Outflows or opportunity?

Josh Kay: I totally get you, Ian, and I think we’ve seen environments like that before. Supply does come back online, but I think there will be demand for it. There will be appetite for it, there will be pent up demand because there has been a period of relatively lower level of supply. I think you get retail demand that’s incremental because the returns in the sector.

Ian Pollick: OK, so I am joined today by Josh Kay. Josh, how was your weekend?

Josh Kay: It was brilliant. Thank you so much, Ian.

Ian Pollick: Brilliant. Yeah, it was good. We have a lot of stuff to talk about and obviously we’re coming off a huge week last week, Business Outlook survey, Consumer Expectation survey, dual jobs reports. And looking ahead, we have the Bank of Canada. So, you know, for those of you who don’t remember the last time you were on the show, let’s call it six months ago, it was in January.

Josh Kay: January, yeah.

Ian Pollick: It was the time where, will they go, won’t they go? House few was the bank wouldn’t hike rates? You were pretty adamant at the time that 50 was the right level. And you know what? I actually kind of pooh poohed you. I was like, yeah, okay, like, you’re kind of nuts, but like, I get it and like, it proved to be pretty prescient. So kudos to you, man. But, you know, thinking about the week ahead, talk to me about your expectations for the Bank of Canada.

Josh Kay: Right. So, you know, I thought back in January they should have gone 50 because, you know, inflation was no longer transitory. And when you have inflation, you have to go at it hard. It’s sort of like a like a kitchen fire. You have to go at it hard, extinguish it, and then clean up the mess after. So when I look ahead to next week, I sort of think the Bank’s got to go 75, right? 75 is priced in. I think it’s smart to take it. I think you’ve got to keep moving higher and you’ve got to be serious about fighting inflation.

Ian Pollick: So it’s interesting, right, because I agree with you that inflation has to be fought. And so, you know, you think about market pricing. I look at the OIS curve stub July. Basically 75 are there. But what’s really interesting is that, you know, you look at July, September, you have like almost 70 basis points priced. So, you know, you had the magic crystal ball six months ago. I’m going to ask you to bring it out right now. Do they do a back to back 75 in September?

Josh Kay: Yeah, I think they’re going to do two 75s in a row. I think you got to get to the terminal rate of three and one half percent. And then I think you start to see inflation moderate. The Bank’s goal, and we’ve talked a lot about whether the Bank can fight inflation, given the conversation has been a lot around the supply side. And in order to fight inflation, with the supply side being a challenge, you really have to restrict demand. And so by moving rates higher 75 next week and then 75 in the fall, you’re really going to crush demand. And I think that’s really the goal of the Bank, right? So when we talk about if a recession is coming or whether a recession is coming, I think the conversation should be more like when it’s coming and how deep it’s going to be.

Ian Pollick: Yeah and what type of recession it’s going to be.

Josh Kay: And what type of recession it’s going to be.

Ian Pollick: Yeah, I agree with that.

Josh Kay: I mean, without that, you’re going to have persistent inflation.

Ian Pollick: So you said something that I want to pick on it a little bit. So you said terminal. Your expectation is, what, three and one half?

Josh Kay: Yeah.

Ian Pollick: And so I don’t think there’s anything wrong with that. I mean, the market’s kind of in and around there, but like I’m losing a lot of interest in terminal, to be honest with you. And where I think my interest is increasing is this idea that you can get to some level, let’s call it 3 to 3 and a half, but then you do have a recession, but then what do you do with the interest rates afterwards? Because like even if inflation moderates, you’re going to be in this environment where it’s falling from seven and one half percent, what if it falls to three and one half to four? Like, how do you add stimulus in that environment? And I don’t think you do. So I’m the Bank of Canada. I’m like, okay, well, I’m trying to rebalance the economy. I’m trying to snuff out inflation because I have a smaller supply side. I have to move demand even more.

Josh Kay: Yeah.

Ian Pollick: But then inflation is still high. Do you cut rates? And so what I’m spending a lot of time thinking about is what does that post peak rate stimulus conversation look like? And I don’t think you get this delivery of cuts that are priced into the market. And so from my perspective, I think about the curve. That’s why I think the big inversion, we haven’t even seen it yet. But let me take a step back and I want to ask you something, because you spend a lot of time, you run our sales group, so you speak to a lot of different type of clients. And, you know, really quickly here, view on risk assets. What do you think about the wealth erosion, whether it’s from the equity channel, whether it’s from credit? How are you thinking about that?

Josh Kay: Right. So a couple of things to unpack there from your comments. You know, you talk about the terminal rate of three and one half percent, and I think that makes a lot of sense. But if you ask me if the market was going to go higher than three and one half or lower than three and one half, and you made me decide, I’d say lower than three and a half. And there’s a lot going on to erode the demand side of the equation, right? So we talked about rates going higher. 75 next week, another 75 in the fall. Fixed mortgage rates in the five year space are already 5%. So that’s meaningful.

Ian Pollick: That’s wild.

Josh Kay: It’s meaningful, right? So in the COVID crisis, the handle on a five year mortgage rate, 1%, right? So you’re up at 5% now. That’s a meaningful tightening. You also have wealth erosion, right? So you talk about equities being lower, real estate prices coming off, you talk about crypto being lower. All the COVID related fiscal stimulus has or is rolling off and consumer confidence is lower. And I know, Ian, I saw something you wrote on this this week. You know, people are saving more and spending less. So I think there’s a lot of things really happening to the demand side, that ceteris paribus on the supply side, you really get crushed and you do start to see that recession play out into the end of this year and next year.

Ian Pollick: So you think a recession is coming? You put it together for me. What do you think about the labour backdrop? Like how does the labour market respond in this type of environment?

Josh Kay: So, you know, I love that question and I think this is the only thing really moving against those factors that I just discussed, right? Labour is strong. The employment market is strong. You know, taking aside this morning and you can talk about that a little bit and unpack that if you wish. The labour market being strong is one of the reasons that people think a recession is not coming. I’m of the view that you don’t have to have a massive upset employment situation in order for a recession to materialize. What are your thoughts on that, Ian? Do we need to see unemployment back up around six, seven, 8% to have a recession or small moves could generate the downturn that the Bank needs to see to crush inflation?

Ian Pollick: Well, I think, you know, people don’t really recognize it. If you look back the past 30 years of data in Canada and I think it’s similar in the US, but I’m going to focus on CAD here. You’ve never had more than a 4/10s increase in the unemployment rate without a recession. And I know historical comparisons are difficult right now and I know we’re in a different environment, but the point is that the unemployment rate is at a historic low right now, generational low in Canada. So it’s not like you need to see a double to manifest itself in a recession. And I would say that when I looked at the CAD job numbers, you know, a couple of takeaways from me. You know, number one was wages were obviously huge. But, you know, it’s kind of baloney, to be honest with you, because I look at year ago levels and the year ago comparable from June 2021, you know, it was a monthly decline. So you had this big optical move in wages. And I think that gets exaggerated within just the current narrative of inflation. The other thing that it stuck out to me and this is something that I think you can say in the US too, is that you have this very fast pace of labour market absorption and jobs are being created, but you’re not getting the output growth on the other side. And you kind of heard comments from Waller about this last week and they basically were talking about GDI versus GDP. Those are two measures that really should be measuring the same thing. But, you know, their divergence is almost 4% right now. So something’s happening where either the deflators aren’t working or productivity is just much worse than we thought it was. But like when I look back to the Business Outlook survey, you know, I know this is hindsight. But when I was thinking about the Business Outlook survey, the thing that stuck out to me was businesses said that the cost of capital goods is now so expensive that they are going to rely more on labour than investment in machinery. That’s important because if I told you you’re in a wage price spiral or wages are generally rising, you say, you know what, mine the very large equipment, I’m going to be more productive. I don’t need as much labour. So the fact that you are now saying that these capital goods are too expensive and you’re going to hire more workers, that puts a lot of vulnerability into the unemployment rate if you do get a downturn.

Josh Kay: That’s right.

Ian Pollick: Now, I think the way that I look at the world is a bit different in the sense and I agree with you, I think that you could have this kind of job plentiful recession, where the really productive parts of the economy get hit. Those parts of the economy actually don’t have a lot of labour attached to it. And so that doesn’t lead to a terribly bad recession. And remember, there’s three types of recessions. You have a household recession, a business recession or financial market recession. All things kind of point to this being a business recession so far because, you know, businesses seem to be believing that demand is going to be on line for a very long time. They’re doing their best to try and increase capacity. And then when you get that falloff in demand, that’s when they have to all of a sudden right size themselves. So I find this really interesting, to be honest with you, is what this all means for credit. Because, you know, if I heard the word recession, I think about credit in general. The two don’t really go together. So in our last call, if I think back to it in January, again, decent call credit was going wider. Before we jump into what recession means for credit, give me kind of a mark to market. What’s going on with credit right now?

Josh Kay: Right. So in January, we talked a little bit about credit and credit spreads and where we thought they were headed. And the conversation there prior to the rate hikes happening was that credit typically doesn’t like rate hikes and that credit was probably poised to move wider and that we had seen the tides of the year. That was the conversation that so credits move meaningfully wider. I think-

Ian Pollick: Can you just frame that for me?

Josh Kay: For sure. So I think when we spoke in January, a five year bail in and we talked about bail in being a good benchmark for credit, would have been probably around 115 to 120 basis points from 75 basis points three months prior. Moving forward now, a five year bail in is probably around 170, 175 basis points. So call it 50-ish wide or for round numbers.

Ian Pollick: And the underlying level of rates is 100 higher. So these things have been crushed.

Josh Kay: Exactly. Exactly. So I think it just tells you that credit has started to look a lot more compelling since we last spoke. And I think a lot of risk has been priced into credit.

Ian Pollick: Wait, so does that mean a five year bail in all in yield is above four and a half percent like you’re almost 5%?

Josh Kay: Exactly right.

Ian Pollick: What?! That’s high yield. (laughs)

Josh Kay: So it’s funny you say that. It wasn’t long ago that the high yield index had a 3% handle. And just last week we did a deal for our bank and the coupon was 4.95%. So that’s a commerce bail in deal. And when you think about how much break even protection is in that trade relative to the amount of risk you’re taking, with a smaller PBO-1 because of five year risk, you’re looking at about 115 basis points of breakeven with a 4.95% coupon. So corporate credit is starting to look very, very compelling and in particular in that five year sector.

Ian Pollick: So, listen, I think that against that, the question I have and again, I’m not a credit expert, but, you know, where I am an expert on is understanding just the flow of funds within the market in Canada. We know that there’s a dynamic going on where as QT ages it slows the pace of deposits relative to loans. You’re in this environment there where you need this persistent funding need. We’ve seen financial issuance larger year to date than all of 2021. It’s a pretty well understood story. It doesn’t look like that’s necessarily stopping anytime soon. So when you think about the risks, what you just said, we have a decent breakeven, spreads are wide, all in yield levels are high. How much are you worried about general financial supply? And talk to me again in generalities of just general supply in the CAD energy market.

Josh Kay: Right. So you talked about bank supply being up, and I think we can unpack that just a little bit. So the data tells us that corporates so non-financial corporates are drawing on their bank lines to fund. Right? Because the markets have moved very quickly wider and bank lines represent a compelling alternative for financing. So when corporates are drawing on their bank lines, then banks need to fund. So that’s why we’ve seen a lot of bank issuance and we’ve seen a lot less non-financial issuance this year.

Ian Pollick: And so like I looked at before this, before we sat down to record this, I looked at the returns of the FTSE TMX, you know, you’re kind of -13% on the headline. Corporate credit, not much better, you know, and some of these energy names holding up a little bit better, but like the financial subindex kind of down 17%. These are really big numbers. So is this one of the situations where the numbers are so big? Do you think that it creates outflows or does this create opportunity?

Josh Kay: So the conversation around flow of funds has been that they’ve been fairly stable in fixed income and stable and-. 

Ian Pollick: In Canada.

Josh Kay: In Canada, yeah. And reasonably stable in credit. I think that you start to see opportunity and inflow into corporate credit. You know, when we talk about breakevens and we talk about our bank deal as an example and a 5% coupon, I think as inflation starts to come down, that type of security represents really compelling opportunity for investors and you start to see flow of funds into corporate credit. And I think when corporate credit moves tighter, it’s going to move tighter, very, very quickly and probably into the recession. So if you want to wait, you could miss an opportunity here in corporate credit. I think you want to start to get long if you’re not already there.

Ian Pollick: Okay. So I want to unpack that a little bit in a second. But I guess my question for you is, when I think about corporate credit, we’re talking generalities. Let’s just break it down a little bit more granular and talk about sectors. So like all of a sudden you’re talking about the high rate sensitive sectors like REITs. I can’t imagine they’re doing all that well. But then against that, maybe you have some industrials, some durables, and then you have banks. So like walk me through what you said and give me the call to action, what sector I care about and which ones do I want to avoid?

Josh Kay: Yeah. So we’ve seen a lot of bank issuance and we’re in an environment where there’s been a lot of new issue concessions and that’s a term that we talked about a lot.

Ian Pollick: Yeah, we talked about NICs last time, right?

Josh Kay: Yeah. So banks have been playing new issue concessions which are you’re paying incremental return to issue a new issue security relative to the secondary market. And so banks have moved very quickly wider in this environment because of the supply that they’ve had to bring to market. Some of the other sectors, like you mentioned, REITs, telco, midstream, other triple B sectors in that same term, that five, five year term haven’t moved as quickly wider because we haven’t seen as much supply. So the bank sector in the five year space looks very compelling and I think there’s a lot of opportunity in that space. And the ten year space, you don’t see as much bank issuance. So some of those other sectors that I mentioned in the Triple B space represent good opportunity in the ten year sector. And then when you sort of wed that credit perspective with my rates view, which is a recession is coming, I think the ten year sector looks very, very compelling from a rates perspective as well. I think 5/10s could flatten a little bit more, potentially invert the ten year sector looks great across market and on a fly. So I think you want to own ten years in general and then I think you own ten year triple B credit.

Ian Pollick: But talk to me about the curve, right? Because I think one of the things that we saw, at least in the initial rate rise, that was kind of coupled with the equity drawdown. You didn’t get that normal offsetting behaviour where you had this kind of flatter CAD curve, steeper credit curve or steeper CAD curve, flatter credit curve. That relationship has not been working. Recently, I haven’t looked at it. Do you have any views on the shape of the credit curves?

Josh Kay: I think you’re right to say that typically when credit moves wider, the curves steepen out. We haven’t really seen that. So if you look at tens versus longs in general in credit and I did have a look at this, it’s moved wider, roughly parallel this year. So there’s been a pretty good demand for longs and there hasn’t been a lot of issuance out there. So Longs have performed sort of in line with the ten year sector given tens longs inverted on a Canada basis. I don’t love owning long credit in general, so I think that you want to own five and ten year credit.

Ian Pollick: There’s also no rolldown in the 30 year sector, right? All your credit rolldown is in your 5 to 7 year sector. That’s the juice, right? So I mean, one of the things we talked about on an episode a couple of weeks ago was this idea that you now have such high returns that if you are a structural investor with an investment bogey, you’re supposed to buy corporate credit here. And you’ve seen kind of this narrative in the United States. Is it as well socialized in Canada? Are these the conversations you’re having with people or even tens, right? Like you just you need longer data credit because that’s going to satiate whatever your bogey is.

Josh Kay: Yeah, that’s right. I think that that’s, you said it bang on. The conversations like that are happening all the time. And I think, you know, as credit has moved wider, it’s just getting more and more compelling. And I think you’re starting to see more and more interest to get long corporate credit, even with this sort of uncertain backdrop.

Ian Pollick: Yeah. So let’s just talk about this uncertain backdrop, right, because you tell me we’re heading into a recession, whether it’s household or business. I think default rates are very low right now. They probably have to rise. What are general balance sheets doing? What is the health of corporate balance sheets? Are we as levered as we were five years ago, pre pandemic? And from your perspective, how do you look someone in the face and say, I fully expect a recession to come. Get long credit. Like, just walk me through this because it doesn’t sound intuitive.

Josh Kay: Right. OK. So I mean, good question, Ian. And a couple of thoughts. So two things you want to look at when you think about corporate credit in particular into a recession are leverage levels. And you sort of mention that when you talk about balance sheet and default rates. So default rates are really low right now. Like US corporate default rates are around a percent and a half and that’s versus an average of call it, 3%. So that tells you that the balance sheets are in very good shape going into this recession. And that’s unusual. Typically heading into a recession, default rates are trending up. The other thing is you look at leverage and balance sheets in general are leveraged at about 3 and a quarter percent. They’ve come down from about three and one half percent.

Ian Pollick: It’s not a huge move.

Josh Kay: It’s not a huge move. But you’ve seen deleveraging, post-pandemic, which is nice to see. And again, typically that moves in the other direction prior to a recession. And I suspect that comes down further because of what’s happening in the energy sector. We’re seeing energy companies deleverage and-

Ian Pollick: Save so much cash.

Josh Kay: Exactly right. And they’re not putting it into the ground, right? So leverage is come off highs and is coming down. Default rates are low. So I think that gives you opportunity and spreads are wide, right? So I think that into a recession, people might find corporate credit a good place to hide out and generate return.

Ian Pollick: So let me ask you this, though, because a lot of the stuff we talked about was the relative attractiveness of these oversupplied sectors like banks relative to ones that just aren’t coming to market, right? Now if you’re telling me that right now debt markets are expensive, they’re volatile, people are drawing down their lines and that’s because of the rate volatility. So let me fast forward a year. Let’s say we’re in June 2023. The bank stopped hiking rates earlier that year. You have slowing growth but rate vol isn’t as high and the overnight rate expectations are that the Bank, if they’re going to do anything, they’re going to cut rates. Does that prompt supply to come back online? And if it does, does that offset any of what we just talked about? You know what I’m trying to say?

Josh Kay: I totally get you, Ian, and I think we’ve seen environments like that before. Supply does come back online, but I think there will be demand for it. There will be appetite for it, there will be pent up demand because there will have been a period of relatively lower level of supply. I think you get retail demand that’s incremental because the returns in the sector and you get an environment where the backdrop, bad news for the economy could be good news for credit because you see an environment where the central bank pauses, like you said, and then that that could be good for risk assets.

Ian Pollick: Well, that’s a very good point, because we’re in this environment right now where the bad news in macro hasn’t actually been good news in equities or in credit.

Josh Kay: That’s right.

Ian Pollick: You need this central bank pause to realign kind of that post 2008 bad is good.

Josh Kay: That’s right. Bad news is good news for risk. And I think that you start to see that play out in the first half of next year.

Ian Pollick: So it’s the start of the week. It’s a busy week ahead obviously with the Bank of Canada like we said, we’ve been on this on the mic for 20 minutes. So before we leave, I want to ask one very, very important question.

Josh Kay: Yeah, sure.

Ian Pollick: What is your favourite trade right now?

Josh Kay: So I like owning tens on the curve from a rate perspective. I like owning them on the fly-

Ian Pollick: Fives tens bonds very cheap.

Josh Kay: And I think they look cheap cross market. If you want to own ten years and you’re a credit investor, go buy some ten year triple B credit.

Ian Pollick: OK. Well, listen, everyone, good week ahead. And remember, there are no bonds harmed in the making of this podcast.

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