Scotia’s $1.97 million leveraged notes on Mexico ETF likely to be hit by upcoming downturn

By Emma Trincal

New York, Oct. 9 – Bank of Nova Scotia’s $1,196,0000 of 0% market-linked securities – leveraged upside participation to a cap and fixed percentage buffered downside due Oct. 5, 2022 linked to the iShares MSCI Mexico ETF – offer compelling terms but the duration is not appropriate, according to Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

The payout at maturity will be par plus 3 times any gain in the ETF, up to a maximum payout of par plus 30%, according to a 424B2 filed with the Securities and Exchange Commission.

Investors will receive par if the ETF falls by up to 7.5%

Otherwise, investors will lose 1% for every 1% that the ETF declines beyond 7.5%.

Value

“There are some good things about the structure. A buffer is good to have even though it’s small. And the underlying is not a bad choice,” said Kaplan.

Kaplan looks for undervalued assets, which are increasingly harder to find in what he considers an “overpriced” U.S. stock market.

Emerging markets offer some potential.

“Mexico is not as overvalued as the U.S. This market has rebounded since March so it’s not as good a bargain as it was six months ago. But it’s still undervalued as all countries south of the U.S. are right now.”

However, Kaplan said he would not consider the notes due to the tenor.

Two-year term

“Two years is not great,” he said.

“Within this two-year cycle, we have a high probability of getting inflation, which will be followed by a recession.

“While it may take longer than two years to get from one to the other, I think it’s very likely, especially given the extremely high valuations in the U.S.

“If the Nasdaq collapses it will affect the rest of the world.”

Kaplan says a bear market is already underway and it began last month when U.S. markets peaked.

Hello bear!

“We’re in a market bubble similar to the tech bubble of 2000,” he said.

“Stock valuations are not justified by earnings. The market will drop a lot more.”

While stock prices toward the end of March fell by a third from their February high, a robust rally followed, pushing both the S&P 500 index and the Nasdaq to new record highs on Sept. 2.

Kaplan would not be surprised to see the Nasdaq down 70% at the end of this bear market. In the 2000-02 bear market, the Nasdaq lost 78.5%.

“Today the same thing is happening again. An overheated market. Millions of inexperienced investors jumping in for the first time and buying the same stocks over and over,” he said.

“Even if the Nasdaq fell by only half, Apple’s P/E would still be double than what it was five years ago.”

What comes next is unexpected by most market participants.

Inflate, then deflate

“Inflation is coming,” he said.

“You get a bear market first, followed by inflation. Then you get a recession. That’s usually the pattern,” he said.

“Once the price of gasoline, the price of food become too high, you’re already there,” he said.

He offered several examples showing the sequence.

At the end of 2007, U.S. markets fell into a bear market. By the summer of 2008, inflation soared. A recession followed until June 2009.

The same happened at the beginning of the century. The 2000-01 bear market was followed by a burst of inflation.

Going back further, an extraordinary inflationary phase in 1973-74 came just after the 1971-73 bear market.

“Today, we’re already in a bear market. Small caps have been in a bear market for more than two years. Inflation could make a comeback as early as next year,” he said.

Consensus, stimulus, dollar

History can also debunk what was perceived at the time as unshakable truth by the market.

“People can’t even imagine inflation because it hasn’t been with us for a while. The market believes that rates will be low forever. Forty years ago, people thought that rates will be high forever,” he said.

“As a contrarian, I tend to be skeptical about conventional wisdom. Inflation is going to come back in a big way.”

Extraordinary government spending and monetary policies injecting liquidity create inflation.

In the past few months, the Treasury has added $3 trillion to the deficit while the Federal Reserve has increased its balance sheet by $3 trillion.

“If the Democrats sweep the Elections, there will be more stimulus spending and prices will be rising as a result,” he said.

The underlying ETF should benefit from inflation as the exchange rate benefits U.S. investors when the U.S. dollar depreciates as it does during inflation, he said.

“It could help the performance of the note but not for long.”

Inflation may not last more than a few months. After that, a recession is likely and stock prices could continue to be depressed.

Currency risk

“During a bull market, inflation is felt in asset prices only. Once the stock market bubble bursts, what used to shield the economy starts to impact real assets,” he said.

“Inflation is cutting people’s spending.”

The dollar as a result begins to rally as it is viewed as a shelter.

“The exchange rate is now unfavorable to U.S. investors.”

The blame game

A government can print money and create inflation, and it can also do the opposite.

The risk of tax hikes if the Democrats win should not be overlooked, he said.

“Biden said he would raise corporate tax rates from 21% to 28%. He also plans to raise long-term capital gains tax rates for wealthy investors.

“If Biden is elected, he might be blamed later for a recession. The same happened to Obama. Unfortunately, anytime a new president takes power near a peak, that’s what happens,” he said.

Based on this macroeconomic outlook, the uncertainty around the elections and the current bear market, Kaplan believes the timing for the note is just too risky.

Panic selling

“It would have been much better as an autocall,” he said.

“To sit there for two years until we get into a worldwide recession doesn’t make me comfortable.”

Asset diversification does not offer much protection. Even if Mexican markets are not correlated with the U.S., in a bear market, correlations rise along with fear.

“If the Nasdaq drops every few months for a while, people will feel more jittery. They’ll sell almost anything. When things go wrong, most assets are affected at the same time, from real estate to corporate bonds and from commodities to emerging markets,” he said.

Obviously, Mexico would be no exception.

Scotia Capital (USA) Inc. and Wells Fargo Securities, LLC are the agents.

The notes settled on Oct. 5.

The Cusip number is 064159WY8.

The fee is 2.33%.

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