Scotia’s $4.32 million dual directional notes on Russell 2000 to face stagflation risk

By Emma Trincal

New York, Nov. 3 – Bank of Nova Scotia’s $4.32 million of 0% dual directional trigger PLUS due May 5, 2025 linked to the Russell 2000 index may have benefited from a longer tenor given the risk of further market declines along with persistent inflation headwinds, sources said.

If the index return is positive, the payout at maturity will be par plus 200% of the index return, subject to a maximum return of par plus 44%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive a 1% gain for each 1% loss if the index declines but finishes at or above the 80% trigger level and will lose 1% for every 1% decline if the index ends below its principal barrier.

Small-cap exposure

Ed Moya, senior market analyst at multi-asset trading firm Oanda, pointed to macroeconomic risks during the timeframe of the notes.

“We’re talking about May 2025. During those next two-and-a-half years, what’s going to matter is whether we’ll have a stagflation or not. That, to me, is the biggest market risk. Will the Fed remain aggressive in tightening over the next year or two? If not, then we’re in trouble,” he said.

Inflation would be particularly threatening for the small-capitalization market, which the Russell 2000 index offers exposure to, he said.

“We’re starting to see small business owners feeling the pain of inflation a lot more. Small businesses, small companies could be significantly hit by higher prices, more so than large corporations and multinationals...those will be able to make up for the shortfall,” he said.

Walking a fine line

The Federal Reserve’s tightening policy against inflation during the term of the notes will have a direct impact on the performance of the underlying benchmark, he said.

“When you make that type of call for two-and-a-half years, you need to have a macroeconomic outlook,” he noted.

“So far, [Fed chair Jerome] Powell is pushing back. He made that clear during his press conference yesterday.

“But until May 2025, the Fed has plenty of time to be wrong about fighting inflation.”

On Wednesday, the Federal Open Market Committee increased the Federal Funds rate by 75 basis points, as expected. During the press conference following the announcement, Powell said that he will pursue his efforts to tame inflation with further rate increases. The market reacted negatively to his comments, pushing the Dow Jones industrial average more than 500 points lower.

“Right now, he remains hawkish. He needs to be. If there are any signs of a pause, the market will start pricing the easing,” said Moya.

Just that window

“Personally, I see a risk in the Fed cutting rates too soon. Or they may take a pause and if there is not enough demand destruction to bring inflation down, they may have to resume rate hikes aggressively. My concern is that inflation may be lasting longer than it should.

The analyst pointed to other potential inflation triggers, such as geopolitical risks, shortage risks and a resurgence of Covid cases and lockdowns.

“There are a handful of scenarios that could support higher prices,” he said.

With an underlying benchmark representing stocks of companies that are likely to be the most harmed by inflation and a timeframe that gives the Fed opportunities for monetary policy missteps, Moya said the notes were relatively risky.

“The timing of this investment is not as attractive as it may seem,” he said.

“It’s just that window that makes me uneasy. The next two years are really going to be challenging.

“The U.K. is in a recession right now.

“We’re probably heading up into in the middle of next year and I think we’ll stay in a weak spot going into the Presidential Elections.

“A four-, or five-year maturity would have been much better.”

Downside risk

A financial adviser agreed.

“The problem is timing,” he said.

“The protection is delivered via a barrier, and there are chances that you could be down more than 20% in the next two-and-a-half-years. Just because small-caps are less overpriced than large-caps doesn’t mean they can’t drop more than 20%.”

During the short-lived pullback of February-March 2020, the Russell lost more than 40% of its value.

The index was already 25% off its high of a year ago when the notes priced on Monday. But for this adviser, investors are still facing the potential of hefty losses.

“We’re only a fraction of the way through,” he said.

“The Russell peaked earlier than the S&P but only by a couple of months. It’s trading a little bit closer to fair value than the S&P. Still, I don’t think the barrier level gives you enough protection. If you’re down less than 20%: great! You’ll make money on the downside. But it’s unlikely in my view. The range is too narrow. Your chances of breaching the barrier and losing a big chunk of money are pretty high.

“I wouldn’t use this.”

Scotia Capital (USA) Inc. is the agent with Morgan Stanley Wealth Management handling distribution.

The notes settled on Thursday.

The Cusip number is 06417U578.

The fee is 3%.

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