Quarterly Check in September 2022
Quarterly Check in September 2022
Thank you for joining us today for the Burnett Okanski Dale Financial Group's quarterly Check In. For our meeting today, Tom Burnett is going to provide an update on the state of the markets, followed by Andrew Dale, who will talk about stagflation. Then Tom Okanski will wrap things up with stress testing your financial plan. If at any time you have a question, you can type it in where it says Q&A or where some of you may see a speech bubble with question mark in it, depending on the version of the teams that is running. If you'd like to remain anonymous, there's the option of posting the question anonymously. Thank you so much for joining us. And now I'm going to turn it over to Tom Burnett for an update on the state of the markets.
Thank you, Jamie, and welcome, everybody, to our third quarter call for 2022. We're back in the office or most of us are, and we're here in downtown beautiful London, Ontario. So first I thought I'd go over the various markets and what they've been doing year to date. I'll talk about the sort of average portfolio experience of a 60/40 portfolio, a little bit into inflation, and we'll talk about again this presidential cycle, which we talked about last time. So as of last night and these quotes are all off Bloomberg and Thomson Reuters and all the sources that we get. The Toronto stock market was down 10.6 sorry, 10.06% year to date, and that's one of the better ones in the world. DOW was down 14%, S&P500 down 18%. Nasdaq down 26%. It was down 30 by about the middle of June. Fixed income, also known as GICs and Bonds, bonds are having one of their worst years in history and today our bank rate was set up by another 0.75% or 75 basis points. It's three and a quarter percent now. And if you're looking in papers and other media, you're seeing about what mortgage rates are doing and real estate. The Canadian dollar is, the exchange rate actually versus the US is basically a two year low almost for the Canadian dollar or a two year high for the US or about 1.32 on the spot. This morning when I was preparing this. This is the highest since 2020. We'll see how this continues. On the commodity front, oil is still up year to date. Before today, it was up around 15%. Gold was down 6%. Nickel and palladium were the only maybe two of the three commodities that I actually saw, they were up year to date. Nickel being up 2% and palladium being up almost 5%. It's kind of funny when gold is an inflation hedge and yet it's down 6%. So we'll see how this pans out as well. Going back to the Canadian market, the strength year to date still is in energy, meaning oil and gas and the fertilizer stocks. The metals are up. These are the base metals, not gold. They're up a small, small portion. Also, staples, you look at the staples sector, that's going to be the grocery, the food companies, things like that, they're up about 5% and utilities are up around 3%. In the US, it's pretty much the same story. Oil and gas before today we're up 42% year to date and utilities were up just under 4%. Out of all the sectors in the economy and in the markets, those are the only ones that were up. So that's where we are as of right now. The next slide Vivien's going to show us is this is to do with the 60/40 portfolio, this is your balanced portfolio. And this is going back with various periods in time and showing some of the some of the worst years of declines. So basically going back to 1976, so we're talking almost 50 years here.
So we have years where the S&P500 is down and on average it's down probably in the teens. And then you have the bond index. And what is the anomaly this year is when you have the markets down, usually the saviour has been the bond market, but the problem is as rates have gone up, bonds have also gone down. So if we look at it here for 2022, the S&P 500 was down 16% when this was written. This is back a month or so it's August 31, to be exact. And the Bloomberg US bond index was down almost 11%. So if you do the basic math on this, a balanced portfolio, which is what most people strive to have, is down 14% year to date. We'll have some clients more than that in some clients a lot less than that. It just depends on the overall mix that people have and what your objectives are. So this is just just showing you that this is this is an anomaly year. So it hasn't been great for most portfolios. And part of this, I think, especially on the bond side and why it's been acting up is the next slide Vivien will show us, and I had put this or we had put this in one of our quarterly reports that we sent out to our clients. This was a Bloomberg News or a Bloomberg cover from 2019 April. Is inflation dead? It was probably at the bottom of inflation. And as usually happens, the cover of magazines is usually counter to what's happening.
So what we're waiting for now is to see a dead bull on the front of a newspaper where the bull market is dead. And that might be showing us the bottom, or at least a sentiment swing to the negative. But on the right side of this, we have a lot of global inflation rates. Again, this is about a month out of date now, but you can see the different countries and then the various inflation rates. Venezuela has 167%. I don't think we're quite there, but in bold we have the US at 9% and Canada at about 8.1%. The latest numbers that just came out are a little bit less than that, not much. And what we're all waiting for is the inflation rate to tick back a bit, so the Federal Reserve and the central banks can lower rates. That's what we're hearing now. But last year we also heard that inflation was transitory and there was no big danger for it. So the problem is we don't want it entrenched. But what is happening is if we look at the price of oil today, it was $86, I think, when I did this this morning. It's down about $3 right now at about $83, $84 bucks. It was $130, $135 when Ukraine was initially invaded by Russia. And that was the peak for it so far. And there's a saying that there's the best cure for high prices is higher prices.
And what's happened is if oil kept going up or keeps going up, people, they spend less, they travel less. If you if you live in Europe right now, you're probably looking for wood, coal and other things to heat your house this winter. We will see how this plays out as well, because they're looking at alternatives again. Some of these some of the governments are now looking at restarting up nuclear plants and things like that. So, again, this will play out. But is inflation going to stay at these peak levels or go higher? We don't know yet. But again, once that stabilizes, you'll see some stability in rates going back down and hopefully a better stock and bond market. The other thing, the last thing I wanted to address and I talked about it before was the presidential cycle. And this graph is essentially what looks to happen over the four year term of a US president. There's three there's three years that I'm really interested in. The fourth year is the sort of the lame duck year usually, or the last year with a lot of things get passed and it's, things just happen. But. The error on this slide actually is you see a little insert in there, where it says a quarter. We are just beginning, that's that should be year two. We're actually in year two of the presidential cycle, which in the third and fourth quarter are usually the worst years for the market. But the overall year is usually a flat year or a nowhere year.
That doesn't mean we should be flat and not down 10%, it just means this is a year where things don't don't usually work out for the best for the equity investors. But coming out of this, usually you have the best year, which is the third year. All the all the unpopular stuff is usually driven through or go through through the first couple of years of a presidential president's term. And we're about to get through the midterm election in the US. We'll see how that pans out. There's other things that I can bore you with, but they're probably beyond the scope of this as well. There's all kinds of studies that were done. There's one that a guy named Lee Bohl did. There's a Charles Schwab researcher, and he analyzed markets from 1933 to 2015. And essentially, of all the four years, this is the worst year. But through all those periods in history, it averaged about 5.8% for the year, whereas the third year was something like 16%, and then the fourth year was about 7%. So again, nothing really seems to be great on the horizon right now if you're watching media, reading the news, talk, all the things that are happening, but there is usually a light at the end of the tunnel. So I want to leave us with that note when I'm talking about the state of the markets. So I'll pass this on or pass this back to Jamie now. Thank you.
Thanks, Tom. Now over to Andrew, who's going to speak about stagflation.
Thank you, Jamie. For the first time in a long time, we're hearing the term stagflation thrown around in the media. The word stagflation is a combination of stagnant and inflation, and the inflation part is pretty self-explanatory. The stagnant part refers to the economy specifically to slowing economic growth and an increase in the unemployment rate. If we move on to the slide, thank you very much. For the 15 year period between 1968 to 1983, a period of stagflation, the Consumer Price Index in the US rose by over 185%. The average annual rate was about 7.3%, a rate that we're familiar with right now. The issue we had back then, the 15 year period that we went through back then, the Federal Reserve was really slow to raise rates and then cut them several times too quickly whenever the economy entered a recessionary environment. Inflation was not brought under control until Paul Volcker took over at the Fed in 1979, when he eventually pushed the Fed funds rate over 19%, resulting in two painful recessions along the way. The current period we're in is not the same as the stagflation period we went through back then. Not yet, anyway. Economic growth is slowing. Inflation is way up, but maybe moderate. And although we were hearing about mass layoffs at a number of companies, particularly in the tech industry, the unemployment rate is not increasing. If anything, we are still trying to work through a labor shortage. There's no question that we've been dealing with inflation at elevated levels for more than a year now. The price of just about everything has been rising, especially on the commodity front.
In the last few months, we have seen some prices begin to moderate. In southwestern Ontario we've seen gas prices that went above $2.00 Come down to around $1.50. Lumber prices that went parabolic last year have also moderated. We've seen the demand for housing cool off as interest rates continue to go higher. All other things being equal, there is generally an inverse relationship between housing prices and interest rates. Many people who buy a home, particularly first time homebuyers, don't really care about the price of the home they're buying. They care about the monthly mortgage payment. With a 20% down payment, $1,000,000 home at a 1.75% interest rate, has a monthly mortgage payment that is about $1,500 a month cheaper than the same home with the same down payment at a current 5.25% interest rate. Not surprisingly, rising interest rates have been successful in cooling off the housing market. In Canada and in the U.S. Inflation is still elevated, but it is hoped that it may have peaked. The outlook in Europe is much worse. They have been impacted to a greater extent by the Russia-Ukraine war and the high US dollar. Pardon me. It's causing them to import inflation as most commodities are priced in the US dollar and both the pound and the euro have dropped significantly against the dollar. In terms of economic growth, we are showing signs of a slowing economy, but it is slowing from a really high level. 2021 had a tremendous amount of growth coming off the pandemic shutdown year of 2020, lots of pent up demand for just about everything and an easy year over year comparison. We're now comparing our 2022 numbers with numbers from 2021, and not surprisingly, we are slowing from that elevated level.
One definition of a recession is two consecutive quarters of slowing economic growth. By that definition, we are already in a recession. A better definition is provided by the National Bureau of Economic Research that involves a more robust set of criteria, including the change in the unemployment rate. On that front, the labor market is still incredibly tight. We have seen rising wages due to labor shortages and what is being called the great resignation. Wage inflation tends to be quite persistent and can result in a wage price spiral. If most employees wages go up, so will the cost of most things being produced or most services being provided and a company wants to maintain their profit margin, so they raise their price. As the cost of everything goes up, employees will demand a higher wage to keep up with inflation. Which then, we'll go through the cycle all over again and help push inflation even higher. What is the cure for the high inflation we are all feeling? Generally, it is a higher interest rate environment and if we look at the next slide, we can see the short term rates have gone up substantially in the last half year. This graph, as of September 1st, it would look differently today as the Bank of Canada, as Tom Burnett mentioned, raised the overnight rate by another 75 basis points a.k.a. 0.75%. That has been a significant change. And if you look at the orange dotted line, if you can make that out, that was where we were half a year ago. The blue line is where we were last week. Six months ago, the two year rate was under 1.50%. It is now over 3.50%. That is a tremendous move in a relatively short period of time. As long as the labor market remains tight, both the Federal Reserve and the Bank of Canada are likely to continue hiking in 2022. If you look at the shape of the Canadian yield curve, the yield curve is what we're looking at, it would indicate that the bond market is not expecting rates to continue increasing. It is an inverted yield curve, meaning that you get paid more on the short end than on the long end. It is often a leading indicator of a recession. In the current inflationary environment, a mild recession may be what is needed to cool off the labour market, which would reduce wage inflation and hopefully gradually bring inflation back down to the long term target of around 2%. We won't see the inflation that low in 2022, but maybe by the end of 2023 we will be getting closer to that target. The road ahead is likely to continue to be volatile. A couple of things to keep in mind: The stock market is not the economy. The stock market tends to lead the economy by half a year, and if we are in a recession or we do go into a recession, the stock market usually rebounds long before the economy will. On that note, I'll turn it over to Jamie.
Thank you, Andrew. And last but not least, Tom Okanski is going to discuss stress to stress testing your financial plan.
Yes. Thank you, Jamie. So we know a lot of growing anxiety out there about finances. Recent polls suggest about 70% of the population is beginning to experience some financial anxiety. What does this financial anxiety mean and what are the consequences? The meaning comes out in sort of different shapes for different people, for those that are working and saving questions like: Will I have enough to retire if inflation and the markets don't cooperate? Can I possibly save enough to retire securely? How much of my lifestyle today do I have to sacrifice to compensate for this inflationary and market poor performance? For those that are retired and living off investments and pensions. Questions like: Will my capital last my lifetime if inflation stays high? Is my buffer large enough to account for higher inflation and poor market returns? So with inflation picking up and returns in the markets, both bonds and stocks looking really rather unimpressive. It's understandable that the anxiety levels are rising. And they may be rising for you as well. So let's talk a little bit about the inflation side of of this picture and and and deal with the stress of it. This this stress, we're not there yet. I think we're not in capitulation stage yet, but the stress of this sort builds and can result in some really unfortunate outcomes. First outcome might be you make a dramatic decision in the heat of the moment. Emotion that tears away at all of us can otherwise derail a pretty healthy strategy.
That works both sides, the optimism and the pessimism. You might exit an otherwise healthy portfolio structure that you have that's been tried, tested and true, the 60/40, for example, for many years. So you get into this, get me out before it gets worse, find me an escape somewhere! And that typically is done at the bottom of whatever the cycle is. So we do have to be conscious that that our emotions play very heavily over the the rational sort of reasonable outcomes that might might still prevail in these in these markets. So let's examine these anxiety producing events in the context of how much impact that they might have on our best laid financial plans. As an aside, we are assuming that the majority of you have done this exercise. That is, you have somewhere in your drawer a financial plan. So two things that are happening that are testing our plans. First, inflation is running away, way above average projections that are used in these financial plans. Financial Planning Canada, the institute that oversees financial planning professionals, their long term number that they recommend using is 2.1% in financial plans. And so this number in creating financial planning projections is commonly used and has been a standard in the Institute for some years. Inflation as we know it today is like probably three times that number. Number two, markets are down. Both the stock and bond markets have dropped over 10% year to date, as Tom Burnett points out.
Long term interest rate projections used in financial plans run around 1.375%, in stock projections around 5%. So are these being derailed long term, permanently, or or short term? And what are the effects of that? So what I want to do is maybe help us understand how much these recent effects might affect our long term plan outcomes and with this call deal with the inflation issue. Focus on that one. Please refer to the accompanying table. I call out the effects of changing inflation rates on the average rate. Now what I've done is illustrate how financial planning Canada. 2.1% number comes about, and look at how it might be affected if inflation persists at higher numbers for the next few years. So let's look at that 2.01% number. You can see it is the average of all annual inflation numbers from 1990 to 2021. You know, that might seem like a pretty reasonable good length of time to figure out an average plan to work with in the history and going forward in your life. But you can see in this table. That that 20 years only takes into account two of the higher years from the early 1990s. And remember of the eighties and seventies and eighties and nineties were inflation numbers were substantially higher. This 20 year average just picks up two of those numbers. Look in look in 1990 at 4.8% and look at 1991 at 5.6%.
Other than that, you hardly see a number over the high 2% range. So this this series takes into a lot a lot of years, but a lot of years of falling and low inflation. Have you used that 2.01% number in your plan? That average that that that's being recommended? If you had a plan with us, typically, we have tried to be more conservative and use the number closer to 3%. Whenever this planners come out with a what are we going to use as a plan number? And here's the here's the recommended 2.01%. We almost always default to saying, you know, let's just look at 3.0%, let's look at a more worst case scenario and go to 3.0%. So there's a bit of comfort in there in that any plans that we've done will typically have a higher inflation number than than the current average, but maybe not the higher average going forward. So let's look at let's look at what happens if inflation is higher for a few years and how it affects that average. You see, I've done some estimates for the next five years that are dramatically higher than what we've recently experienced. And maybe these estimates are nothing but ballpark estimates, but I don't think that they're unrealistic. So you see that in 2022, I'm showing a an 8.0% number, not so far off what we've seen so far, year to date. 2023, the high interest rates and upcoming recession and slowdown in the economy, we've got that down to 6%. 2024, we're at 4.0%, 2025 we're at 4.0%, 2026 were at 4.0%, 2027 were were 3.0%. And now remember, as Tom points out, that the long term goal for the federal bank central banks is a 2% inflation number. And you can see that in this series of inflation numbers that you see in many years, they've they've accomplished that number. So will we get back to that number in the next four or five years? Hopefully. But what does that extra high number of inflation in the next five years do to financial plan exercise going forward? Well, it says that the average inflation used in financial plans might move up a fair bit from 2.01% to 2.46%. You see my average down there from 1990 to 2027 using those higher numbers. So what does that mean to us in purchasing power and for our financial plan? Well, in 20 years, if I use a rate of 2.01%, $1 will have a value of about $0.47 in today's purchasing power. If I use the rate of 2.46%, that dollar now has a value of about $0.40 in today's purchasing power. So if your plan today was based on 2.01% and the reality going forward is going to be something like 2.46%, your future cushions value in your financial plan is reduced, reduced by about 15% in today's purchasing power numbers.
So what conclusions do we want to reach out of, out of a possible higher impact of inflation in our financial plans? Well, number one, sudden changes in inflation can have an effect on the long term projections outcomes. You see, I've put in some dramatic numbers and it will affect, if those come true, it will affect your your outcome, and that that that sort of 15% decrease in your future value of of funding is a significant. Number two, it's better to use a higher number for an inflation projection in your plan to be conservative. So start out when you're doing your financial plan or revisiting it with a higher number than this average, and especially if this average that we're looking at is used on a series of lower inflation numbers, as we've seen mostly with this current average. And finally when planning insure your final net worth cushion is not skimpy. If the goal is to run out of money on the last day of your life, well, try altering that goal. Maybe from $0 to another 15 to 20% over what the $0 might have been otherwise. So I've just now addressed some of the financial impact on financial plans and how it might be stressing your current financial plan. So tune in next time and we'll have something to say about stress testing your financial plan when it comes to market and interest rate projections. Back to you, Jamie.
Thank you, Tom. Onto our question, period. We do have a couple of questions that have come in. First one, Tom Okanski. If you could handle this one, could you further describe what measures might take to ensure our financial plan is robust with the uncertainty of returns and inflation rates?
Well, I think, first of all, you want to confirm your goals. And there are two sort of general camps here. One camp of goals might be I want to use my assets for my lifetime and I don't really have any estate considerations, so I just want to run out of money on the last day, ideally. Second camp would be I want to use my assets for my life and I want to leave an amount in an estate whether whether that's for children, beneficiaries, charities, whatever it might be, but I want some sort of an estate in there. So depending on which camp you fall into, the strategy, of course, differs. If you're an option one, look at the buffer that you created. What life expectancy is your financial plan using? Maybe you want to do a projection that has you living longer. Typically, financial plan projections take you to 90-95, maybe you throw a few more years in there and see how that plan, stress test that plan a little bit to see if your life expectancy is longer. That should allow you to have a bigger buffer if you if you do pass away in within the life expectancy. And that cushion, what's that cushion projected? We always like to see a cushion here for a few years.
Maybe you want to make that cushion a little larger. And life projections moving up a factor of, say, 20% over what it might be now. And then finally, then you're looking at, well, what do I have to do to get there today? And today's actions, spending returns, whatever it might be. Now, if you're at option two then understand the effects of inflation on what that estate value will be in today's dollars. As I explained from using the FP, Canada's inflation number means that a dollar in your estate 20 years from now is really worth $0.47 for your beneficiaries in terms of spending power today. Altering that by a higher number that I said might happen, then I'm saying, well, maybe maybe that dollar out there at your desk is really only worth $0.40 today. So that estate that you're projected to have, once again, whatever your goal is for that estate, consider it in terms of spending dollars today. And if that doesn't meet your goals, what you're leaving your children, grandchildren, dogs, cats, charities or whatever? Well, you have a few choices. Once again, spend less, save more, get more returns, perhaps, which entails, needless to say, taking some more risk. I hope these suggestions are helpful to your question.
Thank you, Tom. Next question I'm going to pass on to Andrew Dale. The question is, when you consider analysis, how do you determine real inflation and real value of energy companies?
Andrew, Thank you, Jamie. I apologize right off the bat because I haven't had an opportunity to to click on the link and read the article. But we can get back to you definitely with a more detailed response after we take a look at the actual article. For now, I'll mention when you talk about a real interest rate or pardon me, a nominal rate, you're looking at taking the amount of inflation away from that and then you're left with the with the real rate. When we're talking about real inflation, which you've got on here, there's a number of different metrics that are used when calculating inflation. And when we look at the real value of a of an energy company, I mean, at the current level of prices for oil and particularly natural gas, when you look at the market in Europe, the value of these energy companies is, oh, my God, huge. If you make the assumption that that we're going to remain at these elevated levels for a longer period of time. There's no no easy answer to that. But there has been an underinvestment in the area. Traditional energy investing has been quite unpopular and due to the underinvestment we're seeing a big pop and it may be more prolonged. We've got to get energy where it needs to go, where it needs to be. We see issues in I believe it was Massachusetts came out or New England, it could have been, I apologize, one of the two, that you know, they're right by a huge, huge deposit of natural gas. And I believe the Marcellus Shale is the lar gest in the world. And they they're importing natural gas and, you know, which which is crazy, but they don't have the infrastructure to get it where it would need to be. Anyway, before I go off on a tangent, I think I already did, the value of of energy companies today is, they look like, depending on what you mean by the real value of them, if we're looking at inflation adjusted or if you're referring to their valuations or valuations are very appealing and we can get back to you with a more detailed response after we're after we're able to take a look at that article. Thank you for your question.
Thank you, Andrew. We have no further questions at this time, so that will conclude our call for today. Thank you for tuning in. And we look forward to seeing you in our next quarterly check in. Have a good day.
Quarterly Check In May 2022
[00:00:04] Thank you for joining us today for Burnett Okanski Dale Financial Group's quarterly check in. For our meeting today, Tom Burnett is going to provide an update on the state of the markets, followed by Andrew Dale, who will talk about valuations and volatility. Then Tom Okanski will wrap things up by talking about the energy transition. If at any time you have a question, you can type it in where it says Q&A or where some of you may see a speech bubble with a question mark in it, depending upon the version of teams that you have running. If you would like to remain anonymous, there is also an option of posting the question anonymously. Thank you so much for joining us. And now I'm going to turn it over to Tom BURNETT for an update on the state of the markets. Tom.
[00:00:53] Thank you very much, Ann, and welcome, everybody. This is our second call, I believe, of 2022. Spring has sprung, at least it has. In London, Ontario, we have green shoots and green leaves coming now. So hopefully that's a good omen for us all. I'd like first off, just to go over a recent market statistics and we'll also go over a couple of charts to show you the state of state of things at the present time. So these are numbers from Bloomberg. And as of last night's closes, the Toronto Stock Exchange is down almost 5%. It's actually down 4.8% as of last night. Dow Jones, New York is down 11.32 year to date. S&P500 is down 15.9. And the NASDAQ, which is the home of many of the tech stocks, also known as Fang, is down 25.45% year to date. These are large numbers, EAFE, which is also known as Europe, Asia and the Far East, which is pretty much everything outside of North America, the major markets, is down 16.68% year to date. So you might ask, what is up this year? Well, oil's up this year. Oil year to date, as represented by West Texas Intermediate, the Cushing is or Cushing spot price is up 48.3%. All you have to do is go to the gas pump and actually you can see that two gases over two bucks a litre here in London, and depending on your metric conversion to Imperial, we're pushing well over eight bucks a gallon.
[00:02:23] Hasn't been this high, I don't think, in our lifetimes. Gold, interestingly enough, is flat year to date. As of last night it was zero in US terms, depending on the futures contract you're looking at. I was looking at Bloomberg. It's very interesting with all this talk about inflation, that gold is flat. Also, if you look at the grains, wheat is up 59% year to date, corn up 35%. A lot of this has to do with the Ukraine. That's one thing that we can say is happening there because we're a breadbasket of the world, but so is the Ukraine. I just thought we'd also go over a few other things here. I'm going to look at the first slide here, which is going to be a little chart on the bond market. This is the Bloomberg Aggregate Bond Index, annual returns from 1976 to 22, 2022. This is as of, I believe, May 10th this year. This is an index, an intermediate term bond index, which is two to a maturities from 2 to 10 years in US investment grade bonds. So this is not junk, junk bonds or high yield bonds. These are investment grade bonds that we would put in portfolios or you would buy and feel comfortable with as far as the credit quality, like a bank bond or a big corporation bond. As you can see, this is down over 10% year to date and it's the worst in history.
[00:03:43] This is going to be addressed by my two colleagues after they'd be talking about certain things about inflation and things like this. But this is the state we're in right now. And on this chart, you can go back to the beginning where you see periods in the late seventies, early eighties, and that's when we had old timers remember rates in the teens. You had a massive mortgage rate maybe of 14 to 18%, depending on if you're lucky to buy one at 18, that's not a good thing. We're nowhere near that right now, but what's caused a lot of this is the acceleration or the rate of change in the rates. Usually after a bad year like that, you're due for a good one. So that's just one thought. The next next slide, if somebody can move that on for me, is of the Nasdaq stocks above the 200 day moving average. What this is about is basically the stocks that are trading above an average price over the last 200 days. And this is a metric or a measure that a lot of portfolio managers look at to see what the long term trend of the market is. And we're down there in a low range of around 16%. Again, this is as of May 10th, so it's a bit out of date, maybe small. It probably went actually lower in the last couple of days.
[00:04:57] But you can see other measures on here at previous lows, like '07, '08, '09. Then we had this little bit of a meltdown in 2011, and then we had other smaller sell offs. But the NASDAQ represents all where all the growth is. So again, this is where FAANG is Facebook, Amazon, Netflix, Google. Also, you can throw in Tesla in there and Nvidia. So these stocks are what are representing this to a large extent, this index and they are down. But this is also a measure, measure of pessimism. And right now we are very pessimistic, as in the average investor is ,usually it's the sign of a bottom approaching or something close to it. The headlines aren't good as we know. The next slide I wanted to go at, which kind of coincides with this as well, and this is one of these seasonal studies, but there's usually a cycle to the presidential, like the US presidential cycle, which applies to the markets. We're in year two right now. So this is what the average cycle is over many years. But we're basically right now in the second quarter of year two and year two is not necessarily a good year. If you can see by this chart, the best year is usually year three. Year four has a bit of a downtick and sometimes, that's basically based on the, I guess the what people are looking at is the uncertainty who is going to be the next leader.
[00:06:22] You're going into an election and then once you're out of that, usually there's a big run up. But year two is historically where unpopular or things that are maybe not good for the market get passed through the Senate, through the House. The president tries to push stuff through that maybe are not good for the capitalist system. Who knows what the what the excuse is du jour. It's also basically the year where the honeymoon is over. Other things are happening that he's doing that people are not happy about or the party in power is not happy about. The other thing that happens in this year is there's a midterm election and usually there is a change, sometimes in one part, form of the government or another. We'll see. And that also leads to uncertainty. So I thought that is typical of a presidential cycle. We're in the year two, but if you throw on to that a war in Ukraine, the interest rate and the inflation inflation situation that we're in which my colleagues will talk about and valuations is where they are. You can see where we are right now. Maybe it's not a good time, but I think what we'll see is out of bad times comes good, come good times. Anyway, that's a little bit of an update of where we are right now and I think I'll pass it back to you Ann.
[00:07:37] Thanks, Tom. We certainly live in interesting times. Let's keep things moving. Andrew was going to speak about fluctuations in volatility, Andrew.
[00:07:51] Thank you, Ann. I'm going to split my time talking about both the valuations and the volatility we're seeing in the market this year. And I'll begin with the P/E ratio and if we put that up, thank you very much. It's relatively basic valuation concept. Price to earnings ratio, more commonly referred to as the P/E ratio. It is the price of a stock divided by their earnings per share. And we generally use the forward P/E which looks at the projected earnings 12 months out. Now the P/E is not the be all and end all for valuing a company. It has many shortcomings, but it is a good starting point. In general, the higher the P/E ratio, the more overvalued a company or market is. And for this discussion, I'm going to look at it from an overall market perspective. The broadest market in the world is likely the S&P 500, so that is the one I'm going to talk about. If we look at the chart here and the chart is from FactSet and the numbers I'm going to talk about going forward are all from FactSet as well. So the five year average P/E ratio for the market has been about 18.5, which is well above the longer term 15 year average of 15.5. As of May 5th, the forward P/E ratio in the S&P 500 was at about 17.5. So we are cheaper than the five year, but more expensive than the longer term. The S&P 500 closed on May 5th, a little under 4150, which corresponds to aggregate earnings per share for the market of approximately 235.
[00:09:33] If the earnings estimates do not change, for better or worse, and the P/E for the market was to return to the 15 year average of 15.5, it would correspond to a level on the S&P 500 of almost 3650 now. Full disclosure, I don't have a crystal ball and I'm not making a call that the S&P 500 is heading to 3650. It might get there. It could drop even further or it might not get that low at all. The main variable in the equation is what will earnings be going forward? They're unlikely to be static. Many companies will be able to pass along the inflationary cost pressures that are facing, higher than expected revenue growth in nominal terms for these companies. And some of these companies will actually have a better bottom line as a result. Now, if we estimate that the earnings forecast for the S&P 500 will be revised upward by 11%, then that 2.35 EPS forecast, earnings per share, would increase to 260.85, if we're if we're getting specific, and if we multiply that by the 15 year average market P/E ratio of 15.5, that would give you a value of 4043, which is more or less where we were last week, realizing we were higher and lower than that last week. If earnings are revised lower, then obviously that would correspond with further weakness in the market. The big takeaway is that just about every market in the world is having a bad year and it could get worse before it gets better.
[00:11:03] We know it will get better. The market has rebounded from every decline in history. We know it will happen. We just don't know when. Now, I've been speaking about the stock market, but the weakness we have, we have been seeing has been happening in just about every asset class. Negative returns and above average volatility has hit the equity market, preferred share market and the bond market. The bond market in Canada is actually down more than the stock market, which also happened last year, but last year the stock market did great, so most people didn't care that their bonds were a bit negative. In 2022, so far, everything has been down. Now, getting back to the equity market, I should mention that there's an inverse correlation between the P/E ratio and the interest rate. If you look at the chart that we have up there, the the huge drop there in March of 2020 was, you know, market crashing due to fear with the pandemic. But it also went along with, as the rebound will show you, as rates were being cut to essentially nothing, the P/E got an incredibly elevated from a historical perspective and remained elevated until it became very clear that rates were not going to be be staying at, you know, half a percent on the ten year, they were beginning to come back down and pardon me, go back up. There's an inverse relationship. The chart is going back down.
[00:12:30] So with that, if you use a discounted cash flow model or really any time value of money calculation, the discount rate is going to be in the denominator and it will be some version of the risk free rate. Often the ten year US Treasury bond. The higher the discount rate, the lower the present value of the future earnings. And you can see how lower present value for future earnings would equate to a lower stock price for a company and that higher discount rate will affect every company and the market. Now, the other thing affecting stock market valuations and may continue to affect stock market valuations has been the death of TINA. And Tina is an acronym for There is No Alternative, and it applied to the stock market because nobody really wanted to invest in a bond paying you pretty much nothing. So the expression TINA or acronym TINA came around and there is no alternative to the stock market, which could also explain a little bit of the the froth we got in equity markets over the last two years. That has changed this year. Well, rates are certainly not an exciting level compared to the 1980s, nor are they keeping up with the current level of inflation, they're much higher than they had been. On that note, I'm going to turn it over to Anne, because I know Tom is going to get, Tom O, is going to get to that in a little more detail. Over to you in.
[00:13:54] Thank you, Andrew. Last but not least, Tom Okanski is going to talk about the trek to neutral. Tom.
[00:14:03] Thank you. I'd like to spend some time on this topic to explain what it means and to highlight some of the potential effects on the financial world. And why? Why is this important? Well, we have an inflation problem. We all acknowledge that. And the issue of where interest rates are going addresses this problem. For for our understanding, we really focus on what the US central bankers are conveying and the reason the Federal Reserve Bank, i.e. the US central bankers, are so important, well, there's still, can you mute, please? So the reason for the central bank is so important is the US is still the most important economy and most powerful economy in the world. More recently, the it's even takes a higher ranking given the instability caused by this war. The US and its currency have been and continue to be to this day, the safe haven of the world. Thirdly, the US monetary action has been an important leader in dealing with world crises, i.e. the dot com bubble of the late nineties, the 2008 financial crisis, and the COVID response in 2020. By driving interest rates upward or downward, they have responded to crises in the world and help the world get through those crises. So that it's understandable then why we watch the Federal Reserve and what it's doing as it plays a really this world leadership role in tackling this now big issue in the world of inflation.
[00:15:46] So what is this thing that we call neutral or natural or for the academics in the crowd, the r star rate that is, simply put, the interest rate that both supports the economy at full employment, and maximum output, and also keeps inflation constant. A nice little wrapped up package of ideals. So that rate is is viewed as a tool for accomplishing these three goals. The US Central Bank really began using short term interest rates to control inflation and stimulate the economy in the late eighties, and so this idea of a natural rate began to be studied at that time. This rate that is so carefully followed by all in the financial world is natural rate, neutral rate. It's the benchmark from all other rates are also set. So what then is this rate in terms of numbers that mean something to us? Well we have to, first of all, understand that there's a lot of disagreement on what this rate actually might be. The only consensus seems to be that the rate has descended over the years. For example, the rate in mid 1994 that the Fed modeled as the neutral rate was 5.25%. Now that, remember, is a nominal number. The nominal rate will always be higher than the real rate due to whatever inflation is at the time. The chart that's been posted and you're looking at right now is a picture of the neutral rate in real terms.
[00:17:22] And you can see then from the eighties through the nineties how that, into this decade, how that neutral rate has has drifted down as as I indicated earlier, it's descended. So I mentioned in 2004 that the nominal rate was 5.25%. So if you were to go back to the 2004 number, you'd see that that the real rate was somewhere around 3% and inflation back then was probably around 2%. Now let's look at where we are today, what are current rates. Now the US federal rate is targeting 0.75% to 1%, having moved up half a basis point or 50 or 50 basis points or half a full percentage point a couple of weeks ago. Now, remember that this what we're seeing is the nominal rate. And more on that in a bit. The Canadian equivalent known as the Bank of Canada overnight rate is currently 1%, also having moved up by half a percent in mid-April. Again, that's a nominal number. Now, about that time, the prime borrowing rate in Canadian banks moved to 3.2% from 2.7%. That's the rate that you and I will go to if we're prime borrowers will achieve at our at our at our bank for our prime borrowing rate. So if we accept the proposition that the natural rate or the neutral rate is a real 3%, you can see that there's a long, long way to go to get to neutral.
[00:18:51] And why do we have to get to neutral? Well, the background, quite frankly, is an economy that has weathered the COVID, effects of COVID, remarkably well. And because of the actions taken by monetary authorities in 2020 to drive interest rates lower, really almost to zero, ensured that this medical disaster did not cause a recession. We really find ourselves in a too hot economy now with inflation pressures persisting. Now, recall what I said earlier about this neutral rate being one that supports the economy at maximum output and full employment and keeps inflation constant. So the inflation part of that problem right now, is the problem right now. We have really full employment. No secret about the numbers of jobs that are falling, unemployment levels, we have maximum output. And now some might argue that this has not been quite reached due to supply restrictions and so on. But those two components of this tripartite goal are pretty much fulfilled. Now this inflation thing comes to roost now. You may recall late last year, there's a lot of division of opinion. A number of the key bankers in the world were saying inflation would ease without much problems or much control or much issues, inaction from the central bank. Now the assumption was that the supply chains disruptions of COVID would be solved. And and of course, plenty of goods would then be made available and the prices would start to fall.
[00:20:21] Instead, what has happened is that that rebound in demand from people not able to spend in the lockdowns has put pressure on supply, combined with an ageing and reduced workforce where workers are hard to find to help supply that demand, a sudden war that's disrupted supplies even more so, and you have an inflation problem that persists. So given this this persistence and even acceleration of inflation, inflation numbers in the recent months, the view of inflation just rolling over has changed. And what do we conclude? Well, once again, that the policy bank rate is far too low, nowhere near neutral. Now currently. And this is an important thing to understand. All central bankers in the United States are uniformly calling for this key interest rate to hit neutral by year's end. That's a dramatic turn of opinion from a few short months ago. So we saw a few weeks back a 50%, 50 basis point or half a percent move in the in the federal rate with a distinct promise for more. Now as we move along this curve somewhere to neutral or at least something higher than what we have now, at 1%, the markets react. So why and what more can be expected? Please understand that in all of this process, this trek, as I call it, there's a lot of talk, a great deal of communication, communication going all over the place.
[00:21:56] This open talk and demonstration of strong intention can itself solve some of the problems. That is, if people think that interest rates are going to rise, they might do the following. They might buy less on credit. Consumption is being greased by low interest rates, and some of that's consumer loans. Less consumption will hopefully occur from credit users that have backed off and therefore relax prices because it would be more supply than demand. Investment leverage. A great deal of investment in stocks and real estate has occurred using low cost borrowed money. This has created what we understand to be evaluated, elevated valuations and really even bubbles in some sectors. So if the view is that it will cost more to finance that investment purchase, demand from the borrowing sector diminishes and therefore prices may cool. As a result, interest rates may not have to rise as much because the economy, and therefore inflation, may have cooled in advance of the actual rate getting to somewhere near neutral or so. So acknowledging this need to get inflation under control and start the move back to neutral, the Fed made this rare half percent move a couple of weeks ago. The market had been expecting that, and we'd already seen a bit of experiencing price adjustments downward in the stock market, about 9% to that point in the US stock market.
[00:23:23] Now on the day of that move, Federal Reserve Chairman Powell indicated that that was a pretty large move and that perhaps continued aggressive moves of that quantity might not be needed. On that day then, the market felt interest rates might not move much more up, and so the market rallied 3% that day. That's a huge daily move. Alas, the following day, the market rethought that idea based on some skeptical comments from some economists and some other federal bank officials and it gave up 4% the next day. So within one day, optimism from communication up 3%, pessimism the next day, also from communication down 4%. So now we turn the conversation to wondering, well, is this a repeat of the eighties? When we had inflation kept running and running and fed by wages and we had this wage price spiral and the Federal Reserve had to overcompensate by large measure, it really pushed the interest rates way, way above the neutral rate, eventually causing a significant recession. So if we don't get the message early from all this communication, here's how a story of how how that unwinding might happen in a little kind of microcosm, that sort of way. So we understand that the the price of what drives a piece of real estate or a business or a stock is really an estimate of the cash flow that it will provide, as Andrew alluded to earlier.
[00:24:49] And we put a multiple on that. When interest rates drop to what was recently near zero, that cash flow from even more risky assets that might promise a big cash flow in the future, it looks even more attractive to buy. Up go the prices and at the end combined with the low cost of financing because interest rates aren't a barrier to entry, a frenzy happens, the cash flow is being ignored, but rather the expectation that prices will just keep rising because of the world piling into a limited, limited supply. Then this is of course, something that we've seen in stocks and we've seen it in real estate. So borrowed money plays a large part in these excesses. And what I want to do is give a little illustration of how the first part of the unwinding happens and that's and that's the downside to leverage. Let's examine $1,000,000 investment with $40,000 annual cash flow. And this doesn't have to be a piece of real estate. This could be a stock with a dividend or a private business that's looking to value. So we're not looking at whether this investment goes up or not or down in price. Right now, we're just looking at the cash flow because we're going to use some borrowed money to do the deal. I'm going to walk through the first scenario.
[00:26:04] This is back in 2021. We see the Fed funds rate, they're at 0.25%. The closed mortgage or a line of credit with the five year interest rate roughly 2%. Many of you, if you had mortgages in your life, were happy to lock them in, perhaps, or 2% or less last year. So the cost of this investment is $1,000,000. Now we're going to put down 20%. We're going to put down $200,000, and we're going to go and borrow or line of credit or a mortgage or something for $800,000. So here's what the income scenario looks like. The income from the investment, from the share or the property, the dividends, $40,000, the cost of the interest that we're paying is 2% on our $800,000 loan. That $16,000, our net income then after costs is $24,000. So on our investment, which is $200,000, we're earning $24,000 after all costs. That's a 12% return. Sounds pretty good, right? Interest rates that low, people are piling in. Let's go to the next slide. Today, 2022 so far. The Fed's Fed funds rate is now at 1%, having gone up a substantial amount, still not a very high number, but having gone up. Closed Mortgages, line of credit now are at 4%. Cost of the investment is, again, $1,000,000 our down payment or equitie's, 200,000, our mortgage or a line of credit cost is going to be 800,000. What's the income situation? Well, the income from the investment is still $40,000.
[00:27:43] Cost of the interest on the mortgage is 4%. Now it's $32,000 on our $800,000 loan. So our net income after costs is $8,000. So a return on our investment is not $9,000, but $8,000 divided by 200,000, which is 4%. That's down from 12. So a small move in interest rates, a little bit more cost of borrowing. Our borrowing deal and our leverage play is down to a 4% return, looking a little less attractive. Now, let's go to a third scenario here where interest rates are. Let's call this neutral, the Fed funds rate at 3%. Now, as I said, that's the real return. I'm saying no inflation out there whatsoever. Fed funds rate, if we add on current inflation, would be somewhere closer to 10 or 11%, which is which is, of course, a ridiculous number. But let's say the Fed funds rate gets to 3%, which is which is 2% more than is being talked about right now. In reality, we're at 1% going to three. So when does this happen? Does this happen by year end? Does this happen by next year? What we know is that the direction is certain. The federal bankers are communicating very clearly. It's going on. So let's look at this million dollar investment producing $40,000 in cash flow. What if we use the same tools, our down payment of $200,000 and our mortgage or line of credit now of 800,000 is costing us at least close to 6%.
[00:29:22] Income from the investment is $40,000. The cost of our interest on the mortgage is 6%. That's $48,000. Our net income after costs is now we're losing $8,000 a year. Our return on investment is 8000 -8000 divided by $200,000 investment. We're losing 4% on our money. So with a loss of 4%, what's going to be the outcome in this in this situation? Well, first of all, borrowers start to exit the market. Some may have to sell urgently because they're being called for extra cash to put in the into the bank because their mortgage values are a little bit less. So they may be asked for more money or they can't afford to take a loss of 4% on their on their loans. So some may be selling urgently. So secondly, by that happening, the value of the investment starts to fall, both because borrowers are exiting and cash buyers want a higher return than the original 4%. The cash buyer coming in a couple of years ago, 4% was getting a good deal, but maybe that cash buyer now wants to earn 6% or 7%. Well, if that cash buyer wants to earn 7%, that cash flow, that same cash flow of $40,000 means that that that buyer will be now willing to pay only about $700,000. So will the price of that investment, that was in 2021 being snapped up for $1,000,000 on borrowed money and cash buyers that were out there, will it fall from 1 million to $700,000? Or further based on panic selling that pushes the investment into bargain basement territory, as Andrew alluded to earlier in the stock market. Well, we'll have to leave that answer to the mystery of the marketplace at work. So in summary, it's not a nice scenario for us to be realizing that the homes, the shares, the businesses, where we were all recently amazed at how ridiculous they'd grown to in our pricing to have them mark down by 30% to 50%, is a huge shock and huge disappointment, but it's not an unrealistic possibility. And I turn to The Globe and Mail today's headline in the business section. Some economists are predicting that the real estate market may fall off exactly that number, 30%. Well, the only thing that we really know is that rates have to go much higher and with some concerted, rapid effort to solve the inflation problem. The total uncertainty about all of this is what is that moving target of neutral? What is really neutral going to be that sustains full employment, full capacity and keeps inflation in check? Well, I hope we all get this message as we walk through this and the history of the eighties won't have to repeat itself. Back to you Ann for any questions that you might have.
[00:32:21] Thanks, Tom. We do have some questions today. If the real natural interest rate is 3%, what might the nominal rate be if we have some inflation? Over to Tom Okanski for this one.
[00:32:38] As I was mentioning, we're dealing with the nominal numbers because that's what we're seeing the Federal Reserve do currently at about 1%. If the real natural rate is 3% and we add current inflation that talks about a nominal rate of 11%, well, I think we could all conclude that if borrowing rates were were now 11% from the central bank, we would have a major depressions, not just recessions going on out there. So we don't personally think that the Fed is going to be pushing rates anywhere near that number. Our sense that maybe a nominal rate of somewhere around 5% or so will probably be more than enough to have erased this excess leverage problem, brought prices down to reasonable numbers and can cool the economy substantially. So 5% is the prediction from here. We'll see. It's a long way to go from the current 1%.
[00:33:40] Thanks, Tom. Okay. Question number two, how long do bear markets last? I think I'll go to Tom Burnett for this one, Tom.
[00:33:49] Thank you, Ann. It's a good question. One good thing we can say about bear markets, there is historic precedence- They do end at some point. From a quick study of Thompson One, Value Line or Market Smith or any chart service, basically what I could glean was there's been about 26 bear markets since the 1920s. That's 100 years. A bear market is defined by a decline of 20% from the peak level. So we have one or two of our markets right now in the process of going through the bear market. The average bear market over this period of time has lasted about 290 days. Some have lasted much longer and some much shorter. For example, in 2020, with the onset of COVID, the bear market there lasted about six weeks. Was probably one of the shorter ones we've ever seen. And that was basically from the end of February into the beginning of April, May, depending on which metric you were looking at. In 1987, it was one of the more famous ones, for those of us who were around then, there was a crash in 1987. That's when the market went down over 20% in one day. But that whole bear market lasted from about August until right there into October, November of 87 was three or four months. It only was about 33%. So it was actually not that deep. It was just one big bad day in there. And interestingly enough, 13 months later, the S&P 500 was making new highs. So it took it took time of 13 months to get back. There's two more prolonged ones in history, and they had different nuances.
[00:35:30] In 1929, the market went down after the Roaring Twenties. And some people have parallels or made parallels, including myself previously to the 1920s, the Roaring Twenties, and then you have an aftermath that's not good. But in that period, from about 1929 to 1942, there was multiple 20% bear markets, but there was also many, many uptrends. The same thing happened again from about 1966 to 1982. And in that period, the market itself, represented by the Dow, really didn't go anywhere and went basically sideways. But there was all kinds of new sectors, new industries, new companies, and basically new opportunities coming to the fore. And part of being in a diversified portfolio, you should be having exposure to some of those things anyway. There's there's always an adage that's been out there for quite some time, and it was it's akin to or attributed to Martin Zweig, who just passed away a few years ago. And it was "Don't Fight the Fed". And this alludes to what Tom O just talked about, if rates are going up, certain things don't look that good. And historically, rates going up has not been good for bonds and stocks. But again, there are parts of the sector and parts and sectors that will perform well in bear markets once we figure out where the new the new path is. So at some point, the Fed will ease up. The rhetoric about inflation will change and then the cycle will reinvigorate and start going back up. Back to you Ann.
[00:37:07] Well, if there's no more questions, that will conclude our quarterly check in. Thank you so much for joining us today and we hope you will join us again in August for the next one. Thanks again, everyone, and have a great day.
Quarterly Check-in February 2022
Check-in Feb 2022
Thank you for joining us for the Burnett Okanski Dale Financial Group's quarterly check in. For our meeting today, Tom Burnett is going to provide an update on the state of the markets, followed by Andrew Dale, who will give us an update on interest rates and inflation. Then Tom Okanski will wrap things up by talking about the energy transition. If at any time you have a question, you can type it in where it says Q&A, or where some of you may have a speech bubble with a question mark in it, depending upon the version of teams that is running. If you would like to remain anonymous, there is an option of posting the question anonymously. Thank you so much for joining us, and now I'm going to turn it over to Tom Burnett for an update on the state of the markets. Tom. Tom, I'm having trouble hearing you. It looks like you're on mute, can you unmute, please?
We're unmuted here. Thank you very much and welcome to everybody to 2022. Our first call, our update call with our clients. Glad you could make it. And I believe this will be taped and we'll have it on our website as well. I'd like to start off talking about the markets and on our next slide, we'll have basically what has happened year to date. I will go over that for the Toronto stock market. We're basically flat before today. We're up about 0.6%. Dow Jones is actually, in New York, is off almost 5% pre today. S&P500 is almost down 8% and the Nasdaq at one point was down 15%. And this is, if you listen to other calls and other things that we've put out, there's a battle between growth and value, and the Nasdaq pretty much represents growth. And at the worst point this year, it was down about 15%. It's probably down around 10 as we speak right now year to date, and this is where all your FAANG stocks are the Facebook, Amazon, Netflix and Google. And I have a little chart here on the side here, just going over 10%. It's the previous slide, please. The the Nasdaq 10% corrections going back quite a few years and there's there's they happen pretty regularly and it just shows you how many days they are involved. This is 61% to the middle of January, and now we're into the middle of February. So it's been going on a bit longer. And a lot of this has to do with interest rates, which the next speaker Andrew will be talking about to some extent. So I'll let him handle that. On our next slide, it's interesting when you start looking at reasons to sell. Interestingly enough, this this chart goes back pretty much to the low of the Great Financial Crisis March of '09 was the bottom there. This is the S&P500. It bottomed at 666. That was the number. Now it's well over 4000. So you see all these all this growth along in here and you see all the reasons to sell, like the BP oil spill, flash crashes, crude oil is falling and rising, earnings recession, Brexit. All these things. The longer you get out and you look with a telescope or a microscope, I guess it depends what you're looking at, the longer you go in history, the smaller these things really mean anything because the market does rise over time. What's also interesting interesting about this is if we go back nearly five years previous to this, the market was peaking in about 2007 at about 1500, so that that crunch back in 2009, The Great Financial Crisis, took this market down quite a bit. So it all depends on your frame of reference, what you're looking at. And right now at the far right of this, this is about three months out of date. As far as the data on it and the events right now, we have, of course, reasons to sell. We have Ukraine, we have China, we have what's going to happen after the election. We have interest rates going up.
There's always a reason to sell. But I think the thing that we take out of this for our own portfolios also is if you're diversified, you will probably always have some sector that's doing very well. And some that is not. Just case in point, the best performing sectors last year and continuing into this year in Canada and pretty much in the U.S. as well, are oil and gas, metals and mines, and financials. So depending on what's in your portfolio, you might not even notice some volatility on the negative side. It might be on the positive side. So we always have to have diversification, and that's what we intend to do with all of our clients and that's how we manage our clients money. The other thing of interest in here is the Canadian dollar. We'll get to that in a minute. The Canadian dollar is basically flat to within one cent where it closed the year last year. It's about 1.277 as I speak. So that's another thing of interest. It comes up a nice quote, it's in the next slide is attributed to Bill Miller. Some of you may know who he is. He's one of the most successful money managers of all time. There was a book, I believe he wrote it, and it was also about him. Basically, it was an autobiography or not, but "People often say there's lots of uncertainty, but when was there ever certainty in the markets, the economy or the future? I'm just trying to understand the present." And this is what this is a guy that manages billions of dollars in what he is saying.
So again, the moral of the story is you have diversification, you have a method that you stick with, whether it's value or growth and you stick to your knitting and you will do fine. Next slide, please.
This is a bit of humor, maybe it is well needed. What's going on in the country right now. People basically have been pent up for over two years now, and one of the things I was reading on the weekend is we have been basically saving money, investing money and buying stuff. So witness the price of houses, witness the shortages, but it's all about acquiring stuff and investing, but it's not about doing anything. And the same person that came out with this quote on the weekend said people now want to do things. They want to get out, they want to enjoy life, they want to go to a concert, they want to do things. So this is probably the next part where we think maybe things might benefit from is, you know, where, where, where does the money go next? Is it travel? Is it tourism? You know, that's probably what's coming out as in the cartoon says, people just want to go out and spend a stupid amount of money on a dinner. They want to get out. That's kind of where we are right right now. Next slide, please. And as we as we leave or as I end my part of the presentation, what we're noticing and what's happening right now the Canadian/U.S. dollar is, like I said earlier, is well within a range. But what's happening with oil and gas and metals and mines and these things moving up in price, part of it's Ukraine related, part of it is the economy coming back, and a lot of it has to do with inflation, which Andrew will allude to and get into. So what happens is if we have this type of things or events happening in the economy, that's inflationary and that is actually good for the Canadian dollar. It's good for Canada, it's usually good for Australia, and it's good for Brazil because we are the people that produce these resources. Whether or not these industries are in decline, there's a perception right now that that's what's needed. So we'll see. What is also happening today is oil is down about four dollars per barrel because the Russians are moving back 8000 troops from the border. So we'll see if this is just the start of something or a start of a retracement and things go back to normal. If they do, then maybe we have less stress on the energy markets. But the reality is there's a lot of money being printed. We have some inflationary forces. In some measures, it's the highest in 40 years. But I'll end on that note and let Andrew go into his portion, but I'll go back to you first Ann.
Thank you, Tom Burnett. And now I'm going to turn it over to Andrew Dale.
Thank you, Ann. I'm going to start off talking a bit about inflation move to the current and expected interest rate environment. And finally, take a look at what all that means for the stock market and your money. Starting with inflation, we've got Chairman Jerome Powell here. The long run target for inflation in both Canada and in the U.S. is 2%. Before the pandemic, inflation was generally below that level, and there was actually concern about deflation. After the pandemic, we had all kinds of government intervention in the market, both fiscal and monetary, that increased the money supply and gave the economy a lift. By early 2021, we were already seeing inflation way above the 2% target level, and now normally both the Federal Reserve and the Bank of Canada would act to try to rein in that inflation by raising the the overnight rate. They did not. And the argument for most of the year was that inflation was transitory. You know, oil prices were briefly negative in 2020. So obviously they were going to be much higher in 2021. And a host of other, you know, commodities that had been beaten down and left for dead came came back in 2021. And the thought from the Federal Reserve was that this was a transitory thing and that it wasn't going to go any further. Now obviously, what we've we've seen is it has continued to go up, including wage inflation, which is generally never transitory. You can't really bump a guy their, pay up to $30 an hour and then try to get them back to 15 or 20.
People aren't going to work. So we've had wage inflation, which tends to be quite quite sticky. By October 2021, some members of the Federal Reserve publicly began commenting that inflation was not transitory, that in fact, inflation was broadening. It did take Powell till the end of November to say that it was time to drop the word transitory. I believe, you know, they made a big policy error in not trying to get ahead of that earlier. I know, you know, global pandemic wasn't exactly run of the mill stuff that they were dealing with, but at the same time, rates probably should have began rising by the end of last year. Instead, they're forecast to begin rising in March. And in fact, the Federal Reserve is continuing to do quantitative easing- 'QE', which likely won't wrap up until the end of the month. On Thursday, there was an inflation print of 7.5%. Now I'll remind you that their long run target is 2%. Now we're looking at what could be an aggressive rate hiking cycle combined with quantitative tightening. Meanwhile, in Canada, if we take a look at the yield curve. You'll see that our overnight rate remains unchanged at a 0.25%. The rest of the yield curve has already been going up and the U.S. yield curve looks incredibly similar right now.
There has been a relatively big increase over the past year and even over the past month at just about every term to maturity. And those moves have already happened. What we hear online or on TV or in the newspaper is that rates are going up, rates are going up and they're talking about the overnight rate. All the other rates have already gone up. They've been going up for for over a year. So the overnight rate, as I mentioned, is at 0.25% If the Bank of Canada were to raise five times, we'd only be at one and a half, which is not a historically high level. Now what does all of that mean to you? All other things being equal, as interest rates go up, the price of bonds go down. The ten year has already hit 2%. Many bond market prognosticators are calling it for it to go up to 2.5% before the economy will begin to cool and eventually rates begin to drop again. Now, you know, that that's a call for today. There's a new economic report out at least every week that could change that outlook. Getting over to the stock market, as interest rates go up, it does tend to have an impact on equity valuation. The higher the interest rate generally, the lower the valuation. A dollar today is worth more than a dollar tomorrow. The higher the prevailing interest rate, the lower the value of that future dollar.
There are a number of ways to value a company and the market, for that matter, that use the current interest rate. Often, the 10 year is used as a risk free rate in the denominator of the formula. Whether you're looking at a dividend discount model or doing discounted cash flow analysis, the higher the interest rate you plug into the denominator, the lower the value of the company. Now we generally see the price to earnings multiple of the overall market start to decline as well. Companies that have pricing power are able to kind of fight that trend as as they're growing their earnings greater than the inflation or interest rate, and they're able to pass on that higher cost to their customer. Most direct beneficiaries and Tom Burnett kind of mentioned it, they tend to be found in the commodity sector. There's generally a global price for commodities, so if you're a producer and these prices are going up, you're going to benefit. Another sector that tends to do well in a rising rate environment is the financial sector. Banks benefit from a higher net interest margin: The spread between what they can borrow money for and what they can lend it out at. You're chequing account if you've noticed it pays you nothing right now, and if rates go up substantially, your chequing account will continue to pay you nothing. And the banks will have that money to lend at a higher and higher rate. Insurance companies will also benefit as they have all kinds of restrictions on the type of product they have to hold. Generally, high quality government bonds and that is used to offset the liability of insurance policies they have. The higher the rate, the lower the amount of capital they have to set aside to offset the liability. Now, the last group of companies that tend to hold up well in a rising rate environment are the dividend growers: companies that have a track record of raising their dividend year after year in any market environment. In terms of the overall stock market, move forward, thank you. If we take a look at the S&P500 and the current pullback we're in, it is currently not anything out of the ordinary. The corrections over the last 10 years, from peak to trough have lasted an average of 38 days and the average time it took to recover from those declines and make a new high was 52 days. This pullback could last significantly longer, or it could be over today. The market could drop 30% further from here, or, you know, we're we're up right now, it could continue to go up. We do not have a crystal ball. What we do know is that the market always makes a new high and every sell off in history has been a buying opportunity. With that, I'll turn it back over to Ann.
Thank you, Andrew. Now, Tom Okanski is going to talk about the energy transition. Tom.
Thank you, Ann. My discussion part today is to address a major theme that will impact our financial picture going forward. And today's topic for me is the energy transition. So having delayed and procrastinated on this scientific evidence for several decades now, the reality of the consequences of ignoring climate change are beginning to be felt in our everyday lives. This has brought us to the point finally, where it's accepted by the great majority of the global community that a transition to renewable and sustainable energy must be accomplished as part of the need to address this climate change. Now, transportation and electrical generation rank one, two in the production of greenhouse gases, causing this climate change, therefore a fundamental revamp of these two industries is beginning to happen. Kind of irony of this is that by altering transportation to the various other methods like IE electric or other means, hydrogen, the demand for electricity increases many times over. So you got something fixing on the transportation side, but you're asking for more electrical generation. So the greatest possible impact, positive impact, then on this climate issue is going to occur by growing and revamping electrical production and distribution. And all of this involves really a huge, huge transition to some different models, and we are now what I call in the sort of first inning of this of this ballgame. There's a slide now coming up on your screen that says sort of highlights what's needed.
And it's a really, I think, an impactful sort of slide because it illustrates the magnitude of what's to come. There in each of those, each of those charts, there are three bars and in each chart is trying to address the some some aspect of the energy transition. On the right of each of those four charts is the current investment in those areas. Now we move to the center, that bar in the center says the estimated investment that will be taking place under sort of everybody's collective current plans to 2050, there's 2050 reaching some sort of net zero. So that's that's actually what's what's what's planned, what's theoretically committed to, what's what's on the table. The left side is what's interesting. That's what's actually needed to achieve the net zero emissions. So we're not only a far cry from what we're spending presently, we're a far cry from what we're expecting to spend and we're a very, very far cry from what's needed to achieve this target that we've all set out that says 2050 will be net zero. So the understanding that we all have to take here is that this transition to a more sustainable energy future involves a capital deployment of really historic proportions. You know, just think in the next couple of generations, the great energy revolution that occurred just over a century ago with the development of oil powered vehicles and equipment. It's going to be revisited, and this time, again, within a few few short generations, this time it's going to be various means of energy production that suddenly don't burn fossil fuels anymore. How fascinating is that? And of course, how costly is that? It will obviously be underway and happening and is underway and happening, and I want to just discuss sort of three areas of the energy transition and bring out some highlights. First generation, second transmission and distribution and third storage. And I'll just offer a few comments in each of those areas and maybe broadly describe the some of the likely investment characteristics that we see coming out of that. In generation, well, what's happening and what's needed. In this slide now that you're going to be seeing shows the the energy transition from a generation point of view, and we can see that the last, really last 15 years, has seen a pretty steady increase in investment capital being deployed into the renewable space. Now, the projected amount for energy generation to 2050 should see this chart double in size. That's what's committed. Now again, again, if we turn to what's required to get to net zero, that's a chart that you would have to add on these bars four times this amount. It's pretty staggering, once again, the capital commitment, whether you look at the needed capital commitment or you look at the stated capital commitment, they're both fantastically huge numbers.
So what kind of returns might we be expecting in this generation area? Remember, that generation is sort of a source in our in our investment portfolios, the companies that do this sort of thing. It's a source of predictable, stable returns. Established companies, even in the sustainable space, tend to be a bit more predictable dividend earnings, earnings type of companies. And these sustainable companies, now we would describe as the hydro companies, wind turbine, solar and nuclear installations. So what are the risks of of of these sort of stable returns in this space? Well, there's going to be some increased volatility due to uncontrollable factors as we introduce wind and solar into the picture, you got-- and hydro, for that matter too, you hot water levels, wind and sunshine, those are all factors that really can't be controlled. So there's some variability in terms of the production. We saw that last year, you know, in terms of the climate factor visiting on on Texas and taking down some of that sustainable production there. Long term maintenance costs are going to be an issue and another risk in this generation space. I think they're largely figured into the rate base, but there's some uncertainty, particularly with things like nuclear and wind. You know, what's the cost of maintaining these huge turbines? What happens is TransAlta Utilities recently found out if they weren't installed properly in the first place and we have to reinstall 50 of them. That was $100 million hit to that company. What about the nuclear waste issue as we perhaps ramp up for future into new various themes of nuclear? So at the fringe, though, any breakthrough possibilities in this generation area revolve around sort of new versions of nuclear, it would seem. We've got fission and fusion. With nuclear, though there's this huge long lead time because research really had had largely been dropped in the last few decades. Much uncertainty and risk of failure here, but potential blockbuster returns could come from companies that succeed and bring to the fore new ways of generating electricity through nuclear. But I guess we still have to be careful. Remember, there's a long standing joke about the arrival of nuclear fusion that it is 30 years away indefinitely. Little pun on the idea of fusion. So turning to the transmission and distribution. Transmission and distribution companies are really a source again of consistent, modest and predictable, predictable returns, with the current players. Largely focused on an income theme, we usually buy these kinds of stories largely for a for a dividend stream that that's modest and growing in a stable earnings number. Regulated utilities in this mix are still a good, stable source of earnings and dividends. I think going through going into this energy transition, some will have to become. Many will have to become growth stories for at least part of their business.
And let's take Hydro One as an example. It's a name that's familiar to us all. It largely distributes electricity to most of Ontario from its current generation sources: nuclear and hydro. But now it must build out its core system to accommodate what we call distributed generation. That means many more poles, lines and substations. And the reason really is twofold because this generation in these new models often takes place where distribution capacity is weak or doesn't exist. You know, some of the great wind turbines you're seeing up in North Shore Lake Superior. Well, there's not a lot of capacity there for for distribution coming out of there just yet. At the more local level, if we're going to replace gas pumps with charging stations, there's a whole lot more electricity that has to flow into those spots on the corner and a whole lot more electricity coming over those wires. They have to be beefed up. The transmission capacity has to be beefed up. So we largely expected established distribution companies will provide that capacity growth for the most part, unless we find a way to transmit power wirelessly there's not likely to be any kind of upending or disruptive change in those traditional models in that industry. The reasoning behind this is largely that it's pretty hard to get new rights of way barriers to interconnecting to existing grids. So those traditional companies that are in place will largely continue to serve serve that function and should be good and consistent, modest growing companies with good dividend streams. I think that if there's any disruption in this space, it'll be the cable companies, the electric equipment and network companies that may show some greater innovation and growth. If we could find a way to create a cable that would transmit energy without as much loss over time in the grid, you know that would be sort of a disruptive technology in that space. Finally, storage. Some of these new sustainable energy installations don't always produce when it's needed, and the means to capture and store all this power is really an industry that's in its infancy. One could compare the quest for the holy grail of battery storage to the search for the miracle cancer curing drug. Accordingly, this area of the transition is going to be a source of risky but very high returns. As the technology develops, it is subject to the entry of numerous new growth companies. And really, there are no established players in this space just yet, we we have a few kind of well-known brands and such, but nobody really takes up much of the market and it's a it's a market that really has a huge opening for for demand, but isn't really being served yet by by any significant players. I think that what you've got is really case here where disruptive high growth risk area will be available for investment dollars at this point. And as these companies evolve, and this will take decades, you'll expect a transition to a source of stable earnings. Once you've got a bunch of established storage companies out there, however they do it, you know, pumping air into old old gas wells and using that, storing up water in canals that you dump overnight, whatever kind of lithium or other battery that might be out there. All this technology will develop and and be fascinating, but once it's in place and we'll see, I think a transition to, you know, pretty much I use transmission utility kind of company story now, but that's not the kind of company, I think that we're expecting to experience. Probably this is more of what what we might see our grandchildren experience in their old age. So meanwhile, for us today, I call this sector something that I might term necessary speculation. Almost have to speculate because the companies that are that win, this will, will, will obviously, you know, do well and become great, great sources of revenue and consistent dividend players over many years. Well, I hope my piece is given a little bit of an introduction to what's becoming, really the most important investment theme of our times. Pleased to take any questions and comments from our audience. So back to you Ann.
Thank you, Tom Okanski. Well, we do have some questions today. What sectors could benefit from the reopening of our economy? That sounds like one for Tom Burnett. Tom?
Thank you Ann. I'll gladly take that question and it's on everybody's mind. I think a lot of our clients and investors and people in general. I think some of the obvious ones for the reopening as we get back to normal, are entertainment restaurant, restaurant sector, you can also look at travel, some of the people that look after your accommodations, hotels. One that's been sort of interesting to follow through this whole piece has been Airbnb, and let's see if they can take some market share here. There's anecdotal evidence where people are maybe not even through going on a vacation. They're saying they're going to decide I'm going to go work somewhere else so they go and rent a place for a month or two in an area they want to be. Maybe it's in the mountains or whatever, and they get an Airbnb for a couple of months. But I think one of the poster child, poster children for reopening is going to be one company that we we do have it in many of our portfolios. It's going to be like Walt Disney. If you look at it, it's a company that's been around for a long time. It's in theme parks, it's in travel, they have cruises, they have entertainment, they are into all kinds of consumer products and it's basically a worldwide media company. The library alone that they have is humongous. When you compare it to some of the other ones, Netflix is spending money to build a library, and Disney pretty much already has one, and they've acquired a lot of other companies. So I'm not necessarily saying that's a buy this second today, but that's the type of company I think that would benefit from the reopening. I've also heard stories on the weekend of people trying to get to take their family to Disney for the coming this coming season, for next year, for the Christmas season, and they're having a heck of a time even getting reasonable prices and or getting accommodations. So that's one that maybe to keep an eye on. And then we'll, you know, we'll have to see. Maybe there's many sports sports fans out there who are the companies that are behind some of these big sports franchises. Madison Square Gardens, things like that. You want to go to an event, somebody is going to be profiting from it. We'll see what happens. But I think that's the type of company and that's the type of sector that's going to benefit. You can also throw in airlines there. Historically, they haven't been a great moneymaker for shareholders. They basically have let people down over time, but when they have a decent ramp in their in their earnings, there could be some stock appreciation there as well. I think that's pretty much what I would have to say there. Ann, back to you.
Thanks, Tom. Ok, so question number two, what about investing in an inflationary environment? Andrew, I'm going to send this one over to you.
Thank you Ann. Investing in an inflationary environment. Well in general and being very, very broad. The equity market will outperform the bond market. Within the the equity market, the stock market, the financial sector and the commodity sector tend to be the outperformers in there. And fortunately for a Canadian investor, the Canadian market has a ton of exposure to both financial and commodity sector. One other thing I'll point out, and I'm keeping my my answer brief here. If you're, if you're a nerd like me and follow different yields in the bond market, you could make the interpretation that right now the bond market is actually pricing in that the average rate of inflation over the next five years is going to be around 2.5%, a far cry from the seven and a half we're at today. So I do expect that the inflationary environment that we're currently in is unlikely to last long term. But but I imagine we'll be at an elevated level all year. Over to you Ann.
Thanks, Andrew. Are the recent spikes in energy costs a problem for this energy transition? Tom Okanski, I'm going to let you handle this one. Tom?
Oh, thanks Ann. Yeah. Good question. These sort of recent spikes from remember, they're from fossil fuel sources, this is oil and natural gas. If they're sustained, I think they provide an added incentive really for the renewable sector from a capital allocation point of view, because this is really what it's all about, isn't it? This great build of sustainable and renewable generation capacity needs capital. And if if it's going to earn money because because the fossil fuel sources are, you know, more expensive, well, then so be it. And you know, many have observed that sustainable energy up to up to recent years, at least the production costs measured, measuring them narrowly by the hit to our bank accounts today, and remember, that's a very narrow definition because the issue of what's the cost of fossil fuels over the lifetime, over climate change, what's the real cost to the world of of that sort of story. But if we just think about what's coming out of our wallet today, you know, the production costs from sustainable energy was always considered to be much higher than than fossil fuels, coal natural gas costs. But in the great technological advances in the recent years in this sustainable energy sector, these costs have really become a lot more competitive and it's not so long ago you're you're seeing, especially in the southern United States, that that the cost of your solar panels on your roof are competitive to any fossil fuel or natural gas production plant. And so that was when oil was around $40 or $50 a barrel, so with oil at almost double that and natural gas triple those recent levels, I would suggest that if fossil fuel pricing sustains around current levels for any length of time, there's going to be a huge boost to the investment thesis for renewable producers. So that's my thought on that. Back to you Ann.
Ok, it looks like we have one more question, and it pertains to that, Tom. How feasible is it for a country in the North like Canada to make this change? Tom Okanski.
Oh, yes, that sensitive one. You can't do this in Canada, can we? Even Canada's position as a really a major world oil producer, I think what do we do something that 10% of the world's total oil in our in our production? There's really a wrenching change that's inevitably going to happen and this largely affects our western provinces, of course, but the country as a whole, because so much of the spin off job creation is comes out of that energy sector. But, you know, I'm encouraged at the direction Canada's oil producers are taking to make their operations more carbon neutral. Out of all of the nations around the world, oil producers, I think Canada is at the forefront in that area. You know, they're doing things like reducing methane leaks. They're more aggressive at trying to employ carbon capture and storage techniques. And these are really forward thinking investments. And what I hopefully think that'll do is position some of these Canadian companies among what I would see as a smaller group of future what we call acceptable carbon producers. Carbon production is not going to go away forever. It's more of a slow slide into some kind of basic level. But I would guess that something around the acceptable oil or the green oil, or whatever it might be in the future, green hydrogen and that sort of thing, Canadian companies are moving among, as I said, among the foremost companies in the world moving that way. So I think that's a that's an opportunity for Canada to make that change. So the other opportunities in the sustainable space, of course, have really hardly been touched in Canada. Our wealth of hydro generating capacity really kind of overshadows and may continue to overshadow the really vast wind and solar opportunities that do exist in this country. We really only barely scratched the surface in that area. So to answer, is it feasible? Yes. But will the willpower of the nations, people and politicians stay the course? You know, that's the biggest uncertainty. Thanks Ann.
Thank you, Tom. If there are no more questions, this will conclude our quarterly check in. Thank you so much for joining us today, and we hope you will join us again in May for our next one. Goodbye, everyone.
Check-in November 2021
Check In August 2021
Aug 4th Quarterly Check-In
Ann Martin: Thank you for joining The Burnett Okanski Dale Financial Group for our quarterly check-in – in the past we’ve done a conference call but we’ve decided to try out an online format this quarter for a change.
Tom Burnett is going to start the call off with an update on the State of the World followed by Tom Okanski who will discuss ESG and finally, last but not least, Andrew Dale will talk about Inflation, Interest Rates & You.
***If at anytime you have a question you can type it in where it says “Q & A” or where some of you may see a speech bubble with a question mark in it- depending on the version of Teams that is running. If you would like to remain anonymous there is the option of posting the question anonymously.***
Tom Burnett: State of the world or what’s happening
Mark Twain Quote----History doesn’t repeat – it rhymes
Similarities now with periods past…..
1960’s & 1970’s unrest, big spending governments – Johnson Administration in US
End of Vietnam war – pulling out of Afghanistan
Inflationary pressures – “transitory” – new buzzword…
If same paradigm have to go through the 1960’s to get to the 70’s – boom first? Pent up demand
Every crisis ends and new technology is born in the crisis --- ZOOM --- teleconferencing?
Comparison with 1918 Spanish Flu epidemic – claimed more lives than WW1
Birth of the mass adoption of the phone – see add graphic. Teleconferencing work at home – pros and cons.
Reference to Jamie Catherwood – Investor Amnesia – great site for history buffs
Like 1990’s to early 2000’s??
Tech outperformance Growth vs Value – how measured – PE/ yiled etc
PE’s now vs then of major stocks and indices. Interest rate factor in the equation
When does this flip usually after the “event”
Secular growth stays firm
Barbell with both
Going forward – current challenge – China? Lesson for capitalists?
ESG topic notes:
It is no longer acceptable to pursue the world of investment as make money for the shareholder without dealing with these factors. Across key investment pools in the world today: pension funds, state investment pools; and most institutional investors criteria for selecting corporations in which to invest have broadened immensely.
What is ESG?
An acronym to describe several factors that have become current in financial evaluations.
Show the picture. Categories: Environmental; Social; Governance
Issues of how the business deals with the risk of its impact on the environment.
Investors now asking for dollars based assessments. Now seeing notes to financial statements including estimates of the cost to mitigate environmental impact of operations.
Certainly a growing need to account for
In some ways wraps up the two before, the E and the S. It’s here that firm is measured on accomplishments of the previous two via accountability and transparency.
How to measure and rank:
Number of institutions have created ranking systems that give weights to various factors and produce a summary score. The idea being those companies with the highest aggregate score are most favoured on an ESG basis.
What we have found using this aggregate scores surprises us. Ie: a traditional oil producer scores higher than a wind and solar power producer. What happens in this case is the the oil producer has focused on the S and G heavily, knowing it can’t do much about the E.
So we don’t want a bunch of companies that are environmental disasters but boast ESG overall scores. Thus the challenge is more than just picking high scorers. Our method to get through this conundrum is to consider the companies on the merits of the three categories and see how they rank against others in the industry group.
Thank you Ann. We are well into the 2nd half of 2021 and we are now about a year and a half from the start of the pandemic- depending on the start date you want to use. It has definitely been an unusual period of time.
Like usual we’ve been paying close attention to the various economic numbers that regularly come out – primarily in Canada and south of the border but the rest of the world matters too so we keep our eyes and ears open for that information too. What has been a little more interesting than usual in 2021 is the amount of inflation we are seeing right across the board- the price of just about everything has gone up.
A great example of this inflation can be seen in the price of lumber. (Slide) If anyone needed to buy wood in the past year and came into Home Depot or Rona they were in for significant sticker shock. In the last 10 years the futures contract for lumber has generally traded in a range between $200 on the low end and $500 on the high end. The contract was trading at over $1,500 dollars earlier this year. While it is still trading at a higher than normal level it has come down significantly from the peak.
During our last quarterly call we had we talked about the level of inflation we were seeing and also the rising interest rate environment we were in. 3 months later, interest rates have come off their earlier high- the yield on the US 10 yr treasury bond was well below 1% in the last quarter of 2020, went as high as 1.74% earlier in 2021 and now has come back down to 1.18% (as of the start of the call).
In the past quarter we’ve seen many commodities pull back from their peak but they are still trading at an elevated level. At the end of June the US Consumer Price Index or CPI was up 5.4% over the past 12 mths.
Generally both the Bank of Canada and the US Federal Reserve would like to see the inflation rate at a level around 2%. The typical tool that central bankers use to try and fight inflation is to raise the overnight rate- in the news you hear about whether the Bank of Canada or the Federal Reserve are going to raise rates or not- they are referring to the overnight rate. Under normal conditions if a central bank of a developed nation saw inflation running at more than 5% they would not hesitate to aggressively start hiking rates. Keep in mind that the purchasing power of your dollar is eroded by the level of inflation. So why aren’t the central banks raising rates? They believe- or at least they are communicating that they believe- that the inflation we are seeing will prove to be transitory. We think some of it will be and some of it is likely here to stay.
Wage inflation is a type of inflation that generally does not go away. If workers are demanding $15/hr to go to work this year it is incredibly unlikely that they will start working for less than that in the future. There appears to be a worker shortage in a lot of areas of the market and it is unclear if the culprit is competition from Government programs, fear of Covid-19, or if it is related to a lack of child care options. Likely a combination of the 3.
Prices of many things dropped dramatically last year when we were working our way through a global lockdown- so although the inflation numbers are high - it is off a really low base number. We won’t know for sure how much of this inflation truly is transitory until 2022- and if it is stickier than central bankers are expecting they will be pretty far behind the curve- if that’s the case, rates will rise faster than we are currently expecting.
Ann Martin: (Reads off questions) . BOD responds.
If there are no more questions that will conclude our Quarterly Check-In. Thank you so much for joining us today and we hope you will join us again in November for our next one. Thanks again.
Personal tax increases—what’s on the table?
Jamie looks at four areas that may see changes—the capital gains inclusion rate, the principal residence exemption, the future of personal income taxes and a wealth or inheritance tax.
Personal tax increases – What’s on the table?
[Soft music plays]
[Personal tax increases – What’s on the table?]
[Jamie Golombek, Managing Director, Tax & Estate Planning, CIBC Private Wealth Management]
COVID-19 had obviously a huge impact on the economy, but also on government spending with billions in dollars being spent on both personal and corporate support for Canadians and for Canadian businesses. Many have been asking the question, how is the government going to pay for all this? What potential tax changes do we see in the months and even year ahead?
[1. Capital gains inclusion rate]
In terms of the capital gains inclusion rate, what you see here is a hundred years of capital gain inclusion rates in Canada. Before 1972 of course, we didn't have a capital gains tax at all. That started with the 50% inclusion rate. We've seen it as high as 75% in 1990, and then of course, it's been back down to 50% for the past 20 years. People have asked, could that rate go back up? The answer, I think, is potentially. After all, at the end of the day, who pays capital gains tax? It's mostly the upper-income Canadians, the top 10%. So, I think it's certainly a possibility. It would also get rid of this planning they don't like with corporations surplus stripping by moving the capital gains tax rate higher, more equivalent to a dividend rate.
[2. The principal residence exclusion]
The second thing people are asking about is could there potentially be a tax on the principal residence? Of course, in Canada, we don't pay any tax on the principal residence. The entire gain is tax free. You take a country like the U.S., where in fact there is a principal residence tax on gains above $250,000 U.S. or $500,000 per couple. So again, if this happened, I think it would be prospectively. It would be unfair, I think, to tax everyone's wealth accumulated inside their principal residence retroactively. But perhaps they’ll do some kind of proration like they do right now with the years of principal residence exemption where effectively what happens is, if they introduce this at some point in the future, the number of years, let's say before 2020 would be sheltered, but the years after that, there would be a pro-rated gain.
[3. Future of personal income tax rates]
In terms of tax rates, people ask me, well, how high can you go? We can see by this chart that we have basically 8 out of 10 provinces in Canada having a personal top rate of over 50%. That rate is pretty high. If you look at who pays the taxes in fact, what we’ve got here is a distribution for you - if you look and really focusing on the top people, maybe the top 9% of all taxpayers, these are people with incomes of over $100,000. They earn 35% of all the income in Canada and yet paid 55% of all the tax. If you take a look at just the top 1%, those are individuals making over $250,000 a year. Their tax rate basically accounts for 23% of all personal income taxes paid in Canada. Canada ranks basically seventh in the world right now in terms of the top statutory personal income tax rate. So, I'm not really sure there's much more to go in terms of competitiveness and therefore I don't really see a lot of increases there on personal tax. 2
[4. Wealth, inheritance and estate taxes]
And finally, the subject of wealth taxes. The Parliamentary Budget Office did an estimate that if they tax people over 20 million dollars on a wealth tax, even at a 1% wealth tax, about fourteen thousand families would pay and that would net about five billion dollars of revenue. That being said, a lot of debate in the public domain about the pros and cons of a wealth tax and whether it's fair, whether it results to double taxation, whether it ultimately could lead to people using all kinds of tricks to avoid the wealth tax. And in fact, if you go through the years, go back even 20 years ago where you had about 12 countries having some type of wealth tax, you fast forward ahead to 1991 and between 1991 and 2000, that dropped down to only nine countries. And then finally right now, today in 2020, we only have four countries that have any kind of wealth tax. You know, could Canada be the fifth country? Again, I don't really think that's in the cards. And then finally, what about an inheritance or an estate tax? Well, again, here are a list of select countries around the world. You see U.S. there with a 40% top estate tax. Canada doesn't have any type of estate tax. However, what we do have that's different than the U.S. is a capital gains tax on death at a fair market value realization. So, again, it's certainly possible, but I'm not really sure that our government would go there.
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