Are the Bears Ready to Hibernate?
A balanced strategy served us well while the market kept punting on the recession question. But given the preponderance of negative indicators, we must consider a slightly more defensive posture, and equally importantly, how we should implement it. Should we take risk directly off the table by selling some equities? Or should we plan for a sideways market by taking covered positions—and if so, for how long? For now, we will start by taking some equity risk off the table, but we will continue to analyze which is the best way to play this slow grind down in the economy as a recession draws nearer.
Growth Expectations Fall as Credit Tightens
The timing of a likely recession remains somewhat unclear. Going back to the end of 2022, a downturn had been the expectation. But it’s been pushed down the road by unexpectedly resilient economic numbers, such as the recent employment report for April which showed that the U.S. economy added 253,000 jobs, crushing expectations. This means that no recession cliff is imminent. The summer appears to be the earliest that a recession could hit, with sometime in the second half of the year a likelier possibility given the banking stress we’ve seen and the impact on credit.
Another reason why the housing market is strong is because Canada’s employment picture remains quite exceptional. Almost 250,000 jobs have been created in the first four months of the year. As a result, much like the U.S., a recession does not appear to be imminent. But America remains Canada’s largest trading partner, so if there is a slowdown south of the border in the second half of the year, Canada will feel it as well.
Despite some resilience, the economic backdrop for Europe remains weak. The latest numbers out of Germany show that factory orders are coming off. It’s a tough situation to read— COVID-related shutdowns and supply shortages, as well as last year’s concerns around energy, have created a lot of noise that make it difficult to positively identify current trends. But we do know that the pace of growth is near zero, and that the economy has effectively stalled. Right now, it’s a close call as to whether the Eurozone is already in a recession.
China remains the outlier when it comes to outlook—growth is definitely not cooling, and there’s effectively no risk of recession. The reopening of the Chinese economy is lifting up 2023 growth, and this may even spill in 2024. The big question is: will this dynamic be enough to meet markets’ high expectations? That’s what we’re all waiting to see. For now, it’s safe to say that investors need not be concerned about growth downside in China as much as in Europe and the United States.
BMO GAM house view
Headline inflation is trending in the right direction
Food inflation is still problematic
We appear to be near the end of a long and brutal hiking cycle in North America
The bar is set very high for a negative interest rate surprise over the next few months
You cannot have a recession without job pain
Canada and the U.S. are still creating jobs at a high pace, meaning a recession may be several months off
The labour market remains tight
In the short term, the debt ceiling is a concern
The lack of clarity on who will run in the 2024 presidential election creates uncertainty
Wage growth is now outpacing inflation
If we don’t see job losses, the consumer will be fine
This recession is likely to be triggered by the business side rather than being consumer-driven like it was in 2008
The market is bottoming out earlier than expected
In Canada, there is still a huge imbalance between supply and demand
Housing is likely to shift from a headwind to a tailwind as we head into 2024
Likely to remain a source of concern for markets
Smaller, regional banks tend to be more exposed around the recessionary cycle
As the woes of smaller lenders drag on, the question of whether we see a couple more capsize is not the overriding concern. Tightening credit and loan growth are. The second-order effects of the crisis are what hold the potential for broader economic damage.
What’s been made clear by this financial crisis amongst smaller lenders is that the words “idiosyncratic” and “isolated” are not synonymous. As we suspected, more U.S. regional banks are under pressure for moderately different reasons, but the fact remains, the crisis isn’t fully confined. What’s reassuring when comparing this to 2008-09 is that they’ve skipped to the end already by guaranteeing deposits. As long as depositors are left intact, a bank run is less of a systemic issue; only equity and bondholders need to worry about getting wiped out. More broadly, whether we see a couple more smaller lenders capsize is not the biggest concern. Tightening credit and loan growth are. What began as a contraction of credit to smaller firms and individuals is shifting into less demand for credit, and we may reasonably expect these conditions to persist.
So, there’s a notion of a kind a soft landing for markets and the economy that might be possible—I’ve seen the words “rolling recession” more than once in the past few weeks. But there are some pretty optimistic views out there at the moment considering we’re experiencing one of the biggest contractions of financial liquidity1 that we’ve seen in a very long time.
In terms of positioning, we’ve moved to a negative view (-1) on equities from neutral; we’ve had a pretty good rally and taking some profits is well advised at this point. We’re still overweight bonds relative to cash, and are only modestly biased toward an overweight of duration.
Investors are pricing in tighter financial conditions now, which will help mitigate a sharper correction later. Regardless, markets should be braced for a U.S. slowdown (which Canadian equities won’t be immune from) while the tailwind from China’s recovery slows, too.
We’re still concerned about some banks, but by and large deposits have stabilized for most lenders. The probability that this goes into a full-blown financial crisis is very low, so the focus is rightly on the knock-on effects that could hurt the broader economy, such as tightening lending standards. But that is consistent with market expectations, which are being priced in.
In terms of corporate earnings, we’ve seen a more resilience in the first quarter than initially thought—aggregate profits have beaten expectations. But there are two things that keep us cautious: first, we are still seeing negative earnings growth. And second, the market is turning skeptical that this can keep up—we’re not seeing the usual pop that companies get from upside surprises. Misses are being punished by investors, yet earnings beats are seeing muted reactions. That speaks to the fact that the market is cautious. Could we see the same kinds of outperformance again next quarter? It’s possible given the economy seems to be tracking well. But I don’t think we’ll see a blowout or return to a very strong earnings expansion in the coming quarters
Regionally, we’ve upgraded Canada to neutral (0), while we’ve kept the U.S. market underweight for the month, based on that banking stress and looming recession risk. With respect to Canada, our view is supported by ongoing, strong population growth which is keeping employment resilient as well as aiding the housing market recover off the bottom. Canada, relative to other economies, has a larger share of the economy tied to housing, so a pickup in the sector delivers a bigger relative boost. Interest rate risks2 are levelling off as well with the Bank of Canada on hold. What’s keeping us at neutral and not outright bullish on Canada is the fact that it’s tied to the U.S. Internationally, we’ve lowered our emerging markets (EM) rating a notch to slightly bullish (+1) from bullish. We’re still positive on EM, but China’s pandemic recovery has starting to slow..
We’ve seen a further steepening of the yield curve, and it will likely continue to steepen now that we’ve had what is probably the final interest rate hike from the Fed in this cycle. Recall in the May 3 Federal Open Market Committee commentary they removed the key messaging that “additional policy firming may be appropriate.” That’s a dovish signal. Any further tightening is going to be entirely data dependent. Fed officials also acknowledged the risks related to tightening credit conditions. So, unless inflation reverses course, we’re very unlikely to see further interest rate increases from here. We think the base case that will play out is that the Fed and Bank of Canada don’t reach their inflation targets by year-end, but CPI will be in a place where the central banks feel comfortable that they don’t have to tighten any further.
Looking at rates, we did move to overweight or slightly bullish on Duration (+1). We think we’re at the peak of the tightening cycle now, and there’s now a higher probability of rate cuts in the next six to 12 months than there is of additional hikes. That’s given us some conviction to move further out on the curve. In terms of credit, we’ve kept Investment Grade at slightly bullish (+1). Again, we like to be higher up the quality spectrum, holding debt tied to balance sheets that can weather a recession or material slowdown. In particular, large banks are providing a good opportunity, trading at relatively attractive spreads. We moved High Yield from neutral to slightly bearish (-1) for the same reason that we’re slightly bearish on U.S. equities—bank stress and recession risk. There is also the U.S. debt ceiling uncertainty, which could cause some tremors for credit markets.
Style & Factor
The growth rally may have a bit more gas left in the tank, but not much more. We’re beginning to see investment intentions, consumer credit and other data rolling over, steering us toward Quality and low-vol strategies.
The headline for earnings season was basically ‘Hurray, It Could Have Been Worse’. That’s hardly encouraging, particularly after the bar had been lowered several notches. Growth’s rally has been a knee-jerk reaction that began after the Fed pivoted to pausing rates upon the collapse of Silicon Valley Bank, a reversal of the earlier spike in expected terminal rates resulting from January and February’s off-the-charts job numbers. We’re still seeing that labour market resilience, including in April, which beat expectations. But that print came with a footnote that said March and February’s combined data were off by 149,000 jobs. So, can it sustain? Perhaps for a little while longer, particularly if rate cuts are priced in. But we’re skeptical the further we look out. If you look at the technicals on rallies, that range is getting narrower and narrower. It’s going to require a pretty significant breakout above certain levels to be deemed a sustainable growth rally. Growth stocks make up north of 25% of the S&P 500. When investors start selling growth, it’s going to take many names with it. That’s why we’ve positioned growth back to neutral, favoring value and quality this month. Low-vol is still performing quite well, as well.
With recession closing in, we favour a return to gold across our portfolios through exposure to materials stocks and direct bullion ETFs, while moving out of other positions in Energy and Technology. There is, however, a shorter-term possibility of the greenback re-asserting its safe-haven status.
The USD has been softening on anticipation of a potential pause in further rate hikes. But the flip side of that is once we go into recession and markets get nervous, the greenback becomes a safety trade. So, we’ve reduced the Canadian dollar (CAD) back to neutral (0) from slightly bullish; the CAD in the short-run may have some upside potential, but as we head into a recession, we expect that trade will reverse course.
1 Liquidity: The degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Cash is considered to be the most liquid
asset, while things like fine art or rare books would be relatively illiquid.
2 Interest rate risk: Refers to the chance that investments in bonds will suffer, as the result of unexpected interest rate changes.
3 Yield curve: A line that plots the interest rates of bonds having equal credit quality but differing maturity dates. A normal or steep yield curve indicates that long-term
interest rates are higher than short-term interest rates. A flat yield curve indicates that short-term rates are in line with long-term rates, whereas an inverted yield curve
indicates that short-term rates are higher than long-term rates.
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