TDAM Talks Podcast: Keep Calm and Carry On in the face of market volatility

NARRATOR: TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management.

INGRID MACINTOSH: As we close out the third quarter, North American equity markets find themselves at or near lows for the year against the backdrop of aggressive, persistent central bank moves to tame inflation. To help make meaning of the current market landscape, I'm joined on this edition of TDAM Talks by Justin Flowerday, head of public equities here at TD Asset Management.
I'm your host, Ingrid Macintosh. And together, we're going to talk about the current state of equity markets and offer some guidance to investors who want to know what's driving this market activity and what to expect going forward. With that said, welcome, Justin.

JUSTIN FLOWERDAY: Thanks, Ingrid. Great to be here.

INGRID MACINTOSH: So how are you? It's been a busy month, I think, for you.

JUSTIN FLOWERDAY: Yeah, Ingrid, just coming off a couple of weeks of visiting some clients across the country and some advisors. And so it's been great to reconnect. This is our first real opportunity to reconnect in, I think the number was, 1,000 days. And so it's been really, really good. The backdrop of the market hasn't been as good, and there's been a lot of volatility that is somewhat concerning to clients and advisors. And so some of the common themes and common questions we're getting haven't changed, which is, when will this end? And it relates to-- the answer, at least, relates to inflation and central banks. And so yeah, some good conversations were had, but no easy solutions.

INGRID MACINTOSH: And all at the same time as you're getting your real life back on track, too. I think you got three kids that are getting back into school right now?

JUSTIN FLOWERDAY: Yes. Yes. Yes. So grade 12, looking for universities. Grade 10 and grade 4. And so yeah, everyone's back to school, and the sports.

INGRID MACINTOSH: Volatility all the way around, right?

JUSTIN FLOWERDAY: That's right. The tryouts have started out. Yeah. One thing is consistent-- lots of busyness, but the one thing that does stay the same is there's 24 hours in the day. And you can't change that, so time's been crunched.

INGRID MACINTOSH: OK. Well then, we're going to focus on using your time wisely here. As we record our podcast today, we know there's always a couple of weeks before we get to market. We're seeing North American markets back down to levels last witnessed in the spring of 2021. If you like them in January, you really like them now.

Inflation's been identified as the key culprit. And the latest readings for inflation remain somewhat higher than expected. So let's start with the foundational. What are the implications for consumer spending, and then, by extension, for the markets more generally?

JUSTIN FLOWERDAY: Yeah. OK, so why don't we start with the consumer? The consumer has been incredibly resilient. And it's been continuing to spend, and it's because of a couple of things. Number one, the job market, in particular, in the US.

We haven't seen any cracks yet. They're going to come, but we haven't seen them yet. And so you have a lot of people who are employed. And you have a bunch of people now who are working two jobs. So income levels are healthy.

The other thing that's happened is balance sheets have been restored to really, really healthy levels over the last couple of years. And I think the number that Jacky He has been throwing around recently is-- he's our consumer discretionary analyst on the research team-- is that $5 trillion in savings is the level for checking accounts in the US. And that's quadrupled up from $1.3 trillion at the beginning of the pandemic. So those have been cushions for the consumer and have provided them with ample opportunity to spend. We've seen a shift from goods to services. And you have this whole revenge travel theme and entertainment revenge.

And I don't even know if that's a term, but it's pretty wild. You mentioned I was going across the country, and the airports are packed. The restaurants are packed. Every venue we went to was jammed. And so people and businesses are out there consuming. It's just a little different. It's not so much on goods. It's on services.

INGRID MACINTOSH: It's interesting because you're giving me two good news stories here, right? Jobs are healthy. Balance sheets are healthy. Consumers are healthy. Juxtaposed that to markets, not so much. What's really driving the differential, if you will?

JUSTIN FLOWERDAY: Yeah. Absolutely. And markets are looking ahead, and they're realizing that all the moves that the central banks have done so far, they impact the real economy with a lag. You've got the early impact of higher interest rates converting into higher interest rate payments for consumers and homeowners on their mortgages.

And that's obviously being felt. But a lot of the other impacts happen with the lag. And so the markets are looking forward. And I think everyone has come to the conclusion that earnings estimates in the market are too high, and they need to come down. And people have come to the conclusion that the Fed has made it their commitment to crack the labor market and really slow down the economy.

And so the economy will slow, and the market is trying to interpret all this. And it's been a volatile time. And we had a rally in the summer, which, actually, it wasn't really the best thing for the longer term, or, let's say, the medium-term state of the market, because it makes everything the Fed is trying to do a little more difficult. It brought a little confidence back. It brought a little bit of positive sentiment back, which delayed probably some of the pain that needs to happen

INGRID MACINTOSH: Right. You guys are feeling too good. We need to throw some more water on this fire. I just want to, before we go a little bit further on the rates-- early on in the inflationary cycle, people talked about transitory inflation and the supply chain issues.

Can you talk a little bit about that? Are inventories sorting themselves out? Is the supply chain improving? Just before we sort of go to what the rate looks like.

JUSTIN FLOWERDAY: Yes, absolutely. So those are actually two-- they're moving in slightly opposite directions. So inventories of goods are building. And this is actually not necessarily a positive for many of the retailers out there as they're writing down a lot of their stock. But supply chains are improving, and container ports are improving. And one of the ones that I've continued to track is that logjam of massive container ships out in the port of Los Angeles, where you had 109 huge container ships just sitting in the ocean idle, waiting to unload their containers. And that was back in January. And it came down to 70, and then 50. And by the summer, it was 20. And when I took a look last week, it was nine. I think, actually, it was seven. And so things are improving. And you know, obviously, China has been slow to reopen, but that also will improve, I think. And so the supply chain is improving. The inventories, for now, have moved in the wrong direction for companies. They're sitting with probably too much inventory of goods on their balance sheet.

INGRID MACINTOSH: Which is anti-inflationary, I guess, but we'll see how it works itself out. Let's pivot and talk about central bankers. So the central bankers-- whether it's Fed, Bank of Canada-- seem dead set on keeping administered rates elevated, or, quote unquote, "high," until inflation is under control. So what are your thoughts on the current level of rates? Are they truly high? And on policy tone and stance.

JUSTIN FLOWERDAY: OK, yeah. Well, let me take the second one first. On policy tone and stance, the central banks are finding themselves-- and we'll use the Fed as the example-- in a difficult position, because they lost credibility. They lost credibility over the last four years-- 2018 until-- probably up until the end of last year. And they're trying to rebuild it. And they've admitted to us that their models are broken. Their inflation models are broken. And so when looking forward at what they're trying to do, is they're trying to regain credibility by talking really tough and making sure that people believe that they're taking inflation extremely, extremely seriously. And I think, for the first time in a while, people believe the Fed when they say, we are going to crack the labor market, and we are going to crack the economy. And they believe that the Fed is willing to see unemployment in the US go up from mid threes to mid fives. And they're realizing that probably means a recession. And then they realize that it probably means, again, earnings come down. So that's the position the Fed's in. When we talk about the level of interest rates, it's interesting, because in a historical standpoint, where we are now, compared to the last 40 or 50 years, isn't high on an absolute basis. But you did have a bunch of folks who entered into first-time mortgages when variable rates were 1.5%. And now variable rates can be upwards of 4% and higher. And so they're feeling the impact of 300 basis points or higher increase in variable rates, which impact their monthly payments. And so yeah, compared to when rates were 10% or higher, we're not seeing that absolute level. And so the impact on the economy is probably a little bit less, but on a relative basis, it's still painful.

INGRID MACINTOSH: And again, that's going to be a lagging effect. I think about one of our kids who bought his first condo and had that five-year mortgage at 1.5%. He's not going to feel that pain for another almost three years, but it's out there. For sure, it's there.

JUSTIN FLOWERDAY: Right.

INGRID MACINTOSH: So let's talk a little bit then about corporate earnings. As I said, we're just rounding out coming to the end of September here. What do you expect corporate earnings are going to look like this quarter?

JUSTIN FLOWERDAY: So we're off to a bit of a rocky start. I think, when I was on the road, we had a few announcements. I know we had a few. We had FedEx announce. We had Ford announce. We had General Electric announce, and a couple others. And they're all talking about headwinds, and revising down revenue and earnings. And I think that's just the beginning. And when you think about the cadence of the year, and people have been talking about how resilient earnings have been throughout this year-- and they've been incredibly resilient. And we've seen companies continue to discuss how they think they're going to be able to make their year-end goals. And it speaks to, I think, the manner in which these goals are set and management teams are compensated on meeting the goals that were set last year for this year. And so they're coming to the end of the year. And Q3 and Q4 are coming up. And they're going to get compensated if they meet the goals that were set last year. But then they have to set the goals for next year. And the goals for next year are going to get set this quarter and next, which means Q3 and Q4 earnings, we're probably going to hear a lower level of optimism. We're probably going to hear a lower bar for them to meet. And that's going to be beneficial to them. And I think it's going to be beneficial to the market because it's going to reset expectations. And we need expectations to reset to form a bottom. And so we're going to go through this period where it's going to feel kind of gross and feel unhealthy because it's going to be all negative news from companies, I think, for a bunch of them. But it's actually going to be a really, really healthy thing for the market.

INGRID MACINTOSH: But if we look at where valuations right now are, would you say those are somewhat, fully, or only partially priced in from where we're sitting right now?

JUSTIN FLOWERDAY: So the valuations on the numbers that are out there today for, let's say, 2023 were-- they're not unreasonable. I think 17 times, probably a little lower after the last couple of days. If the numbers come down and the true numbers of earnings are lower, then that valuation is obviously a bit higher. But look, I mean, we started the year trading at 23 times earnings.
And we've seen a ton of multiple compression. And the market is expecting earnings to come down. And that's what the market's telling you. The earnings will come down, and then the multiple, at the end of the day, may not come down any more.
And so the next leg of the market, you could see-- we could see the next level down being a combination of earnings estimates come down, and multiples actually staying where they are or expanding a little bit as they start looking through to the next phase, which is potentially a Fed pivot.

INGRID MACINTOSH: Feels like finding equilibrium. Let's go a little bit deeper, and we're going to keep taking you down the rabbit hole here. We at TD Asset Management have always had a quality bias. So what are you looking for now in a company when investing? And if I can press you on that one a little bit, if you can maybe give us a view on sectors that you expect to do well going forward. But let's start at the focus on companies.

JUSTIN FLOWERDAY: Sure. Yeah. So I think TDAM is fairly well known for our quality bias. And that can mean a whole bunch of different things to a whole bunch of different people. We have our own definition of quality, and I can talk to that a little bit. But essentially, we're looking for companies that are going to grow their free cash flow faster than the market, or faster than their competitors.
And it's going to come from one of two things. They're either going to be able to grow their revenues faster than their competitors, either because they're innovating and creating new products that target new verticals, or because they're gaining share against their competitors, and they have some competitive advantage that allows them to do that.

And so that's on the revenue side. And then the other source of growing free cash flow faster is on the cost side. And so again, it's looking for companies that have these advantages maybe related to scale, or unique processes, or some other competitive advantage that allows them to be continuing to grow cash flow at a superior rate.

For us, that is the definition of quality. And we have a big framework that allows us to identify all those sources of competitive advantages. And it's something we've built over the last 10 years that's proved to be extremely, extremely useful. In terms of sectors, going into this downturn, there's been some sectors that have worked really well.

And I think we're-- that's been staples. That's been utilities. I think those trades are probably going to end. The other side of that trade has been technology's been hit a whole bunch. Industrials have been hit a whole bunch. And I think, coming out of this, we're going to see an opportunity to buy and own high-quality tech and be compensated for that. And when you think about technology, for me, it's always two buckets. It's the low quality, unprofitable technology, and the high quality, profitable technology that has massive, massive competitive advantages, network effects, sticky customers, all that. And we think that there's going to be a great runway for high quality technology coming out of this downturn. And I'm not saying it's next month or next three months. But at some point in 2023, I believe there's going to be a great opportunity. And there's a few others. One of them would be automation, industrial automation. Higher wages probably provide a huge incentive for companies to look for any opportunity to put robots in their various areas of their business. And I think industrial automation will be a theme.

A bunch of different areas in health care are attractive. So plenty of opportunities once we get through this. But I will say-- and it's a really important point that I want everyone to understand-- there is going to be no end to the volatility for the next little while. We're going to see swings. We're going to see probably some rallies and then some sell-offs. And it's not just going to be this V-shaped bottom. And so we're going to look for opportunities to buy these companies when the market doesn't like them. And that really is what provides us and active managers with an advantage when the market correlations go to one, and everybody just sells everything indiscriminately.

INGRID MACINTOSH: You painted such a dark picture there, but with so much optimism in it, which I just love. So, awesome. Let's round it out with what I always love to round our discussions with, how about a lightning round? I'm going to throw a few words at you, and give us the first thing that comes to your mind. I'm going to give you three of these. So if you're ready, first, how about Russia, Ukraine?

JUSTIN FLOWERDAY: Ooh, Russia, Ukraine. Sad. Nasty. Those are the two words. But we've seen some major moves from Ukraine. And they've retaken territory in Kharkiv. And they've made some big gains recently. And I think the Western world views that as a positive. But even more recently, we've heard from Putin and Russia, and the partial mobilization of, I think, 300,000 new troops. And that's obviously not going to happen tomorrow, but it'll happen over the next--

INGRID MACINTOSH: And some saber rattling a little bit, too.

JUSTIN FLOWERDAY: Yeah.

INGRID MACINTOSH: Saber rattling. Terrifying.

JUSTIN FLOWERDAY: Absolutely. Absolutely. But what it probably means is that this is prolonged throughout the winter and into the spring. And it probably means that there's more volatility for the commodity markets, more volatility or uncertainty for the economies, and for the markets in general. So the two words remain sad, extremely sad for the people of Ukraine, and more volatility.

INGRID MACINTOSH: OK, how about the big C, COVID-19?

JUSTIN FLOWERDAY: So COVID-19 has gone, I think, in two directions. For one area of the world, it's become something that people are living with, and we all know-- I'm speaking about the Western society. We all know folks that are still getting ill, but it isn't causing the kind of disruption that it caused in the last couple of years. And so we're kind of living with it now.

And there's another area of the world, particularly China, which has taken a different approach. And they're obviously having periods of lockdowns that are still occurring. And I think, when I look at that, I think we might actually be hitting an inflection point as we move towards the end of this year, and October 16, and the Congress, and Xi consolidating power.

And I think he has a bit of an incentive to come out of that and start talking about the future, and opening up, and the economies reopening. So I'm hoping that that moves in the right direction. And we shall see.

INGRID MACINTOSH: OK, last one, and this probably ties back to the first one-- energy.

JUSTIN FLOWERDAY: Ah, yes. I think I said volatile earlier. I'm going to stick with-- I think I'm going to stick with volatile. And there's an argument to be made that energy goes to 50. And there's an argument to be made that energy goes to 150. And you can make both arguments really, really well, and paint scenarios for diverging energy prices.

But volatility is going to be, I think, the constant. And for some areas of the world, it's going to be a tough winter, particularly in Europe for natural gas prices and the overall cost of heating the house for folks in Europe. And governments are stepping in, and they're providing support, which, at the end of the day, puts a little more pressure on their balance sheets. But that's what governments are there for.

And yeah, I mean, I'll go back. It's just going to be volatile. A lot of it depends on Russia and Ukraine. And a lot of it also depends on China reopening and the demand that that can create for overall energy products.

INGRID MACINTOSH: OK. So wrapping it up, we just heard the consumer is in good shape. Companies are in good shape. But a whole lot of factors are going to drive a whole lot of volatility and uncertainty for the foreseeable future. Any last comments or any last thoughts to leave our listeners with?

JUSTIN FLOWERDAY: Last thoughts. Well, we didn't talk about WAAC, which is the Wealth Asset Allocation Committee. But I'll just mention, we continue to be neutral on equities. As we see the markets continuing to fall, it looks a little more attractive to us. And we don't know where the floor is, but there are going to be opportunities. And we're looking for opportunities to become more positive. I also know, across the portfolios and the equity team, on these days when you're getting 1%, 2%, 3% drops in the market, we've built up cash, and we're starting to deploy cash. And so I think more opportunities are emerging, and the market is moving into a more attractive area.

INGRID MACINTOSH: That's a good positive. Go ahead.

JUSTIN FLOWERDAY: Yeah, why don't we end it there? Nice positive note.

INGRID MACINTOSH: [LAUGHS] Just saying, what a nice, positive place to end it there. Justin, thank you so much for joining me today. Lots of great insights for our listeners.

JUSTIN FLOWERDAY: Thanks very much, Ingrid. Great to be here.

INGRID MACINTOSH: Great. And for our listeners, you can find our recently published Wealth Asset Allocation Committee perspectives on the TD Asset Management site, along with more of our thought leadership and commentary. And as always, please, to receive the latest expertise and updates from TD Asset Management, you can follow us on Twitter @TM_Canada and on LinkedIn at TD Asset Management. Thanks, everyone. Have a great day, great week, and stay safe.