Playing the Fed’s Game
The most important question on investors’ minds earlier this month was whether or not the U.S. Federal Reserve would pivot from their aggressive rate hike schedule. To markets’ disappointment,
they did not.
Instead, we witnessed the Fed deliver yet another 75bps rate hike, along with some very hawkish comments about the pace of future hikes.
Fortunately, we were not surprised by the decision. All of it is consistent with what we’ve been hearing from the central bank since Jackson Hole—by their own admission, they do not intend to pause on rate hikes until inflation has been brought under control, even if economic growth does begin to falter. They further highlighted that they expect rates to go even higher, given the persistency of inflation. At this stage, price stability is their number one priority. Prior to the announcement, we felt markets were at a decision point of optimism versus pessimism. If the Fed had
paused rate hikes or indicated a lower path forward, investor
Thus far, we have not seen the declines we expected from poor earnings results and the markets have actually held up better.
sentiment would have improved. But if they chose to continue as planned, which they did, we could potentially see further erosion of earnings and consumer confidence—resulting in equity markets moving another leg lower. Thus far, we have not seen the declines we expected from poor earnings results and the markets have actually held up better. It is why we are reducing our underweight to equities and have started to put some of our cash to work. Though, if the Fed is willing to be patient, so are we.
Cooling (Not Crashing) Into a Recession
The U.S. economy isn’t crashing into a recession, but it is gradually cooling into one. The story is similar for Canadian economy despite its resilience so far this year.
Q3 U.S. GDP numbers rebounded after being in negative territory for the first half of 2022. But the underlying trend is one of declining consumer demand. Not only are interest-rate sensitive parts of the economy—like housing—responding to the U.S. Federal Reserve’s aggressive rate hikes, but the economy itself is undergoing a rebalancing of demand and supply. That’s been the reasoning behind the Fed’s tightening—to rein in demand and bring down inflation. Many had expected a recession to arrive this year, and aggregate demand in the U.S. is already flirting with those levels. But the U.S. labour market has been resilient, with strong job creation and a record-low unemployment rate. Wage growth, however, isn’t enough to compensate for inflation, which means that households are gradually losing purchasing power. Ultimately, that will affect corporate earnings and likely lead to job losses. By the early summer of 2023, if not sooner, that labour market pain may be sufficient to bring about the recession’s official onset. And obviously, what happens in the U.S. will be profoundly important for global markets.
Though Canadian households tend to carry more debt than U.S. households, we’re seeing the same gradual cooling of the housing market. You might call it a “buyer’s strike.” Owners aren’t trying to unload properties—there’s no fire sale on real estate. But the housing supply remains restricted because it’s not enticing to consider selling your property if it’ll involve leaving a low-interest rate mortgage. With rates still rising, Canadians with fixed-rate mortgages are in a better position than their variable-rate peers.
Europe remains a weak point globally. The timeline for recession there has been accelerated because the deterioration of economic activity has been faster than expected, with the energy crunch affecting manufacturing in particular. Some manufacturers have even been forced to shut down operations because continuing simply wouldn’t be profitable given higher energy prices. China is another major international story, with the re-election of President Xi Jinping by his party—and the footage of his predecessor, Hu Jintao, being escorted out of the room—making headlines. We lean on the side of caution with respect to Chinese outlook. Structural headwinds are intensifying, and the apparent power grab by hawkish members of the Chinese Communist Party challenges the notion that it’s easy to invest in China. Rumours of a rethinking of the zero-COVID strategy have thus far proved unfounded, and though the Chinese economy is set to rebound in 2023, that doesn’t necessarily mean it will be a smooth ride for equity investors. U.S-Chinese trade relations are likely to erode further, and differences between the two countries remain deeply rooted.
BMO GAM House view
Various indicators are suggesting that we’ve reached it
Overall trajectory is encouraging
Big question is: will inflation decline quickly or be sticky?
Risks are diminishing
Russia-Ukraine conflict, while drawn out, does not appear to be expanding
We appear to be at or near peak central bank hawkishness
Hikes will continue, but a Fed fund rate of around 5% is beginning to look likely
A recession is likely a done deal
The debate is around the timing and amplitude of the recession
We continue to expect a milder recession because of labour shortages
An old story for Canadians
Most debt is being used to purchase real assets (property) rather than pay the bills, which is good news
Government debt is a nuisance but often cyclical
The greater the debt load, the harder it is to support growth
Going forward, fiscal policy will likely be more cautious with respect to spending
Currently experiencing a “buyer’s strike”
Property owners are not feeling forced to sell – there’s no fire sale
In terms of asset allocation, we’ve been gradually shifting from cash back to fixed income, in conjunction with our call on equities moving from bearish (-2) to slightly bearish (-1).
The trade from cash to bonds is a function of the number of interest rate increases we’ve seen recently. The Bank of Canada’s recent 50-basis-point hike was a surprise and indicated that we’re likely approaching a reasonable “cruising altitude” for interest rates. Yields for U.S. two-year and ten-year Treasury bonds are now very competitive versus cash, and our next step is likely to be an overweight to bonds, or at least an overweight to duration.
On the equity side, we’ve not quite bullish yet, but we are sticking our heads out of the proverbial cave to evaluate potential opportunities. Regardless of whether the likely upcoming recession is steep or shallow, it’s not likely to last more than a couple of quarters, meaning that equities will start to become attractive again before too long. To use technology as an example: big names like Microsoft and Amazon have sold off significantly. But they’re still dominant businesses, and our belief is that the correction based on one quarter of negative earnings has been overly aggressive. When the market dips, our overweight to cash will enable us to seize on those kinds of opportunities.
In our view, Canada remains the most promising region, despite oil prices declining from their 52-week high.
Though Canada’s average export price has weakened, the trade surplus remains ahead of historical norms. Even with the recent pullback in energy prices, Canada’s economic growth is holding up well relative to the United States and Europe. Valuations of Canadian companies remain very attractive, and that represents a long-term tailwind and indicator that Canada will continue to do well going forward.
We’ve become more positive on the U.S. equity market recently. The American economy has proven more resilient than the Fed and most observers anticipated. Though high energy prices have impacted consumer confidence, those consumers continue to spend, and the U.S. labour market remains solid.
We have been, and remain, bearish on Europe, Australasia, and the Far East (EAFE). The Eurozone remains the major point of weakness—it’s been our biggest underweight all year, and that position has served us well. Europe has been the region most affected by geopolitical instability stemming from the Russia- Ukraine war, with Germany, for instance, now facing a fiscal deficit and declining trade surplus after years of relative prosperity.
We’re more positive on the U.K., which remains relatively insulated from geopolitical issues, though recent political and financial crises there—including the resignation of former Prime Minister Liz Truss—mean that investors should expect slower economic growth and a hit to consumer and business confidence.
We were negative on fixed income duration for some time, but recently, we’ve moved to a neutral position (0).
Our analysis indicates that we’re near peak expectations for global monetary tightening, meaning that central banks are unlikely to hike rates beyond what’s already priced into markets. The reason we’re neutral on duration rather than outright long is because inflation has been sticky. There is typically a long lag between interest rate decisions and their cooling effect on the economy. As a result of that delay, central banks often overshoot, and that’s a real concern in this situation. If they do hike materially beyond what’s been priced in, those effects on the economy will likely become apparent in 2023.
We remain slightly bearish on High Yield (-1) and Emerging Market (EM) Debt (-1), preferring Investment Grade bonds (0). That positioning is based on likely further widening of credit spreads, which may occur as the economy slows and can be worsened by weak earnings on the equity side. Wider spreads are likely to negatively affect the High Yield and EM bond markets more than the Investment Grade market.
Style & Factor
In terms of styles and factors, we remain slightly bullish on Quality (+1) and Value (+1) and slightly bearish on Growth (-1).
This positioning reflects the fact that we’re overweight Canada and the United States and is apparent in our sector selections. Take Technology: the vehicle we utilize is the tech sector proper, not the NASDAQ or any broader vehicle that includes smaller and more volatile companies. A sizable portion of our Tech allocation is therefore invested in companies like Apple and Microsoft—safe and fairly defensive positions. The underlying logic is that even in our Growth allocation, we’ve got Quality in mind. The same is true for our geographic positioning—when you overweight Canada, you also overweight six very high-quality banks. In the U.S., we’ve overweight Energy, which has gone from a Value trade to a Growth trade in some respects. From a market capitalization perspective, there’s a lot of room for investors to increase their Energy exposure, even after the year to date, which may be attractive given supply constrains due to geopolitical tension and the possibility of a colder-than-usual winter. Another place we see Quality at a reasonable valuation is U.S. Health Care. We originated that position a couple of months ago as a defensive measure, and it’s done very well, especially with the performance of large-cap pharmaceutical companies and health care providers.
Any evaluation of the Canadian dollar versus the US dollar (USD) depends on the time horizon.
If volatility continues—which appears likely after recent hawkish comments from Fed Chairman Jerome Powell—that’s going to favour the USD; in times of crisis, the one asset everyone wants to own is the greenback. The Canadian dollar, for its part, remains the second-strongest currency among developed markets. Other than the USD, everything has declined relative to the CAD, and its current valuation doesn’t reflect its long-term, economicallyjustified value. Bottom line—we’re relatively bullish on the Canadian dollar over the medium-to-long term. We also have a small hedge of the USD back to the CAD. When investors start looking for opportunities, they’re going to be selling their USD to buy equities, and though we don’t expect that trade to begin tomorrow, our hedge balances against that risk.
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