From IPO mania to trade risk and recession worries, Craig Maddock shares what investors need to know to stay disciplined in uncertain markets.
Speaker Key:
GS Gregory Sweet
CS Craig Maddock
VO Voiceover
00:00:00
GS Welcome back to Let's Talk Investing. I'm your host, Greg Sweet. We're closing out in the second quarter. There has been no shortage of headlines. inflation concerns, conflict in the Middle East, trade uncertainty, and yet markets have held their ground through it all. Joining me today, Craig Maddock, Vice President, Senior Portfolio Manager, and head of our multi-asset management team. Craig, thanks for being here.
00:00:23
CM Thanks for having me, Greg. Lots of talk about today.
00:00:25
GS All right, let's start by talking about the big picture. There's been a lot of talk about whether we're heading into a recession. What's the data actually saying?
00:00:34
CM Well, the economy is weak for sure, but it's not breaking. And I think that distinction really matters. We look at a lot of different things, but our internal business indicators right now place the global economy in a late expansion territory. The US flash purchasing managers index or PMI is what we call it for June came in at 52.6. It's held above its 50%, which is the expansion threshold all year. Canada is probably what you're referring to has definitely been a bit of a weak spot. But even here, the PMI crossed back above 50 in May. Bank of Canada's own language is telling like they're talking about the economy being weak, but they don't think it's really in a recession. So it's complicated, but it's not really broken. On the inflation front though, like when you look at what's driving the headline number, it comes down to what I'd call the three Fs. You have fuel, food, fertilizer. And they're all directly tied, no surprise, to the Middle East conflict and the disruption in the Strait of Hormuz. And let's face it, that's a specific, hopefully temporary shock. Core inflation, if you strip out those volatile things, is much more contained. And the consensus forecast for Canadian inflation over the next year is around 2.4%, which, you know, that's not too far off the Bank of Canada's 2% target. So the direction of travel there is still maybe a little higher in the near term. But the key distinction is between a temporary shock and a persistent structural problem. I think this looks temporary.
00:01:55
GS Okay, so where does that leave central banks?
00:01:57
CM Well, Bank of Canada held for a fifth straight meeting at 2.25%. I think they're watching the same things we are. In the US, we've got a new Fed chair, so Kevin Warsh came in and they've held their rates at 375 in June. Also removed some of the forward-looking guidance that was pointing towards cuts. Say those probably are off the table. He's perhaps signalled maybe a hike by the end of the year. So that's a little bit of a shift. And we've also seen a shift in language towards more communications that are focused on inflation than labour. And that matters because let's face it, inflation touches everybody in the economy every single day. And then when we boil it all down and look at these things, we've got some indicators we follow, one of which we call the bear market indicator. And that puts the probability of a US bear market at around 29% right now, which is still pretty low. But we're watching wage growth very closely because we think that's one of the indicators that's near its risk threshold.
00:02:53
GS Okay. If the backdrop is this uncertain, what is actually driving markets higher?
00:02:66
CM Oh, two things. First, AI. The investment that's going into the AI infrastructure right now, it's enormous. You think of chips, data centers, the entire supply chain around this, I just call it next wave of technology, but we're certainly riding it already. That demand has been massive and it's a really powerful driver. And second, and perhaps even a bit linked, is earnings in the US. Corporate profits are up over 11% year over year. Markets follow earnings over time and earnings, let's just face it, they've been way better than anyone expected. So the numbers speak for themselves. The S&P 500 is up roughly 15% for the quarter. Global equities up about 14. Even the TSX up six and a half and a quarter. That's meaningful positive returns for clients who stayed invested and stayed disciplined. even emerging markets, they've been one of the real standouts up about 27% in the quarter. And that directly connects back to my first comment, AI. So you've got Taiwan, South Korea together. Those make up close to half of the MSCI emerging markets index right now through Taiwan Semiconductors, Samsung, SK Hynix. These are the backbone of the global semiconductor supply. A few years ago, we made a deliberate decision to build dedicated emerging market exposure into all of our programs based on our long-term return assumptions. I'm going to say this quarter, Greg, that was a good reason why.
00:04:20
GS That's great. Craig, you and I have talked about this, and there continues to be a lot of conversation around concentration risk, markets driven by a handful of names. How are you and the team thinking about this today?
00:04:31
CM Well, it is a real question that we've had discussions about. I've even more recently heard a lot of people bringing up this idea that equal weight is a possible solution. And it is, but I'd push back a little bit on that. It's kind of a blunt instrument. For us, active management is the more precise answer. We've got high conviction in AI as a theme, but not at the exclusion of everything else. What this quarter actually showed is diversification working as designed. Growth, value, income, and emerging markets all contributing positively in the same quarter. That's the structure doing its job.
00:05:01
GS Okay, so that's a constructive backdrop for equities. What about fixed income? What role is it playing?
00:05:07
CM Well, the fixed income sleeve as well has done exactly what we designed it to do. Our design is to hold shorter duration than the broad market benchmark and diversify beyond government bonds into investment grade credit, global credit, and selectively some high yield. That's really paying off. Our bond holdings are generating yields in the range of three and a half to five and a half percent, depending on the program. Let's face it, that's income that really wasn't available when rates were near zero. And that income oriented and credit diversified mandates, they've really delivered strong returns. Like in the last year, we're talking five to almost 8% range ahead of the broad Canadian benchmark. And that short duration bias has protected clients in an environment where, well, quite frankly, longer bonds have faced price pressure.
00:05:48
GS Okay, so I don't think we can get through today's conversation without talking about the Middle East. The Middle East has been this constant backdrop this quarter. Where do things stand?
00:05:58
CM Moving in a better direction. We've got a 60-day ceasefire maybe in effect. And I think the fear of further escalation has meaningfully eased. which of course means oil prices have started to reflect that. And if that continues, we're gonna see those three Fs I mentioned earlier, fuel, food, fertilizer, they're all gonna start to ease on their own, which means inflation moderates and that moderates without central banks having to hike. And of course it also leaves the Bank of Canada maybe a little bit of room to cut if our economy is slowing down a little bit. And that's a really constructive setup for both equities and importantly bonds in the second half. I think that's watchful optimism.
00:06:38
GS Okay. I think that's really good news for our clients who are listening in today. One of the things that often doesn't get discussed is currency. How did that play into clients' accounts this quarter?
00:06:47
CM Meaningfully. So when Canadian clients hold US or international equities, we carry most of that exposure unhedged. That's a deliberate choice. However, on the fixed income side, we hedge the currency strategically because the currency risk in bonds often doesn't come with a compensating return premium in the same way that equities does. So the structure gives clients full currency exposure where it adds value the most and removes it where it doesn't. And in this quarter, as the Canadian dollar moved towards the 140 range against the US dollar, that unhedged equity exposure delivered a real tailwind. But there's also a third layer worth highlighting. In most of our programs, we can add currency hedging, or we can lean into a specific currency position as a completely separate decision, independent of the underlying asset allocation. So currency, in essence, becomes its own lever, which gives us real flexibility so we can tailor the currency profile of a portfolio. And of course, this core to the structure worked in favor of our clients, but the tools were there if we needed to, to make a different call if the situation ever warrants it.
00:07:49
GS So rarely discussed, but a meaningful tool in active management. Okay, so SpaceX, it just went public in the largest IPO in history. How should our clients be thinking about that?
00:08:15
CM Our job is to be prudent, careful stewards of capital, to build wealth through disciplined decisions, not to chase excitement. So let's face it, SpaceX going public, generally historic. Together, we've also got OpenAI, Anthropic, they're queued up next. We're looking at 195 billion of combined IPO proceeds. This is the largest wave of new issuance since the dot-com peak. And I clearly understand the excitement. These are remarkable companies. The excitement, however, is not an investment thesis. Sure. This is where the rubber hits the road, if you will. And our investment strategy team has done a bunch of analysis on this and the clear takeaway from this, all three of these big IPOs are money losers at listing. So SpaceX is at 79 times sales, which actually exceeds the dot-com peak multiple of 70 times. The historical record is unambiguous. Stocks entering in the highest price to sales quintile have underperformed the broad market by about 3.2% per year every cycle. Loss-making IPOs have underperformed by close to five points a year. The average IPO underperforms the market by 20 percentage points over three years. That's the base case. So, you know... Not a good start for IPOs. However, is there upset? Absolutely. About 8% of IPOs deliver more than a 200% nominal returns. And these companies operate in the winner takes most markets, the secular AI demand tailwind is real, but lottery tickets are by definition, not a base case. Interestingly, on top of that, the NASDAQ is changing the eligibility rules specifically to fast track SpaceX into the NASDAQ 100. And that's a good illustration for us of why active management matters. Passive funds are being told what to own. We get to look at the 79 times sales, loss making financials, imminent lockup expiration, and decide whether the risk reward is right for our clients. But more importantly, if so, how much makes sense? The index reacts. We get to think. Yeah, yeah. And I think, and interestingly, I say that we did have some. So for clients in our programs that had private asset allocations, we actually did hold SpaceX before the IPO at private market valuations, which is different from buying at 79 times sales on day one. That pre-IPO exposure generated exceptional growth. It's a good example of what patient discipline exposure to innovation looks like. Positioned early, grounded in fundamentals, not just chasing the market hype. And for clients in our portfolio solutions, I want to be direct. We'll not be rushing into these names because they're famous or the headlines are loud. If and when we own them, it's because we have a clear long-term investment thesis. We see durable earnings power and a price reflecting what the business is actually worth. And ultimately a conviction that holding it makes the portfolio better for our clients over time.
00:11:00
GS Yeah, that's a pretty prudent approach. Okay, let's turn to prediction markets. They're coming to Canada this summer. What should our clients know?
00:11:07
CM Well, if you zoom out from the headlines, what's new is this. You've got platforms where you can trade directly on, I don't know, whatever specific events happen. Think of that being maybe central bank decisions, inflation prints, environmental forecasts. It could be endless, right? But these are one-time or time-bound binary contracts. They either pay out or they don't. Economically, we call that a zero-sum game. So every dollar that one participant wins is a dollar that someone else loses after fees. And that's really different from investing. But when we're investing, what are we doing? We're buying claims on real cash generating businesses, companies that sell things, earn profits, pay dividends, pay interest. Their pie can grow over time. It's not I win, you lose. So that said, when you think of it from our perspective as portfolio managers, the price of a prediction contract is effectively the crowd's implied probability for that event. So if a contract paying out on two Bank of Canada cuts this year trades at 40 cents, that's roughly a 40% market implied probability at that scenario. Now for us, we can set that piece of information alongside futures curves, option markets, survey forecasts, and our own models when we're thinking about macro risks and scenario weights. But when you step back and think about for clients, we wouldn't present these as a new asset class for long-term investing. Like they don't create wealth the way owning productive assets do. So my short answer, event-based prediction markets are speculation, not investing. That might offer a useful extra data point about a macro policy risk or something we can carefully put inside of our long-term investment process. I think in a future episode, we should go deeper on how they work, how they might fit, and how people could use them in a long-term investment plan. Speculation, not investing is a good way to end that. I like it.
00:13:04
GS We'll definitely come back for a deeper dive into predictions markets and the role they play in an investment plan, if at all. So stay tuned for that. So let's turn to trade. Kuzma, the first formal review is underway. What are you watching today?
00:13:17
CM Well, this is probably shaping up to be the most defining policy event of the second half of the year, although, you know, who knows what could come next. For Kuzma, let's face it, 70% of Canadian exports go to the United States. That's nearly 16% of Canadians' GDP. It accounts for more than 2.5 million jobs that are directly tied to the demand from the United States. For us, The stakes are real. As you mentioned, the first formal joint review is happening now. Like, you know, by the time people start to listen to this, all three parties need to decide whether to extend the agreement. If they agree, it resets. But if one of three parties refuses, we enter into a cycle of annual reviews until 2036. And the biggest economic damage from that isn't probably a dramatic breakdown. It's a slow erosion of business confidence from not knowing whether the rules change every year. We've also got the US midterm dynamic that's maybe a moderating force. So maybe that's the good news, right? So the incumbent administration faces a credible risk of a divided Congress, a chaotic renegotiation amplifying economic uncertainty into an election cycle is probably not a very good winning political strategy. What's also worth understanding is that, you know, why a full breakdown is probably not in the cards, even with all this uncertainty. This is not a zero-sum negotiation. There's deep integration across North American supply chains, and that means disruption feeds back into all three economies. U.S. manufacturers that source intermediate parts from Canada and Mexico, they bear the cost of tariffs just as much as the exporters do. The US automaker doesn't win when Canadian auto parts get tariffed, their own production cost goes up. And that's a shared economic cost that creates a natural pull towards cooperation, even when the politics are contentious. I think all three parties know they're better off with some form of renewal rather than a breakdown. It's economic logic that really tends to assert itself in these situations. Now for our clients in our portfolio solutions, Our deliberate lean into U.S. equities and a reduction in the Canadian equity weight over the past year wasn't a Kuzma call, I'll admit. It was a view on fundamentals, but the U.S. economy has shown greater resilience, stronger earnings, deeper AI exposure, more diversified domestic demand, Canada has faced a softer growth backdrop, bit of rate sensitivity. This trade uncertainty, of course, is layered on top. So when Kuzma enters into the picture, clients are already, fortunately, well positioned on the right side of that asymmetry, not by accident. It's a good example that getting the macro call right for one reason is gaining resilience for reasons you didn't even fully anticipate. And then on the fixed income side, in a disruptive Kuzma scenario, you've got the Bank of Canada's response, I think would be to cut rates, which we can do, which would be supportive for the bond portion of the portfolio. And that to me is the multi-asset design working as a real natural hedge.
00:16:07
GS I love that. Craig, this has been a great conversation. We have a complicated backdrop. Markets are showing genuine resilience. Versification is doing its job. It reinforces the fundamentals that stand the test of time. investing early, investing often, staying invested, staying disciplined. You know, that's really what truly builds wealth over time. If any of today's conversations have you thinking about your investments, lean in with your advisor. |Craig, thanks for joining me.
00:16:38
CM Thanks, Greg. You know, markets gave clients something meaningful to work with this quarter. We've got positive returns across equities, income from fixed income, and diversification that was visibly doing its job. Uncertainty is always present. To me, what matters is whether your portfolio is built to navigate it for clients in our total portfolio solutions, it is.
00:16:57
GS And to all of our listeners, thanks for tuning in to Let's Talk Investing. Here at Scotiabank, we're focused on being your most trusted financial partner for every future. Until next time, be well and keep investing.
00:17:07
VO This audio has been prepared by Scotia Global Asset Management and is provided for information purposes only. Views expressed regarding a particular investment economy, industry or market sector should not be considered an indication of trading intent of any of the mutual funds managed by Scotia Global Asset Management. These views are not to be relied upon as investment advice, nor should they be considered a recommendation to buy or sell. These views are subject to change at any time based upon markets and other conditions, and we disclaim any responsibility to update such views.
To the extent this audio contains information or data obtained from third party sources. It is believed to be accurate and reliable as of the date of publication, but Scotia Global Asset Management does not guarantee its accuracy or reliability. Nothing in this audio is or should be relied upon as a promise or representation as to the future. Commissions trailing commissions, management fees and expenses or may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compound total returns, including changes in unit values and reinvestment of all distributions, does not take into account sales, redemption or option changes or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Scotia Global Asset Management is a business name used by 1832 Asset Management L.P., a limited partnership, the general partner of which is wholly owned by Scotiabank. Registered trademarks of the Bank of Nova Scotia. Used under license. Copyright. The Bank of Nova Scotia. All rights reserved.
