Following the sharp year end rally, our equity targets have been lowered to neutral, in recognition of consolidation and potential disappointment in the expected March arrival of the U.S. Federal Reserve’s first rate cut.
Similarly, we have reduced our overweight of duration (ie. interest rate sensitivity) back to benchmark, as the market’s pricing of 5 to 6 rate cuts by year-end may have been excessive.
We remain overweight U.S. equities versus Canada, on a relatively better employment and growth outlook for the year, and greater exposure to higher growth sectors like technology and communications services.
Back to Life, Back to Reality
Dreams of sugar plums and Santa Claus rallies have faded, and 2024 has begun with a pause in the torrid fourth quarter rally in risk assets. Following a dismal showing in the previous year, 2023 delivered the following price index returns (in local currency terms): S&P 500 Index: 24.7%, S&P/TSX Index: 7.8%, MSCI EAFE Index: 4.3%, MSCI Emerging Markets Index: 7.1%. (Bloomberg, Dec 29, 2023).
As a new year begins, we are now faced with higher valuation multiples on equities, with the potential for market disappointment should the U.S. Federal Reserve (the “Fed”) not deliver on the 5 to 6 rate cuts that remain priced into markets. Recession or no recession, there is still the potential for a correction in the first half of the year, as the average non-recessionary drawdown of the S&P 500 Index is around 13%, a reminder that even in the best of conditions, investing requires some tolerance for volatility. That tolerance is sure to be tested this year, with U.S. Presidential elections, continued military conflicts, and changing global trade alliances. As such, investors should be prepared for more modest gains from developed equity markets in 2024, though still respectably positive.
Our MAST view has cut equities to neutral for the shorter term as last year’s winners consolidate gains, perhaps with some profit-taking delayed past the end of the tax year. The concentration of the “Magnificent 7” [a group of high-performing U.S. stocks including Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA)], is still an almost daily discussion in the media, with the stratospheric valuation of Nvidia and other AI-related players far higher than the 493 laggards. However, when factoring the 3- to 5-year consensus expected growth of earnings, the technology sector starts to look far more reasonable relative to the rest of the market. Software names within the sector remain cash fortresses and offer relatively lower valuations versus semiconductors.
Similarly, the sharp change in rates and related policy last year will most likely normalize as the year progresses, although the last leg of fighting inflation is sure to prove less linear and less rapid than last year. The MOVE index, a measure of bond volatility, remains higher than the CBOE VIX Index’s read of the S&P 500 Index’s implied volatility, reflecting this uncertainty. Matching the equity pullback, bonds retreated as the entire U.S. yield curve moved back above 4%, suggesting that perhaps March rate cuts from the Fed are too optimistic. Further, the December CPI reading came in on the hot side, with new non-farm jobs also exceeding expectations, while weekly initial unemployment claims remain low. This has translated into reasonable strong continued consumer spending, and modest increases in consumer credit delinquencies, both of which remain in the “safe zone” compared to prior recessions. The Fed will most likely need to see more confirmation that labour demand and wage growth is softening, with most of the evidence coming from the softer Job Openings data last year. While still slightly favouring March, the market trend in recent weeks has suggested a May cut at the earliest.
Lest readers become concerned they need to abandon any new year’s resolution to be more positive, longer-term base case is relatively positive, with a soft landing or even mild recession only modestly delaying a return to positive territory by year end. One theme that has materialized is the transition from inflation-driven earnings growth to a trend of better margins via productivity improvements. This has been demonstrated through lower unit labour cost readings, despite still warm year-over-year wage growth (particularly among services).
Rate cuts should also bring the high-flying U.S. dollar lower, which is an additional potential tailwind for U.S. earnings growth. For every 10% fall in DXY (the trade-weighted value of USD), there is roughly a 3% upside to aggregate S&P 500 Index earnings, as foreign revenues gain relative value. As such, tilts toward industries with significant global presence, like tech, industrials and healthcare, all stand to capitalize on this dynamic.
Finally, there is a MASSIVE amount of investor funds still sitting in money market funds and instruments that will continue to bleed into other risk assets as short-term rates fall. Considering the taxable equivalent yield of interest income versus more attractive dividends and equities, this balance could shift after only a few cuts.
Disclaimer:
The views expressed in this document are those of the Portfolio Manager. They do not necessarily represent the views of BMO Global Asset Management. The views and opinions have been arrived at by the Portfolio Manager and should not be considered to be a recommendation or solicitation to buy or sell any products that may be mentioned.
This material may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties.
This communication is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from the Bank of Montreal.
Commissions, trailing commissions (if applicable), management fees and expenses all may be associated with mutual fund investments. Please read the fund facts or prospectus of the relevant mutual fund before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Distributions are not guaranteed and are subject to change and/or elimination. For a summary of the risks of an investment in BMO Mutual Funds, please see the specific risks set out in the prospectus.
BMO Global Asset Management is a brand name that under which BMO Asset Management Inc. and BMO Investments Inc. operate. BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.
®/™Registered trademarks/trademark of Bank of Montreal, used under licence.
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BMO ETF Portfolios January Commentary: Back to Life, Back to Reality
January 19, 2024
BMO ETF Portfolios January Commentary: Back to Life, Back to Reality
January 19, 2024
Steven Shepherd, CFA
Portfolio Activity
Back to Life, Back to Reality
Dreams of sugar plums and Santa Claus rallies have faded, and 2024 has begun with a pause in the torrid fourth quarter rally in risk assets. Following a dismal showing in the previous year, 2023 delivered the following price index returns (in local currency terms): S&P 500 Index: 24.7%, S&P/TSX Index: 7.8%, MSCI EAFE Index: 4.3%, MSCI Emerging Markets Index: 7.1%. (Bloomberg, Dec 29, 2023).
As a new year begins, we are now faced with higher valuation multiples on equities, with the potential for market disappointment should the U.S. Federal Reserve (the “Fed”) not deliver on the 5 to 6 rate cuts that remain priced into markets. Recession or no recession, there is still the potential for a correction in the first half of the year, as the average non-recessionary drawdown of the S&P 500 Index is around 13%, a reminder that even in the best of conditions, investing requires some tolerance for volatility. That tolerance is sure to be tested this year, with U.S. Presidential elections, continued military conflicts, and changing global trade alliances. As such, investors should be prepared for more modest gains from developed equity markets in 2024, though still respectably positive.
Our MAST view has cut equities to neutral for the shorter term as last year’s winners consolidate gains, perhaps with some profit-taking delayed past the end of the tax year. The concentration of the “Magnificent 7” [a group of high-performing U.S. stocks including Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA)], is still an almost daily discussion in the media, with the stratospheric valuation of Nvidia and other AI-related players far higher than the 493 laggards. However, when factoring the 3- to 5-year consensus expected growth of earnings, the technology sector starts to look far more reasonable relative to the rest of the market. Software names within the sector remain cash fortresses and offer relatively lower valuations versus semiconductors.
Similarly, the sharp change in rates and related policy last year will most likely normalize as the year progresses, although the last leg of fighting inflation is sure to prove less linear and less rapid than last year. The MOVE index, a measure of bond volatility, remains higher than the CBOE VIX Index’s read of the S&P 500 Index’s implied volatility, reflecting this uncertainty. Matching the equity pullback, bonds retreated as the entire U.S. yield curve moved back above 4%, suggesting that perhaps March rate cuts from the Fed are too optimistic. Further, the December CPI reading came in on the hot side, with new non-farm jobs also exceeding expectations, while weekly initial unemployment claims remain low. This has translated into reasonable strong continued consumer spending, and modest increases in consumer credit delinquencies, both of which remain in the “safe zone” compared to prior recessions. The Fed will most likely need to see more confirmation that labour demand and wage growth is softening, with most of the evidence coming from the softer Job Openings data last year. While still slightly favouring March, the market trend in recent weeks has suggested a May cut at the earliest.
Lest readers become concerned they need to abandon any new year’s resolution to be more positive, longer-term base case is relatively positive, with a soft landing or even mild recession only modestly delaying a return to positive territory by year end. One theme that has materialized is the transition from inflation-driven earnings growth to a trend of better margins via productivity improvements. This has been demonstrated through lower unit labour cost readings, despite still warm year-over-year wage growth (particularly among services).
Rate cuts should also bring the high-flying U.S. dollar lower, which is an additional potential tailwind for U.S. earnings growth. For every 10% fall in DXY (the trade-weighted value of USD), there is roughly a 3% upside to aggregate S&P 500 Index earnings, as foreign revenues gain relative value. As such, tilts toward industries with significant global presence, like tech, industrials and healthcare, all stand to capitalize on this dynamic.
Finally, there is a MASSIVE amount of investor funds still sitting in money market funds and instruments that will continue to bleed into other risk assets as short-term rates fall. Considering the taxable equivalent yield of interest income versus more attractive dividends and equities, this balance could shift after only a few cuts.
Disclaimer:
The views expressed in this document are those of the Portfolio Manager. They do not necessarily represent the views of BMO Global Asset Management. The views and opinions have been arrived at by the Portfolio Manager and should not be considered to be a recommendation or solicitation to buy or sell any products that may be mentioned.
This material may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties.
This communication is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from the Bank of Montreal.
Commissions, trailing commissions (if applicable), management fees and expenses all may be associated with mutual fund investments. Please read the fund facts or prospectus of the relevant mutual fund before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Distributions are not guaranteed and are subject to change and/or elimination. For a summary of the risks of an investment in BMO Mutual Funds, please see the specific risks set out in the prospectus.
BMO Global Asset Management is a brand name that under which BMO Asset Management Inc. and BMO Investments Inc. operate. BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.
®/™Registered trademarks/trademark of Bank of Montreal, used under licence.
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