this is very different than it is in the United States, where about 75% of households are into 30-year fixed rate mortgages. So, they're less sensitive to fluctuations in rates. So, when you think about the dynamics of how interest rates affect an economy, it's important to dig in a little bit and really understand how it's going to affect consumption on a go forward basis. And the similarities between Canada and the United States is about over two thirds of GDP really come from household consumption. So, it's an important thing to try to understand and get right.

SM: Okay. I want to come back to some of the other factors affecting the economy, geopolitical factors and so on. But are you able to explain briefly, what is the impact on markets, on investors of interest rates at the level that were that we're seeing now? I mean, I know that's a big question and there's different impacts, but generally speaking, how do people who work in your space, like does it scare you? Is it a good thing? I guess there's opportunities and risks involved.

AN: It's a really good question. And I can't speak for everybody that kind of works in in finance or thinks about how interest rates affect things. But I think the easiest way to look at it is if you're trying to value an asset, any asset, you're doing it by determining how much money you're going to make from that asset. So really, you're discounting cash flows or you’re discounting earnings. The price of a bond is equal to the present value of all the cash flows that you get from that bond and hopefully the repayment that you get that promise to repay. You think of a building like this, we’re in Scotiabank Plaza, it's worth the operating income that it generates, but it's capitalized. So, what's that income worth today? So, you need to have a good idea of where interest rates and inflation are headed to figure out what cash flows are worth and it works the same way for equities. Equity investors, I always make this joke, they tend to be a little bit lazy. They apply a multiple to earnings to try to figure out what things are worth. But as interest rates and inflation change, it really does affect what cash flows and earnings and dividends are potentially worth. And that's where as an investor you have the ability to allocate capital where you think there is the most fair value. So, it's that disconnect between, ‘Here's what I think something's worth and here's where it's trading today.’ Certainly when it comes to publicly listed securities. And then if you have some discipline and you're able to realize when the best opportunities exist across asset classes and across geographies, you can hopefully take advantage of any market volatility to compound capital at much higher rates, meaning you don't have to shy away from things because they look cheap or it looks like the markets may be discounting a terrible scenario. If anything, that discipline allows you to anchor to the stuff that looks a lot more attractive from a medium to long term perspective that may be affected, you know, unduly by sentiment and negative sentiment in this case.

SM: Right. So, it comes back to that stability that the Bank of Canada, that central banks everywhere are trying, so that things are more predictable for everybody in the market.

AN: And that's why people panicked in 2022 when interest rates started going up. I say people, investors panicked a little bit and we saw more volatility than we've become accustomed to in the last 12 months show up in bond markets, show up in equity markets. It was because there was all this uncertainty around, ‘What's my normalized cost of capital, what should I discount cash flows at, what are things worth?’ And we didn't know where we were going to stop. I think now we have a better idea of where we're going to stop because most central banks are saying, ‘Hey, for the most part we're kind of done. It's just when do we start cutting and to reinvigorate the economy?’

SM: Okay, quickly putting on your predictor’s hat — GDP in Canada, the United States, as I said, the U.S. in particular has kind of sailed through the last few months doing pretty well from a growth perspective. Canada less so, but still head above water. Where is that going?

AN: So, our partner in crime isn't here. Jean-François [Perrault], our Chief Economist, and we share similar view. The economy in Canada and even the United States – so, in the U.S. will do a little bit better than Canada. But for the most part, we're going to be keeping our heads above water and hopefully treading that water in 2024. The risk is the policy risk. It's how long can we keep interest rates where they are? How long before the Bank of Canada sees something that really scares them? And what kind of rate cuts does that necessitate? So, for the time being, the expectation is that, and I'll give you our expectation, but also talk about the market’s expectation. The expectation is that interest rates will, and I'm talking about the policy rate, so the policy rate is most akin to think of it as a short term government bond yield. When the Bank of Canada moves the policy rate up and down, you see that reflected in a one- or two-year government bond yield. Longer term interest rates do a separate thing. They're a function of people, short term interest rate expectations and inflation expectations. But if we just focus on the central bank policy rate expectation, it is that in a couple of years we get back to something that looks closer to 3% from 5%. And in the US, it's going to hover around there. The key question is when do we cut and how aggressively do we cut? Do we cut gradually over the course of the next couple of years, or are we going to see some trouble spots in the economy that maybe necessitate 50 basis point cuts instead of 25 basis point cuts? And that's where when I said that policymakers are going to be data dependent, that's where it's kind of most important. Is they're going to be looking at unemployment. They're going to be looking at the overall health of the economy, the spending intentions of consumers and corporations alike. And they're going to be taking all of that data and trying to the best of their ability to manage through this policy uncertainty and get us to the other side of things and hopefully not arrest the development or the growth that we're seeing in the economy right now.

SM: Right. You mentioned trouble spots. Speaking of that, you mentioned geopolitics earlier, we still have several significant trouble spots around the world. How do you see that continuing to affect economies generally, markets in particular?

AN: So the geopolitical environment right now, it's, you know, it's tense and there's no question that when I talked about Russia invading the Ukraine and the recent geopolitical developments, that a lot of this is, it's not good in from multiple perspectives. You know, a lack of policy clarity, geopolitical clarity really does rein in spending intentions for a lot of big businesses. And on top of all of that, it's somewhat inflationary. I still make the argument that supply chains haven't fully opened up, that a lot of companies are still adapting from the lessons learned during the pandemic and looking at onshoring and nearshoring. So, there's still this inflationary effect of not just this exogenous event that was the health crisis, but the aftermath of it in terms of companies needing supply chain resiliency. And I think these geopolitical events just reinforce that. So, I think a lot of companies are going to reevaluate how they spend money, where they spend money. And certainly, the political landscape with upcoming elections is going to influence all that.

SM: I was going to ask you about that, because you're talking about trade. Certainly the US election, the key issue there, potentially for Canada, without asking you to predict who's going to win the election in November, I mean, potentially there are risks to trading nations like Canada or the United States, other trading partners, regardless of who wins. Any thoughts?

AN: Yeah. So, still unclear about, who's going to win and how the election takes shape. I will say this, you know, if you look at the U.S. economy, and let's just focus on the U.S. economy for the time being, although 50% of the global economy is going to vote this year. So, this isn't just a U.S. story. This is a much broader, you know, political risk story.

SM: Mexico as well.

AN: Yes. And so, if we think of what's happening in the United States for policy to become transformational, you need to control the House, the Senate and really, the Oval Office. So, if the Republicans do manage to get control of all three of these things, they're going to have the ability to really make a lot of a lot of noise and probably adopt some policies that could be a little bit more protectionist. So to that end, it may force some businesses to maybe invest more domestically. Depending on the stance that they take when it comes to imports, that can affect Canada, it can affect the currency. The U.S. is our largest trading partner. So, a lot of it is still to be determined, but the most important takeaway from it is that it will likely continue to support above average inflation. So if we start to see this happening or there's a likelihood that, you know, coming out of the U.S. election that the administration is going to be a little bit more protectionist, that likely indicates that they may have to keep interest rates up higher for even a little bit longer. And that might have implications for Canadian policy and the Canadian dollar and everything that we do here to try to support our economy while the U.S. is maybe going in a slightly different direction. So, a little bit of political uncertainty and that can certainly start to show up in markets at a point in time, but it hasn't shown up yet.

SM: Right. And I guess there will be yet another renegotiation of USMCA or CUSMA or whatever it is, we’re calling NAFTA now, renegotiated under Trump with some relatively minor changes. Essentially, the deal withstood that process. Will it be another sort of nail biter again as they renegotiate? I guess 2026 is when that's coming up?

AN: Yeah, I think anytime that that's on the table, it's going to be a nail biter because we're not sure which industries it affects and we're not sure how it's really going to affect the Canadian economy and our exports. But again, you know, the undertone is anything that's a little bit more protectionist, it may not necessarily be in the best interest of the Canadians or the Canadian economy. Which is why we always kind of suggest, you know, regardless of the geopolitical backdrop or even the upcoming political elections, we always tell people it's really important to try to be conscious of a home country bias, which most investors have. Whether you're in Canada or you're in Mexico or you're another part of the world, there's this tendency to want to own almost too much of what's available here. So, when you think of the TSX as an example, our publicly listed equity market, it is very heavily skewed towards some sectors and some industries that may get disproportionately affected by, I would say, trade noise. So, it's important to have diversification across geographies and, you know, even across industries.

SM: Okay. We'll come back to some of the specific numbers in a minute. Just one last question around the sort of big picture. Labour markets – there have been over the past few months, several big companies have announced fairly significant layoffs. You’re seeing a bit more of that in the news these days. That said, unemployment in Canada is still under 6%. In the United States, it's probably closer to 5% I think. Where do you see that going? Also, there are some wage pressures as well. Wage increases, I think, are significantly above what they had been traditionally, perhaps in the decade before that. Where do you see that going and what are the implications for, again, for markets?

AN: So, as you were asking that question, I thought of three things. One, I should have told everybody that we were wrong. So we were in the camp, I think when we had this conversation around this time last year, we were in the camp that, we may have a recession, but it would be a shallow recession in part because of the relative strength of labour markets. So we thought that labour markets are still pretty good. And even if we entered into an interest rate induced recession, if it was interest rates that caused the recession, the remedy would be to lower interest rates and get us back on track. So that hasn't quite materialized yet, although we did flirt with recession in Canada. Right now, when you look at labour markets, there is an argument and this is going to be a hot take, there's an argument that, well, maybe if labor markets are so tight, we can support above average wage growth and in turn we could support above average interest rates and possibly higher inflation than we've become accustomed to in the last few decades. And I always go back to something that is somewhat relatable and certainly in the headlines day to day, which is technology and technological innovation. So, when we talk about economies and what economies are capable of producing. In economic speak, it's a pretty simple equation, well it's not a simple equation — I'm going to make it simple equation. It's comprised of people and the goods and services people produce. So, if we used up all of our available resources, if everybody that could work did work and, you know, productive capacity was about as high as it could be, how much could the economy spit out without causing a significant increase in prices, meaning with inflation being somewhere within the central bank range of 2 to 3%. Now, if labour is scarce and labour starts costing a lot more, and there's a lot of reasons why it will continue to become scarce because we've got a population that's aging and rapidly aging. The number of people over the age of 65 is going to double within about 20 or 30 years across various regions. The natural response for any business would be to do what they've always done, which is to substitute labour for capital. I'm going to make the labour that I've got that much more productive. That doesn't happen overnight. It happens over a medium-term time horizon. So, you think of capital formation and deepening into technological investments. And certainly now with the artificial intelligence and the innovation that we're seeing, there's not a question in our mind that companies across a broad swath of industries and verticals are going to become more productive and technology will enable that productivity. So, we don't view it as artificial intelligence is going to displace a ton of jobs, we view it as artificial intelligence and technological innovation is a necessity to deal with a demography that is aging over the long-term and also to address labour shortages today, which will effectively serve as a cap on unit labour costs. So, there is this natural ceiling that will resurface when it comes to wage growth that will also act as a bit of an anchor for inflation over a period of time. We're not seeing it short term, because it's hard to find people to do things, but you're going to start to see it more over a medium-term time horizon.

SM: We'll come back to the AI question in a minute because there's a company by the name of Nvidia that's had a significant impact on stock markets in the last little while. But let's turn to the markets in general. So first, again, from sort of a big picture perspective, you mentioned the TSX concentrated in certain sectors, maybe not as diversified and maybe that's part of the issue here. But TSX, over the course of the last year, it's grown about 5%, something like that. Like literally a year ago today, roughly 5%. S&P 500, 27%. DOW, 18%. NASDAQ, 39%. So like right off the bat, you see a big discrepancy between the United States and Canada. You're also talking about that sort of home bias that people have. But just can you just speak in a general sense about what those markets have done over the course of the past year? Why that big difference between U.S. and Canadian markets and what that looks like in the coming months?

AN: Sure. I'm going to have to frame this again from a long-term perspective. So, if you own equities, equities, one of the big asset classes alongside a fixed income that people use to create diversified portfolios. The bouncing ball with equities is corporate profits. So, if you own a company and the company makes more money, you should make more money. That is exactly how it works over long periods of time. So, you think of, you know, what's happened in the last year and the relative disconnect and performance of Canadian equities versus U.S. equities and a lot of it has to do with some of those compositional differences that you pointed out with indices. We haven't demonstrated in Canada as much earnings growth as some of these businesses have in the United States. Now, we'd characterize the U.S. performance, the relative performance of equity markets as being defined by narrow leadership. The Magnificent Seven have pushed up markets.

SM: Hey just a quick aside here – for listeners who might not know, the Magnificent Seven is made up of Apple, Alphabet, Amazon, Meta, Microsoft, Nvidia, and Tesla. Anyways, back to our chat.

AN: NVIDIA is one of those companies, but it has not been completely unjustifiable and let me let me kind of explain this.

SM: So not a bubble is what you’re saying?

AN: Well, it’s not the valuations haven't become stretched or that we're due for a correction. We are certainly due for a correction, on average equity markets correct about 10 to 15% in any given year and we haven't had one of those in a while. But what I am suggesting is if you were to look back around this time last year and you looked at those Magnificent Seven stocks, you'd see that they made up about 22% of the S&P 500, and they contributed about 20 ish percent to earnings of overall index earnings. That's not completely out of line. You flash forward a year later. Now they represent about 30% of the S&P 500, but they contribute about 25% of overall earnings through the index. These are companies that have demonstrated between 30 to 40% earnings growth just in one year in the last 12 months. So, they're making money, they’re banking cash flow. And investors have responded to some extent by rewarding them with multiple expansion. And there's no question when you look at some of these businesses that that secular theme of technological innovation, artificial intelligence, it is wind at their back. Because it's not so much the hardware companies, it's the monetization of AI and the monetization of that technological innovation, which marks a significant difference compared to where we were in the 2000s. Everybody always draws the analogy between, ‘Look what's happening to technology today and look at the bubble that was created back in 1999 and 2000.’ And while there are some similarities when you look at charts, the businesses are totally different. The Magnificent Seven are sitting on a couple of hundred billion dollars in cash. Not a lot of debt. We're not building the information superhighway. You could draw the analogy that maybe we're expanding the lanes or making it that much more efficient. So, we're on the cusp of what I would characterize as a big increase in productivity and innovation. That really does to some extent support what's happened with these businesses. Doesn't mean that some of them aren't trading at lofty multiples. It just means that they've certainly made a lot more money than some of their other peers. And so, from a Canadian perspective, this isn't just true in Canada, it's true for a lot of international indices. Our market tends to be more tethered to what we would categorize as old economy companies and old economy sectors. Nothing wrong with them, but they just tend to be more affected by what's happening with the business cycle, maybe a little bit lower margin, maybe commodity oriented. And that's why it's really important when you think of, ‘What do I own in Canada, what high quality businesses do I own?’ You can get a lot of great oligopolies and monopolies, companies that pay you really, really well, tax advantaged dividends, and you can complement that with things that we don't have here, like technology and health care in the United States or big multinationals in other parts of the world that sell to emerging markets, where you're going to see middle income population growth double over the course of the next few decades. So, it's important to kind of round out the exposure that you get in Canada with high quality securities that you can get in other markets.

SM: Right. Is it like an innovation gap between the two countries?

AN: So those stocks, I would characterize most of them as they're not all completely innovative. Some of them are, you know, Apple's a bit more of a mature company that’s just got great cash flow and it's turning into more of a subscription based business model. So slightly different, but I don't know that there's an innovation gap, I think we have sectors here that just aren't as well represented as they are in the United States. So, it matters less where a company is domiciled. I mean, for the most part, when you think of building a high-quality portfolio, you're buying businesses with pointy elbows that have some kind of pricing power, that have balance sheet sanctity. And in the technology sector in Canada, there's some of those, but there's a lot more to choose from in the United States. In health care, same thing. You know, we've got some good health care companies, but there's a lot in the United States that are really on the cusp of that technological innovation or the medical breakthroughs that we're probably going to see a lot more of over the coming decade. So, it's really just making sure that the constraints that we have within the index are complemented by whatever exposure that we can get in other markets.

SM: So, speaking of that, from an investor perspective, can you talk a little bit about geographic weighting? Like where do you see opportunities? How do you how do you look at that? Diversification, obviously, is what you want to be doing, but what are you looking at specifically? Because from these numbers, it's like, yeah, put your money in the States.

AN: Yeah. Well that that's kind of that would be that would be the hindsight response. You know, when you think, because I think the questions that you asked were really thoughtful because the compositional differences of indices affects the valuation of these indices. Remember, I talked about this concept of price earnings multiples. So, people tend to look at Canada and say, well, ‘The Canadian market and international markets are very cheap. I'm going to put more money to work in these markets. And the U.S. market is very expensive.’ On the surface, the U.S. market is very expensive. You take out the Magnificent Seven, it's not as expensive. You adjust for the compositional differences of indices meaning on a like for like basis, if I'm buying a bank in Canada, am I paying a lot more for a bank in Canada than I am in the United States? The answer to that question is no. Am I paying a lot more for a technology company than I am in the United States? So, you adjust for these compositional differences. And what you noticed is the U.S. isn't as expensive as people make it seem because the sector weights affect the valuation. And a lot of people don't go through this math. So, there are still some really, really high quality businesses that people can own in Canada. There's still some really high-quality businesses that aren’t trading at 30 or 40 times earnings in the U.S. that people can own. So, you can create that well-diversified, rounded out portfolio. And the same thing applies to international markets. But if you're just thinking of plunking money in an index, that's where you may end up with a little bit more volatility because you're less discerning about what you own. So right now, it would make a lot more sense to really take a look at, from a Canadian investor’s perspective, how much do I want to put into Canada and then how do I create that well-diversified portfolio that still gives me U.S. exposure? So you're not completely getting rid of it because you think that things are expensive and you're not too exposed to international markets, but you've got some presence there, kind of recognizing that as the economy gets back to normal, we're likely going to see an inflection point in global economic growth and emerging market growth, which has been challenged in a lot of spots.

SM: And are there other specific geographic areas that you think are that you're paying attention to that are opportunities?

AN: So, we generally think of we think of simplistically. We think that, you know, again, it doesn't really matter where a high quality business is domiciled. We look for other characteristics, right? Do they have pricing power? Do they have some kind of sustainable competitive advantage? Is their balance sheet strong? Do they have free cash flow? And if you just think of everything I just said, if they've got pricing power and a strong balance sheet and pretty good free cash flow, I worry less about inflation. Equities are a great hedge against inflation. You know that if you think of, you know, how a lot of companies have dealt with inflation by pushing higher prices through to their end markets. Equities are also not a bad spot to be. If companies aren't heavily leveraged, meaning I don't have to worry about the refinancing risk because companies are flush with cash or they've got very minimal debt. If they've got free cash flow, that means they've got a lot of flexibility to manage through an economics cycle, even if we do have a bit of a recession. So that matters more than anything. And then it matters less where a company is. So, we look at Canada, the United States and international markets and for international markets, our focus is more on developed international markets. Because in the U.S., as an example, we think of the U.S. as being U.S. companies but 40% of S&P 500 revenues come from outside of the United States. And there's a good chunk of that that's from emerging markets. You look at well-developed companies in Europe and some of those indices, and you'll see that disproportionately they have a much higher percentage of their revenues coming from EM, emerging markets. So that's the importance of diversification, is that you get exposure to growth in different parts of the world. You get exposure to industries that are growing at different rates. And with that you can create a well-diversified portfolio that is less sensitive to the ebbs and flows that will just come with investing in market volatility.

SM: All right. You mentioned corporate debt there in passing. Has the interest rate situation over the last year or two years had an impact on the corporate debt situation?

AN: We haven't really seen it yet when it comes to the debt of publicly listed companies. I'm just going to focus on the S&P 500, largest market in the world. So, you think of what those companies have done and they were kind of smart about this when interest rates were really low, a lot of them turned out their debt as far as they possibly could. So, you think of the weighted average maturity of the debt outstanding, it's pretty long. It's not three years or five years. It's kind of encroaching upon double digits. So, the rate sensitivity from a corporate perspective has been diminished. We haven't really seen a lot of high-quality companies struggle with indebtedness. Where you have seen it is in some sectors like real estate, where interest rates are part of the dilemma. There's also some demand/supply issues when it comes to certain asset classes that have shown up in terms of public evaluations. But publicly listed corporate debt seems to be a lot more manageable. One area where we do worry – and this goes back to the, you know, what might be on the horizon in 2024 or ‘25 and what would the risks be if interest rates stay too high for too long – is that non-public debt, the private debt. Because since the global financial crisis, we've seen a lot of non-bank financial institutions lend money to private businesses. And if that's their source of financing, those companies are typically more heavily leveraged than, let's say, their public equivalents, where you might find publicly listed fixed income securities. And they're going to be a lot more sensitive to what happens to interest rates. And while, you know, interest rates have affected them, thank goodness the economy is still in decent shape. Because if we were to end up with a recession and all of a sudden they couldn't service their debt obligations or some of their covenants get violated, that can create a bit of an issue in terms of economic vulnerability. And, you know, if you listen to a lot of policymakers and central bankers talk about this, they will admit that it is a bit of a blind spot. Because the regulations around some of that lending and the size and extent of it isn't completely well known or as well known as it is for, let's say, regulated and regulated entities that lend money to other businesses or even households.

SM: Can I just ask you quickly about China? Because a couple of things you mentioned there around real estate issues and so on, and that was the big real estate company in China that has recently gone under. China facing some economic headwinds of its own. Second biggest economy in the world. What kind of impact will that have on global economies and then by extension, on markets?

AN: It could have a pretty big impact. We talked about when I talked about lending to companies. So generally, when you think of excess indebtedness, it can really affect an economy. So we went through the global financial crisis that was caused by excess household indebtedness in the United States. You flash forward three or four years later, we had a sovereign debt crisis in continental Europe, heavily indebted countries. You look at China right now, we have heavily indebted companies. So corporate debt to GDP is well north of 200%. Well, it's north of 200%, It's around 250%. So, a lot of those businesses have a lot of debt. Local governments have a lot of debt. The central government really doesn't have all that much debt. So, they have some levers that they can pull and they'll look at fiscal stimulus, they'll look at ways to really reinvigorate the economy, making sure that the real estate sector, which is a big part of the economy and certainly goes a long way in terms of inspiring household confidence when it comes to spending. They'll look at trying to make sure that they can stabilize that. But again, it is kind of a threading the needle argument for that to work and work effectively, the rest of the global economy still has to be, you know, operating in somewhat decent shape. So, if we were to trip into a recession in the United States or into China, there's no question it'll reverberate across the globe. But hopefully we mitigate some of those risks through, in China's case, fiscal policy and even possibly monetary policy to the extent that it's required a little bit more deliberately later on.

SM: And you mentioned you mentioned nearshoring a while ago, and that in some respects is related to China, but also just about supply chains and all of that. But essentially talking about bringing manufacturing closer to home, to countries that perhaps are, you know, more friendly than certain other countries in the world. Are there opportunities there in North America in particular?

AN: There were opportunities there before we had this conversation about technological innovation and artificial intelligence. You know, if you think of the number of global free trade agreements that were signed since 2000, since really China's accession into the WTO, they quadrupled. So, there wasn't a company that wasn't sitting there thinking, ‘Now the competitive landscape is global. I got to make sure that I allocate my capital in the most efficient way from a global perspective.’ So, we saw a lot of businesses migrating to these offshore markets where labour was a significant cost advantage. That cost advantage really started to erode around 2017 and 2018. When you factor in transportation cost and how much it would how much it would cost really to kind of get everything back to domestic markets or export. So, the labour cost advantage has been diminishing for a while. And now, for any company that's looking at building greenfield manufacturing capacity or greenfield productive capacity, you think of the technology that they can use to address labour shortages or labour costs. And there's no question that it makes a lot more economic sense to look at onshoring or nearshoring, especially if they want to create that supply chain resiliency that we discussed. So, I think in a lot of respects it's a bit of a positive for some businesses. But I'm not sure that we're ever going to go back to the way things were where you just saw companies really focusing on, you know, getting a bit of a labour advantage or a significant labour advantage by going to other markets. I think there are a lot of other things that are going to factor into that equation, including technology and productive capacity.

SM: Okay. Let's talk about some specific asset classes. What are your expectations for equities, earnings, growth over the coming year?

AN: I'll give you our expectations, but you know, we're probably a little bit more conservative than market expectations. The market thinks that we're going to have mid-single digit-ish to, I would say, high single digit earnings growth in Canada, the United States and international markets in 2024. I think that's a little bit challenging. You know, we talked about what happened coming out of the pandemic. So, any business that was dealing with higher input costs or higher wages really tried to make sure that they pushed those high prices through to their end markets, whether they're end markets were households or other businesses. And that old adage, ‘The cure to high prices is high prices.’ It's finally starting to show up. So, they pushed these price increases through, they got away with it for a while. 2021, 2022 it looeds like corporate profit margins were just on a tear. They were near record highs and we're finally starting to see that margin pressure. Because while revenue growth in nominal terms still looks kind of decent, we're starting to see volumes decline and those higher costs creep into the operating structure of businesses. So, where we worry, the earnings growth number is in jeopardy, not so much because we think we're going to have a dire recession, but because we're not sure that margins are sustainable given this moderation in economic growth, meaning there's going to be some margin pressure that'll ultimately affect those earnings expectations. So, we take a bit more of a conservative view. And again, when we talk about these things in general, we're looking at indices, but you look at individual sectors and individual companies and there really are some businesses, high quality businesses that kind of scream, ‘Hey, maybe take a look at me and incorporate me in a well-diversified, high-quality portfolio.’

SM: And on the fixed income side, I think a lot of people were, because you could get such a good rate on a GIC or whatever, people were moving stay on the sidelines of equities and doing that instead. Is that changing or is it going back? I guess as interest rates start to come down, those assets become a little less attractive?

AN: So, it's changing a little bit. You know, we talk about portfolio construction, we talked about equities, which a big part of portfolio construction, you know, that's where you're going to get your growth. And you can think of earnings growth for equities as being a proxy for nominal GDP growth. If you've got a good business, that business should be able to grow above nominal GDP growth, especially if they've got some pricing power. So, most people's expected return for equities are mid-single digit to high-single digit. And it depends on where we are in the business cycle to get there. Fixed income is a little bit different. Fixed income, you lend money to a government, you lend money to a company, you get your interest payments that promise to repay. And the challenge here is, you know, do I invest in something like a GIC or what is my fixed income exposure look like? But that fixed income exposure is supposed to be the ballast. It is supposed to be the thing in the portfolio that holds you in, protects your capital so that when the riskier stuff goes on sale, we get to work and we redeploy, we tactically rebalance. As it pertains to GICs versus corporate bonds, nobody really wanted to touch corporate bonds when interest rates were going up because those cash flows were worth less so people panicked. But we didn't see widespread corporate defaults. You were asking me about public debt, so we didn't really see investment grade companies wildly default. We didn't see investment grade governments really default. We just saw some people getting a little bit more discerning about, you know, which fixed income securities do I own in my portfolio. I want to buy shorter cash flows versus longer cash flows because they're less sensitive to changes in rates. And we also saw people say GICs make a ton of sense because they can get a riskless four or five in my portfolio and that's still true. You can get that in portfolios. But what you don't get is the of capital appreciation potential as interest rates go down. You don't get the ability to have liquid fixed income exposure, meaning you can't put that money to work if you've locked it in for four or five years. So GICs can be part of a portfolio. But right now, when we think of that fixed income exposure, we think it makes a lot of sense to own things that give you a healthy mid-single digit yield. You can get a you know, I'm not going to say riskless, but a very low risk 4, 5, 6 if you lend to companies, if not a little bit higher than that. And then you also get that capital appreciation potential as interest rates fall because those cash flows are worth more. We haven't seen that for a couple of years. So, it acts as a ballast. You may get you know, a bit of a tailwind there if when rates fall. And we can always use that to put the money back to work in riskier stuff if and when market volatility, I shouldn't say if, when market volatility resurfaces because it's inevitable that it will.

SM: And in terms of the overall advice that you give is 60/40 equities, fixed income, is that still thing? Did it go away and now it's coming back again? Or is that just a trope and really you shouldn’t think about it in that way?

AN: I think you know the answer to this question and it's going to be your asset mix should really be aligned with your risk tolerance, your time horizon, your needs and your goals. So, while our industry's become, you know, very focused on 60/40 portfolios and the balanced portfolio, that's not the right thing for every investor. A younger investor with a much longer time horizon should, be able to tolerate more risk should be, more biased toward equities as opposed to a retired investor where you don't want as high exposure to equities and you probably want a portfolio that generates more income. So, the mix really depends on where you are in the stage of the investing lifecycle, if you're accumulating or you're decumulating. And that's why it's really that you go through that needs basis discovery process where we align the portfolio with what you're trying to achieve. What you're trying to achieve with your life and your priorities. So, that's kind of the answer. And it's not you know, there's one answer for everybody, but when people were saying, ‘60/40 is dead.’ They're saying 60/40 is dead because interest rates gone up and fixed income hadn't performed very well. And as I said, you know, our expectation is that interest rates drift back down to something that's a little bit more reasonable. And again, fixed income will serve its purpose in the portfolio. Right now, you're getting really good income in fixed income, which we haven't had for a long, long time. And on the flip side, you're still going to get that capital appreciation potential from equities if you're a long-term investor. So, the mix in the proportion of the mix varies, but you can also do other things in portfolios like include alternative investments, which can improve risk adjusted return. A really important concept that we seldom talk about is how much risk am I taking to achieve return? And a lot of investors don't really factor that into the mix when they think of portfolio construction. You know, the more risk that you take, the higher return that you could get, the more volatile the portfolio is going to be. So, it's kind of important to think of all of that when you think of portfolio design and what your what your investments look like.

SM: Okay, do we have any questions that we wanted to take? There’s one here, a lot of people think about this, “Where do you see real estate prices landing over the next two years in light of the 40% renewal factor and aging population in major Canadian cities?”

AN: So residential real estate, not commercial real estate. You know, demand/supply is really affected the real estate sector and I talked about an aging population in Canada. Our immigration policy has really helped address some of that. But it's exacerbated this demand/supply imbalance residential really across major metropolitan city centers, but the country nationally. So, to that end, I think we're probably still going to end up in a spot where real estate performs pretty well over the course of the next couple of years, notwithstanding that refinancing risk. Like I said, if you think of extending amortization periods for mortgages, you extend them by five years or a little bit longer than five years, you can really absorb some of the increase in interest rates without necessarily affecting the payment that you might have to make for some mortgages. So, it's not like we're going to get completely turned upside down. So that's an important consideration. But we just don't have enough supply to satiate demand. And that's the other thing that's going to prop up prices. Now, the challenge, this is interesting, because the challenge for central banks is do you go out and signal that you're going to cut rates? You probably don't, because if you do, you're going to incite a bunch of risk-taking behaviour and people are going to try to pile back into the real estate market to front run any price appreciation. So that's the tricky part. Okay.

SM: Okay. Probably only have time for one more question. Where do you see the Canadian dollar going?

AN: So, interest rate differentials, the difference between the Bank of Canada's monetary policy and the Federal Reserve's monetary policy, I’m going to assume this is a USD/CAD question, really affect the currency more than anything else. So, if we thought the Bank of Canada was going to cut a lot more aggressively than the United States, that tends to indicate that the Canadian dollar may drift a little bit lower. Over the medium-term time horizon, you could make the argument that that might be a possibility because households here are more sensitive and vulnerable to changes in interest rates. So, there may be a little bit more domestic risks to our economy. Over a longer period of time, the Canadian dollar’s probably got some upside appreciation potential, but the near-term is the risk. So probably a little bit lower before it goes higher, but maybe a little bit lower. And again, the big wildcard here is who knows what happens in November with the US election.

SM: You’ve been listening to a conversation I had with Andy Nasr, the Chief Investment Officer of Global Wealth Management at Scotiabank.