David Lebovitz: Welcome to the Center for Investment Excellence, a production of JPMorgan Asset Management. The Center for Investment Excellence is an audio podcast that provides educational insights across asset classes and investment themes.

Today's episode is on Canada, and has been recorded for institutional and professional investors. I'm David Lebovitz, Global Market Strategist, and host of the Center for Investment Excellence. With me today is Jack Manley, Global Market Strategist. Welcome to the Center for Investment Excellence.

Jack Manley: Thank you for having me.

David Lebovitz: So, before we dive in, Jack, and talk a little bit about what's going on in Canada specifically, you know, it is important to take stock of where things stand with the S&P sitting right on the cusp of a bear market as we record this podcast, and obviously a lot of macro crosscurrents having affected markets so far this year.

And so, you know, I think what's so interesting to me about the current environment is, we don't necessarily have any new information, right? Everybody knows what's going wrong. Inflation is too high. The Fed is hawkish. We have a land war in Europe. You know, growth in China is slowing.

These are all things that are well-known and have been well-known to the market over the course of the past couple of weeks in terms of causing some sort of directional change. We think that that would take some sort of active bit of good news, right? Earnings reports coming in better than expected, a Fed which says they're going to take their foot off of the monetary break.

And in absence of that news, you know, I think we are going to be looking at a macro environment and a capital market environment, more importantly, that remains a bit bumpy, but amidst this bumpiness so far year-to-date, we have seen the more cyclical sectors and cyclical industries, right, the more value-oriented markets very much outperform the growthier side of the equation

And one of those markets from a geographic perspective is Canada. And so, diving right in here, I'd love to start by just getting your perspective on the Canadian market, the Canadian economy, what's been going on so far throughout what's almost the first half of 2022, and what are you thinking about the outlook for Canada over the remainder of this year and into next year?

Jack Manley: So, I think it's important when you are talking about any market outside of the US, to think about the length of the cyclical runway, particularly as it relates to the recovery post-COVID. You know, here in the United States, things have been more or less open for quite some time.

I mean, we've been traveling for a bit. There are parts of this country that never shut down as a result of COVID. The story is not really the same almost anywhere else, and Canada is no exception to that rule. There are many provinces that were under lockdown up until only a few months ago.

I, in fact, was in Canada just a couple of weeks ago. There are still widespread mask mandates throughout the entire province of Quebec. So, COVID is still a problem in Canada, although things are getting better. So, when we started this year, the cyclical runway for international markets in general and Canada in particular, was quite long.

And when you think about the fact that the Canadian market is quite cyclical in nature, the Canadian economy is quite cyclical in nature, this proved to be a very attractive backdrop, I think, for investor dollars. Then of course, as you mentioned, David, war breaks out in Ukraine, and all of a sudden, the outlook for international markets gets called into question.

But I think it was a combination of both the high-quality nature of the Canadian market, and truly the isolation, both geographic and economic isolation of Canada from the rest of the world that helped to kind of buck this trend that we were seeing in places like Europe, in places like the United States.

What's interesting, I'd say, is that up until just about a month or so ago, the Canadian market was actually up year-to-date. There are very few places around the world, particularly high-quality markets, that you can point to that have done so well. I think that is leading to a lot of interest in the region, and I think while things have turned south a little bit recently, there is still a lot of good stuff to say about the Canadian opportunity set.

David Lebovitz: And it's interesting, you mentioned that things have started to move in the opposite direction, you know. I think that given the nature - and I know we'll talk about the composition of the Canadian market in just a little bit, but I think, given the nature of that market, given the nature of that economy, when you see reports about slower growth in China, and perhaps a little bit more moderate policy response than people had originally thought, that's going to impact these economies that, again, are more oriented towards things like commodities and cyclicality more broadly.

And so, obviously the thing that has rubbed US markets and a lot of developed markets the wrong way so far in 2022, is this evolving dynamic between inflation, interest rates, and central bank policy. So, to start, since it feels like Canada has kind of bucked the trend here, at least over the majority of 2022, can you talk a little bit about the inflation dynamics, the interest rate dynamics, what you're expecting from the Bank of Canada going forward, and what you think that means for equity markets in Canada in particular?

Jack Manley: At least in terms of the inflation situation, unfortunately, that is not an area where Canada has bucked the trend. Canada is dealing with a lot of the same problems that a lot of countries around the world are dealing with. The most recent CPI printout, they're north of around 7%, I think.

Clearly, not as hot as what you're seeing here in the US, but you're still talking about inflation that is running at multi-decade highs and has been for quite some time. Now, the issue with inflation in Canada is that typically when inflation is caused by higher commodity prices, and that is certainly something that we're seeing right now, because Canada is such a commodity-focused economy with so many commodity exports, the Canadian dollar typically strengthens during periods like this.

And so, a stronger dollar is good for the Canadian consumer. It helps to erode against some of those inflationary pressures, and actually allows the Bank of Canada a little bit more wiggle room when it comes to the policy response.

This has not been the case this time around, and I think a lot of that can be attributable to this fact that war in Europe is a enormous source of geopolitical tension, and geopolitical tension leads to uncertainty, and uncertainty is inherently a US dollar-positive phenomenon.

And so, that typical kind of release valve that the Bank of Canada would have in the form of a stronger Canadian dollar, is just not present right now. And I think that's made the Bank of Canada act a little bit more aggressively than it would have typically responded in an inflationary environment like what we're seeing right now.

And I think it's interesting to say that Canada and the Bank of Canada specifically, is one of the few places around the world that is moving more or less in lockstep with the Fed. In fact, in a lot of different ways, the Bank of Canada has been more aggressive than the Federal Reserve. It hiked first. It ended QE first. Its quantitative tightening program is a little bit more modest, but we are seeing a pre-flat yield curve and elevated yield levels as a direct result of BOC intervention .

Now, in terms of where things are going from here, we expect two consecutive 50-basis point hikes kind of mirroring what you're seeing here in the United States. That brings us to a roughly 2% target overnight rate at some point in the next few months. We may see a few more 25-basis point hikes from there, and a few more 25-basis point hikes into next year.

That means that at least on paper, rates are going to continue to rise, although I think just as within the US, we have to realize that if economic conditions do deteriorate, and with valuations having eased off a little bit, maybe there is a little bit more room for banks around the world, but particularly the BOC, to wind back some of this aggressive rhetoric and talk back some of the hikes that they've put on the table.

David Lebovitz: Yes. It's interesting, it sounds like the Fed probably could have taken a little bit of a cue from what the Bank of Canada was doing. And it sounds like they've both kind of embraced this peak hawkishness that we seem to be seeing in markets. But there is one thing that again is common to both the United States and Canada that's driven a lot of this hawkishness, which is what's been going on with housing

You know, home prices are up substantially on a year-over-year basis. You're seeing the pass-through from those higher home prices into the government inflation statistics. So, I would love for you to just comment briefly on what's going on in the housing market in Canada, how is the pandemic boom playing out, and, you know, how do you think that the Bank of Canada is kind of factoring that dynamic into their outlook for monetary policy?

Jack Manley: It's a good question, and it's funny because nobody believes me when I tell them that the Canadian housing market is the hottest housing market on the planet, unless you're based in Canada, and then they absolutely understand just how bad things have been, particularly over the last couple of years.

Now, that's a problem that people in the United States are dealing with too, of course. I mean, we're looking at home prices here in the US that are about as rich as they've been in history, even when you adjust for inflation. I think you can say something pretty similar for what's going on in Canada.

The supply-side issues are very similar as to what you're seeing in the US as well, just not enough building, not enough supply on the market, but housing is a larger portion of the Canadian economy than it is here in the US. It's roughly 10% of GDP. So, a sort of outsized role of housing in the overall market.

And I think that's why the Bank of Canada has been so hesitant to do anything about this sort of unchecked surge in home prices until very, very recently, because it is such an important part of the overall economy there. Now, we have seen some signaling on quantitative tightening.

We have seen mortgage rates move higher. We have seen some buyers actually put homes onto the market, just to try to get ahead of this rising interest rate situation. So, supply is gradually improving. But I think the most interesting thing that you've seen happen in Canada recently, is actually policy from the Federal government, something that we weren't necessarily expecting.

We got a budget out, I think it was a few weeks ago, that explicitly laid out protections when it came to the housing market, and if you are not a Canadian citizen, you are no longer allowed to buy homes for the next two years. Now, of course, there are a lot of caveats to that.

If you are a student, if you're a permanent resident, if you're on a working visa, if you're looking to make Canada your full-time home, then you are welcome to enter the market. But if you're buying vacation homes, or if you're looking to speculate, Canada is not the place for you anymore.

And I think that means something pretty interesting, right, because now, not only is the Central Bank trying to take aim at this by slowly but surely raising mortgage rates, you're also looking at it becoming a political problem.

And so, we do expect to see some downward pressure in those home prices as speculative buyers are removed from the market, maybe a little bit of supply comes back online and as mortgage rates continue to grind higher

David Lebovitz: Well, that certainly undermines my plans for a ski home north of the border, but very important. And interesting that you see the Bank of Canada trying to impact both supply and demand in the sense of making financing costs more expensive, and then actively reducing the base of potential purchasers who could, in theory, allow this home price appreciation to continue.

So, having spoken about speculation, let's do a complete 180. Let's talk a little bit about the bond market in Canada and what you're seeing there, both in terms of opportunities, as well as risks.

Jack Manley: Again, I think the parallels here between the US market and the Canadian market are pretty clear in the sense that both central banks are on the rise. Both yield curves have flattened at significantly higher levels, and both have bond markets that have very broadly underperformed this year.

And if you're looking at the Canadian aggregate index, it's off around nine or so percent. Sovereign debt is off quite a bit. Corporate debt is off quite a bit. High yield debt is off a little bit less than that, but still around 5% or 6% year-to-date. It's been hard to find places to win in the Canadian fixed income market, and that I think is a problem that a lot of us are feeling as investors right now. It's hard to find those areas of opportunity.

Now, I'd say that if we do get some sort of Bank of Canada BOC, if you will, where the bank, for whatever reason, decides that all these rate hikes that they've been telegraphing, won't actually come to fruition, or they'll be spread out over a longer period of time, I do think it's possible that you see rates move modestly lower, particularly at the shorter end of the curve.

You know, I don't necessarily anticipate Bank of Canada to cut rates anytime soon. But if you're looking at say 10-year sovereign debt, we may see some downward pressure on yields there. It means that duration may play more of a role in a portfolio when it comes to that higher quality Canadian fixed income, but it also means that just as within the US, spreads have widened out a little bit, and credit instruments look reasonably attractive, particularly since the macro environment, I still think, is more or less benign.

Now, so far this year, it hasn't been fun to be in that space, but if you adapt this mindset of, well, how much worse can things possibly get? And I know that, you know, you're asking for trouble by asking that question, but are we really going to see aggregate bonds sell off another 8, 9, 10% this year?

If you don't think that's the case, then having that more neutral stance on duration, looking to perhaps an extended credit sector, is all that I think makes sense in Canadian markets.

David Lebovitz: And obviously, if we were to achieve some stability on interest rates and kind of put some of this overly hawkish (rhetoric) to bed, that could very well be a good thing for risk assets and specifically equities. You know, we opened up by talking about some of the differences between the United States and Canada from an economic perspective, from a marketing perspective.

Let's shine the flashlight around a little bit on the market side of things. And can you start by talking to us just a little bit about how the Canadian market is different from the United States, with respect to sector and industry exposure? And then, can you spend a few minutes talking about the opportunity set there as you see it in the current environment?

Jack Manley: The Canadian market is highly cyclical right off the bat. And when it comes to sectoral composition, you're looking at around a quarter of market capitalization being focused in commodities-heavy sectors, split pretty evenly between energy and materials

You can add another 10% on that for industrials, and then another 20 to 25% on that from financials, and you're looking at a market that is roughly 60% cyclical. That automatically puts it at odds with what you're seeing in the US, where only around a third of our own market capitalization is cyclical.

Canada, like many other foreign developed markets, has a much lower exposure to technology and tech-adjacent assets, a much higher exposure to this more value or cyclically-oriented sectors. Now, at the beginning of the year, we saw a nice runway, as I had mentioned earlier, because Canada was going through the slow but steady recovery post-COVID.

We did see some upward pressure on commodity prices even before the war broke out in Ukraine a result of increased demand and not enough supply. Canada was doing quite well so far this year, or I guess up until about a month or so ago. We saw very recently, though, things have turned, what drove the market from positive to negative territory, was a further compression in multiples in the technology sector.

So, you're still looking at, say, energy doing quite well this year, materials doing quite well this year. It is the technology sector that has sold off so significantly, despite the fact that it is not a particularly large part of the index that has dragged the overall index lower.

And that, I think, has to do with what we were just talking about, right, this threat of rising interest rates, an overly aggressive central bank, stubbornly hot inflation. As you mentioned, David, you know, if we do see some of these things unwind a little bit, it's not about absolutes. It's about rates of change.

And I've heard you say that before. I think it's the best way to think about this kind of stuff. Even if the Bank of Canada underdelivers by one hike, by 25 basis points, that change in the outlook is enough of a tailwind for risk assets that I think that the more beat up parts of the Canadian market could start to see a bottom relatively soon.

The more cyclical parts, the more value-oriented parts, as long as they remain more or less isolated from what's going on in Europe from a war perspective, I think there's still more room to run on that front. One last thing to add on this, the valuation argument is very strong.

You know, we're looking at an energy sector that is up around 30% year-to-date. People would be hard-pressed to believe that valuations are still cheap relative to average when it comes to the energy sector, and there are a number of sectors that you can point to like that.

Canada is an inexpensive market. Recent volatility has made it even less expensive, but unlike places like Europe or Japan where you have a lot of baggage for one reason or another, I think Canada is a higher quality investment play for cyclicality.

David Lebovitz: So, we've talked about a lot of different things here today. We've talked about the quality of the Canadian market. We've talked about the cyclical runway that we see for their economy. We've talked about how inflation is being a little bit pesky, but that the central bank is actively trying to cool things off there. And we've talked about the opportunity across both equities, as well as fixed income.

Maybe just giving you kind of a wild card here to wrap things up, you know, you spend a lot of time traveling to Canada, interacting with our institutional clients north of the border. What's on their mind right now, and what haven't we touched on today that you think is going to be important for our listeners to take away?

Jack Manley: You know, I think investors everywhere are concerned about at least some of the same things, right? This rising rate environment, hot inflation, war in Ukraine, things that we've already talked about. I will say that when I speak to our Canadian clients, one of the things that's very interesting is that they have a much more global mindset when it comes to asset allocation. There isn't as much of a home country bias as you see here in the US.

And I mean, look, I think that makes sense, right? The US equity market is the largest in the world. The Canadian equity market is relatively small. So, you can't really have a well-diversified portfolio exclusively composed of Canadian equities. But it does mean that the conversation has turned to more broad topics outside of just what's going on in, say, North America.

There is a lot more interest in European assets. There is a lot more interest in emerging market assets and Japanese assets. It is a more global play when it comes to Canadian investors. So, that, I think, has been very interesting because we have been talking about this sort of ex-US opportunity set for quite some time, perhaps a little of a challenge right now because of the war, but still some runway there, I think, especially with prudent sector and security selection active management.

You know, one other thing that I'd add here, David, that I think people need to realize when they're considering the Canadian equity market, is that yes, it is cyclical. Yes, it is high quality, but no, it is not a diversifier in a portfolio. And that is something that's really important to point out here.

You're looking at the Canadian economy having a correlation of almost exactly one to the US economy, a beta of greater than one. If the US enters a recession for any reason, it's going to be very hard for Canada to escape that black hole.

And so, when we think about allocating in today's world, this is not a hedge against US exposure. It's not a hedge against US recession. It is a beta play taking advantage of cyclicality and cheaper valuations.

Still very attractive and a whole lot to talk about there, but if you're looking for those correlations, if you're looking for that diversifier, the Canadian market may not be what you're looking for.

David Lebovitz: I think that's a really important point. Tough to have a house fire and have the addict survive, is another way to think about it. So, Jack, this has been great. Thanks so much for taking the time to join us today on The Center for Investment Excellence, and looking forward to having you back again sometime soon.

Jack Manley: Thanks very much

David Lebovitz: Thank you for joining us today on JPMorgan's Center for Investment Excellence. If you found our insights useful, you can find more episodes anywhere you listen to podcasts and on our Web site. Thank you. Recorded on May 23rd, 2022.

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