From Inflation to Recession
The most recent Fed meeting highlighted its stance: going forward, more rate hikes are likely, but the Fed also wants to give previously implemented rate hikes a chance to work their way through the economy. This means that in Q1 or Q2 of 2023, we’re likely to see the Fed reach a terminal rate of around 5-5.5%. The Fed will likely let rates stay at that level for a while as it re-evaluates the state of the economy and inflation at that point.
This messaging from the Fed is important for investors, who now have greater clarity on what the terminal interest rate might be and when the Fed might finally pause on interest rate hikes.
This messaging from the Fed is important for investors, who now have greater clarity on what the terminal interest rate might be and when the Fed might finally pause on interest rate hikes. This means valuations from an interest perspective are almost fully priced in—though there will still be some debate over valuation with respect to earnings given some big misses in the last quarter by some heavyweight companies. It’s this clarity on interest rates that has prompted markets’ recent rally, which we expect to continue into late December or early January. At that point, the focus is likely to partially shift from inflation to the status of the economy. While a soft landing or short-lived recession is our base case scenario, how well the economy holds up will depend on employment and consumer spending (which is heavily tied to employment). For now, those numbers remain relatively strong but show some signs of softening.
A Longer Runway Until Downturn Arrives
What’s changed recently is that we’re seeing more momentum in the economy, which suggests that a recession isn’t as imminent as some investors thought. The consumer data for October confirmed that retail spending is set for a surprisingly strong fourth quarter and overall GDP growth could be well above its trend pace of roughly 2%. The labour market also remains very tight; the November jobs report showed monthly gains above 200,000 and a stable unemployment rate. That said, we still think the economy is on a slowing trajectory as further rate hikes into next year weigh on demand, and interest-rate sensitive sectors like housing experience a sharp slowdown. Indeed, the ISM Manufacturing Index has now fallen below 50. All in all, we still expect a mild recession, but the onset could be delayed.
BMO GAM House view
The November U.S. CPI report showed a decline in core goods inflation
Leading indicators point toward softer inflation ahead
Likely seen peak in U.S. inflation
The West’s price cap on Russian oil raises risks of retaliation
Overall risks are diminishing
U.S. Fed has signaled slower rate hikes ahead
Chair Powell showed willingness to meet market consensus near 5%
Real yields may have peaked
Economic data has improved, led by consumer indicators
A mild recession is still likely, but onset now delayed
Encouraging data that supply chains are becoming more balanced
November’s ISM Supplier Deliveries Index stabilized at pre-COVID levels
Could lead to more shutdowns in China and delay global economy’s recovery
Shutdowns would prevent supply chains from fully rebalancing
Rising vaccine uptake and loosening restrictions suggest disruptions may be nominal
Current signs of a bottoming
Sector has already slowed sharply in response to rate hikes
A weakening labour market could see housing drop further
The market is convinced that a final interest rate increase from the U.S. Federal Reserve is in store for some time in mid-2023. Markets have been talking about a pivot by the Fed, but it’s probably more appropriate to speak in terms of a plateau. The market isn’t waiting for a decline in rates but it’s certainly looking to the end of this hiking cycle. At a minimum, that’s pushed out the onset of any recession. In a best-case scenario, it’s greatly increased the odds of a soft landing where we don’t see the sharp, deep, and damaging recession that we feared earlier this year. Investors are now pricing in 50 basis-point hikes as opposed to 75 bps, which is similar to the Bank of Canada lowering the trajectory of its rate increases. We’ve been closely watching rates, inflation, and the policy outlook, and all three are softening, which is positive for equities. There’s also an additional tailwind coming from China’s easing of its zero-COVID policy. That’s not only good for global demand, but also supply.
Those two levers—tapering Fed rate increases and China’s economic re-opening—will help not just the U.S., but also the global economy. And it all means we’re moving back towards neutral (0) in our equity allocation versus fixed income and cash. We’re not dismissive of potential downside risks, so we’ve implemented some protection using options, which gives us a little bit of comfort should we see any unforeseen downward shocks. Given that we’re already starting to see things starting to turn in the market, having that cushion below gives us comfort that we can raise our overall equity exposure.
Canadian GDP growth was 3% in Q3, beating expectations and—most importantly—faring better than other developed markets on a relative basis. In general, the Canadian economy is holding up well, and the labour market remains tight. But looking ahead, we do have some concerns. This strong data may give the Bank of Canada cover to stay in rate-hiking mode for longer. The housing market is starting to correct. And the Big 6 banks are increasing their loan loss provisions, which is a sign that they’re preparing for a slowdown.
We remain neutral on U.S. equity but are still confident in the U.S. market overall. In global economic slowdowns, U.S. markets tend to be resilient because of the prevalence of quality companies with high profitability and cash flow. The recent midterm elections haven’t changed our view—a split congress means that the status quo will likely prevail, with little chance of meaningful legislation over the next two years. If anything, this may be a benefit to sectors like Healthcare and Technology, which have had to contend with regulatory overhang.
We’ve upgraded our view on Emerging Markets from neutral (0) to slightly bullish (+1), and within EM, we favour China. Not only has underlying data been inflecting upward—China is now in the policy easing stage, with interest rates being cut—but the softening of the zero-COVID policy is also leading to less strict lockdowns. In Europe, the big news has been the price cap on Russian oil. Given that the cap has been set at around the same level at which Russia crude had already been trading, we expect its impact to be somewhat muted. But we are still concerned about an energy crisis, which is the main reason we remain underweight EAFE.
While inflation numbers have improved of late, we remain neutral (0) on duration, in large part because the Fed’s long-term expectations for a terminal rate remain unchanged. In the High Yield space, credit spreads have been volatile but did end November relatively flat, which is why we’ve maintained our slightly underweight (-1) position. We continue to expect High Yield spreads to widen as we see nominal growth slow, and we’ve also been looking at bank lending surveys, which point to an increase in defaults which could further justify wider spreads. We remain slightly bullish (+1) on Investment Grade credit—IG spreads tightened in November, outperforming High Yield significantly. And we’ve upgraded our view on Emerging Market debt from slightly bearish (-1) to neutral (0) based on the declining strength of the U.S. dollar. A weakening greenback tends to drive flows into Emerging Markets, and EM debt in particular. If, as we expect, we’re approaching both peak Fed pricing and peak U.S. dollar strength, we expect that environment to be positive for EM debt.
Style & Factor
A cash-fat balance sheet is the best defense when heading into uncertainty (and a likely recession), which is why we’re maintaining our Quality tilt.
When money returns to markets after a downtown, it typically goes to Quality names first. That perspective is reflected in our holdings—even in Technology, which has perhaps been the most heavily-punished sector, we’ve maintained exposure to heavyweights like Microsoft and Apple. In terms of the Value vs. Growth debate, that’s generally been an interest rate-related call so far this year, with Growth stocks selling off at the first hint of rising rates. With rates increases expected to slow, that’s somewhat neutralized the trade-off between Growth and Value. But even though Growth stock valuations have come down from their peak, they’re still relatively high on a comparative basis, which is why we do prefer Quality overall. That preference can also be seen in our capitalization, which is weighted toward large-cap stocks.
On the sector level, our tilts haven’t shifted much over the previous month. We’ve maintained our overweight to U.S. Energy but have reduced our overweight to Canada, recognizing that it represents a de facto overweight to Canadian Energy—we prefer the U.S. Energy exposure at this point. Though the tail risk of the Russian war in Ukraine persists, uncertainty around Energy boils down to two competing factors: the recently implemented price cap on Russian energy, which may not be effective at its current level, and the potential reopening of China, which could exponentially increase the demand for energy. We continue to hold our position and expect it to trade sideways, which is why we’ve begun to selectively write covered calls. Covered calls can be a good way to wait out periods of uncertainty while enhancing the yield of the overall portfolio. With this strategy, we can maintain our position and take advantage of any potential upside.
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