GS Gregory Sweet
CM Craig Maddock
WB Wes Blight
VO Voiceover
00:00:00
GS Welcome back to Let's Talk Investing. I'm your host, Greg Sweet. Joining me today, we have Craig Maddock and Wesley Bight from our multi-asset management team. Thanks for joining me today, gentlemen.
00:00:12
WB Thanks for having us, Greg
00:00:13
CM Thanks, Greg. As always, good to be here.
00:00:14
GS Alright, let's dive in. The quarter gave investors no shortage of headlines, including renewed Canada-US trade tensions, conflict in the Middle East, changing energy prices, volatile bond yields, and continued debate about artificial intelligence. Yet, equity markets remained resilient. Wes, what was the defining market theme?
00:00:35
WB Great question, Greg. Markets continue to look through the headlines and really focus on fundamentals. Investors had plenty to worry about, but corporate earnings remain quite resilient. Economic growth stayed positive and companies continue to invest throughout the quarter. These fundamentals help support markets despite some elevated uncertainty, at least in the headlines.
00:01:00
GS Okay, before we discuss markets in detail, we want to recognize that the trade dispute is not simply an investment story. Many Canadians, their families, and their communities are being personally affected, and we don't take that lightly. If clients are looking for support, advice, or simply have questions about what these developments may mean for them, we encourage you to reach out to our advisors. We're here to help.
With that context, how should investors interpret the latest trade developments between Canada and the United States?
00:01:27
WB The immediate effect has not been uniform across the economy or across markets, but the uncertainty itself, that matters. Businesses are making investments and hiring decisions that are based, at least in part, on their confidence in the operating environment. If policy remains unpredictable, as it seems to be right now, some firms may delay their spending initiatives, or they may adjust their supply chains. And we therefore assess both the direct impact on specific industries and the broader effect on confidence, growth, as well as capital markets.
00:02:04
GS Okay, so Craig, when conditions change, what levers can your team pull within portfolios?
00:02:10
CM That's a great question, Greg. Well, we're Canadians and we're not going to like to sit around and take it. For us, we look at portfolio decisions through sort of three distinct lenses. First is strategic asset allocation. And that's like, think long-term, think about looking out the next 10 years and we reconsider the return and the risk expectations in a portfolio. A second lens is through tactical asset allocation. And that's where we make real short-term shifts. Think of what's going to happen in the next 12 months. And we try to take advantage of the market opportunities, or in this case, manage the evolving risks. And then third is security selection. And that's where we can lean into companies, industries, investment styles, and think about how we can best position a portfolio to help perform. And these levers operate on three different horizons, but they ultimately work together for us in the context of a total portfolio. And we don't really know the end game yet. We can look at the tariffs or the resulting government policy and activity, the business levels, and we can, you know, navigate through this new reality.
00:03:07
GS Okay, so how are we applying this process today?
00:03:09
WB We assess the Canadian investment opportunity across each of these lenses. Strategically, we have a high allocation to Canadian investments, and that's true across both fixed income and equities. And it's based on their long-term expected return, risk, and diversification benefits for the portfolios. So strategically, that strategic asset allocation, you've got to think 10 years. The current environment may create opportunities to increase our Canadian allocations, and this is being assessed over a short time horizon. So there, think 12 to 18 months, and that's the tactical asset allocation. But similar to the strategic positioning, any change that we make within our portfolios, that must be supported by the expected performance contribution to the portfolio rather than by the headline alone.
00:03:57
GS Okay, so there's been this market performance understanding that the U.S. is always leading. And, you know, that story hasn't necessarily always played out this year. So what has really stood out year to date?
00:04:10
CM Well, Greg, here's a stat I love to share. With all of this tariff noise, you'd think it's been a rough year for Canada. It hasn't. The Canadian stock market has actually been leading the pack. And that home bias that Wes just mentioned, which means we've got more Canadian equities in our portfolios, has genuinely helped us. The U.S. is still up. It's been a good place to be invested, but in Canadian dollar terms, it's running behind Canada and behind emerging markets and roughly in line with Europe. I know we're still a few weeks from the end of the quarter, so the exact shift could move around a little bit, but I got to say it puts a big smile on my face when Canadians are the ones winning in the face of this challenge. You know, Canada strong. Like more importantly though, the strength in the Canadian stock market and emerging markets is a huge reminder as to why it's so important to mean geographic diversification rather than concentrating in the market that's led the most recently
00:05:03
GS Good perspective. So, equity markets have held up despite the uncertainty, right? Been floating around markets. How important have corporate earnings and AI related investment been to that resilience?
00:05:17
CM That's been critical. Earnings have been the key support. And let's just remind investors on why that matters so much. When you own a company or stocks in a company, what you own is a portion of its earnings. Over the short term, prices can bounce around for all kinds of things that have nothing to do with what the business is earning. Things like sentiment and headlines like we've seen lots of and just people repositioning portfolios. But over the long term, that gap closes. Earnings are ultimately what are going to drive the return, which is the whole premise behind strategic asset allocation. Not trying to time the noise. You're trying to underrate the earnings power you're buying. Over the short term, prices can bounce around for all kinds of things that have nothing to do with what the business is earning. Things like sentiment and headlines like we've seen lots of and just people repositioning portfolios. But over the long term, that gap closes. Earnings are ultimately what are going to drive the return, which is the whole premise behind strategic asset allocation. Not trying to time the noise. You're trying to underrate the earnings power you're buying. Let's face it this year, companies have continued to deliver growth in their earnings. Got that investment in AI, data centers, the infrastructure around it and automation, all kinds of things, right? It's just significant. Importantly, we don't know for sure who the winners are going to be, but there's going to be winners. And figuring that out, that's what stock selection is all about. That's that midterm thing, right? And management teams and companies give us that insight as to what they're actually doing, where where they're headed. It's our job to figure out, well, whose earnings are actually going to benefit. And of course, relative to what their stock would cost us to buy it today. That's not easy, but if I had to put this in baseball terms, we're in the early innings of what is going to be the game of our lifetime. And funny enough for me, this game is far more fun to watch and moves a lot faster than baseball.
00:06:33
GS I'm a baseball fan. So, there you go. I'll take that one though, Craig.
00:06:41
GS What does this uncertainty mean for portfolio construction?
00:06:40
WB What does this uncertainty mean for portfolio construction? I think a lot of what Craig just walked through speaks to the value of diversification. We don't believe this is the time to assume that today's largest spenders, so those that are building out that infrastructure required for AI, we don't think that they're going to capture all of the future value. There will be winners among the technology providers themselves, but there's also going to be winners across industries many different businesses, industries that use AI to improve productivity, improve the service offering, even improving their margins. So keeping their expenses low. It's actually an early stage in our view. So that early innings analogy that Craig used is perfect because even though we are early innings, we see the long-term value and we're also seeing some early winners emerging right now across utilities, industrials, energy, energy sector companies that are helping to support that AI build out, helping to support that infrastructure build out that's required. And this broad participation that we're talking about, that gives portfolios exposure to the theme without depending on a narrow group of names.
00:07:52
GS Okay. The scale of investment is also affecting the financing side of these businesses. What are you watching for?
00:08:00
CM Yeah, it's an important perspective, Greg. Capital expenditure requirements are rising, right? We're talking about massive build out of the infrastructure to support AI and And I think it's really worth putting some numbers around that. So there are estimates that the largest tech companies are spending in the neighborhood of $760 billion this year alone on AI infrastructure. And that's up from roughly $400 billion last year. That's the scope of this, right? And what's changed isn't just the size of that number. It is how it's being funded. A couple of years ago, this bill that was probably for the most part being paid on a free cash flow that these companies were generating. That's no longer the case, right? A meaningful and growing share is now going to come from debt. And that moves this from a cash investment to something that's, I want to call it speculative, but it feels a little more speculative, right? There's a real difference between a company risking its own money on a new idea and a company risking borrowed money. Right? Now, if you spend your own money, your own cash, and you're wrong, well, you absorb that. If you borrow at scale and you're wrong, that failure doesn't stay contained. It extends to the lenders or the bondholders or the credit markets or whatever you're depending on to provide you that funding. We're talking about big numbers here. So that's a risk that's seriously worth considering. And I think it's also worth noting that valuation cushion on some of these massive AI giants is thinner than it was a year ago. So, you know, there's a little bit less room for error priced in than there used to be. So we're not just looking at the revenue opportunity, but the cost of funding, the return on invested capital, and whether this spending ultimately translate into sustainable earnings and cash flow.
00:09:28
GS Fixed income markets have been volatile, with long-term yields moving higher and investors repeatedly reassessing the path for central banks. What has been driving that volatility?
00:09:38
WB Good question, Greg. Inflation remains important to bond valuations, but this environment is different from 2022. Nominal yields have risen faster than inflation expectations, which means real yields have now become more attractive. And at the same time, you've got this fiscal deficit, government bond supply, and the balance of buyers and sellers. Those are all playing a larger role in the market today. We've seen that fiscal deficit rise significantly. We've seen government bond supply increase dramatically as well. We're even seeing some language coming out of the US administration to try and control the bond yield curve with their supply. And these supply and demand characteristics do create that additional volatility beyond what we often think about when we think about bond markets being strictly central bank decisions.
00:10:30
GS How should our clients be thinking about the relationship between the starting yield and future returns?
00:10:35
CM Yeah, and we've talked before, but starting yield is an important component of the expected fixed income return. And that's pretty much the anchor in our strategic asset allocation work. Same lens we talked about earlier. It's just, you know, applied to bonds instead of stocks. - Right. - A higher yield provides more income and a larger cushion against a further rise in interest rates. So that's the good news. We've got a bit of a cushion in case things continue to get a little bit higher from here. But even now, you look at a Government of Canada bond, you're sitting around 4% today. That compares to a low of roughly half a percent back in 2020. And we're not saying bond prices can't still fluctuate, but that return profile available to investors today, starting with 4%, is meaningfully more attractive, clearly, than it was when deals were back at zero.
00:11:25
GS Yeah, so very much a different scenario than we were in in 2022, let's say. Absolutely. Okay, so the conflict in the Middle East has added another layer of uncertainty, particularly through energy markets. What are the downstream effects you're watching for?
00:11:32
WB The effects extend beyond the price of oil or even the refined products that come from oil. Higher energy costs can weigh on consumer confidence and reduce the amount households have available to spend elsewhere. Now, when you go to the fuel pump, you take a little bit more notice when the bill is due. It's a lot higher than it was just a couple of months back. And for Canadian consumers who are still recovering from that most recent bout of inflation I mentioned back in 2022, that recognition that inflation is happening, the cost of goods is increasing, that can affect both your sentiment and your spending rates. The duration and scale of the energy price move and how consumers and businesses react to it, those really matter for the broader economic outlook.
00:12:19
GS And then for Canada, the impact is not entirely one-sided. So how do the offsets work?
00:12:24
CM That's an important point. And yes, it's shown up in the numbers. Higher oil prices can be difficult for consumers and all the knock-on effects that Wes mentioned is important for all of us to recognize and understand. But they can also help support earnings, as we talked before, in the energy sector, which benefits part of the Canadian equity market and provides support as well for the Canadian dollar. Part of that's structural. So energy markets make up somewhere in the order of 15% to 20% of the Canadian stock market versus something closer to 3% or 4% in the US. So moving oil prices simply carries a lot more weight here than it does south of the border. Canadian energy stocks have been some of the strongest performers in the TSX this year, well up over 40%. That's actually part of why the Canadian market has been leading. And for what it's worth, even in US dollar terms, where the Canadian dollar has given back a little bit of ground this year, that still comes out as a strong gain. So it's not just a currency story. And now those effects obviously help offset some of the negative economic headlines with a diversified Canadian investor portfolio. And although the experience clearly will differ across households and businesses, depending on your investment versus your consumption patterns.
00:13:27
GS Okay, so we've talked a lot about the varying forms of volatility or the drivers of volatility. We've talked a little bit about equity markets, fixed income markets. I want to bring this all together. So when we bring these themes into one place, what is the quarter-reinforceable portfolio construction?
00:13:45
CM For me, it reinforces that diversification needs to be intentional. We clearly are seeing market leadership can and is changing. Those winners from AI are not settled. Fixed income is giving us a way better yield than it used to. And clearly, Canadian assets can respond differently to trade and energy developments than you might otherwise expect from the headlines. So thinking through that, strategic asset allocation, tactical adjustments, security selection, all of those continue to play an important role in managing those crosscurrents. Fixed income is giving us a way better yield than it used to. And clearly, Canadian assets can respond differently to trade and energy developments than you might otherwise expect from the headlines. So thinking through that, strategic asset allocation, tactical adjustments, security selection, all of those continue to play an important role in managing those crosscurrents.
00:14:15
WB It also reinforced the value of active risk management. We're not trying to predict every headline. We're assessing how risks interact, where markets may be over or under pricing them, and which portfolio levers can improve expected outcomes while trying to keep the portfolio aligned with its long-term investment objectives. Thinking through the layers of our portfolios, they're designed for that overarching purpose of realizing our clients' long-term investment objectives. But there's purposeful flexibility that we've embedded to help navigate the unique conditions that we're talking about today and those that we'll continue to encounter along the way.
00:14:54
GS All right, let's wrap this up with maybe one message you would like to leave with our investors.
00:15:00
WB I'm an investor too. I spend my day, all day, every day focused on investments. In my role, I'm focused on the drivers of long-term returns. So think earnings growth, think innovation, think of the attractive income that we're seeking, and then taking all of those components along with others to embed in thoughtful portfolio construction. Now, the headlines that we've been talking about here, they matter and some have a very real impact on Canadians, but investment decisions have to remain grounded in fundamentals and in long-term objectives.
00:15:33
CM Yeah, and Greg, for me, it reminded me that you've got a big team spending a ton of time thinking through all these things, And still it reminded me that, as I mentioned earlier, diversification across markets, sectors, sources of return is critical. We do not know precisely which headline or company will lead to a market shift next, but I feel really good knowing that we've built portfolios that are prepared for a wide range of outcomes and we've got the levers we can pull if we need to.
00:15:58
GS So, Greg West, thanks for joining me. This is a valuable and important conversation. And to our listeners, if the recent market or trade developments are affecting your confidence or raising questions about your financial plan, please reach out to our advisors. At Scotiabank, we're here to help for every future. Thank you for investing your time in today's conversation. Be well and keep investing.
00:16:19
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. T
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