Multi-Asset

April MAST Commentary: For financial markets, fear is more contagious than the virus

Financial markets have seen some normalization in recent weeks as stimulus measures have been deployed.
April 2020
  • Financial markets have seen some normalization in recent weeks as stimulus measures have been deployed. Signs that the virus curves are flattening in the Europe and the U.S are emerging. We now look for a late spring, early summer gradual restart of economic activity.
  • The upcoming economic data will reflect a deep recession, but investors are far more concerned with the duration of the recession than its depth. We should see smaller permanent damage to the economy then following the 2008-09 crisis. The rebound should also be quicker given the speed and size of the policy response.
  • We downgraded a notch our overweight to stocks versus fixed income. We expect volatility to remain high although peak fear should be behind us. Stocks should remain above their March lows in the near-term.
  • We expect the U.S. leadership to continue over EAFE stocks. We expect Canadian stocks to lag EM stocks as lower oil prices persist longer than COVID-induced headwinds, which should also weigh on the loonie’s outlook.

There’s always an element of chance and you must be willing to live with that element. If you insist on certainty, you will paralyze yourself.

J.P. Getty

For financial markets, fear is more contagious than the virus

In times of distress and panic, time seems to be moving incredibly slow, especially in a lockdown situation. The road ahead to win the battle against the virus remains uncertain while the global tally of confirmed cases continues to rise. Financial markets have seen some normalization in recent weeks, notably in credit markets, an area where central banks have worked to provide a critical backstop, but volatility will remain elevated in the weeks to come.

While it remains hard to argue stocks have touched their near-term bottom, we believe the near-term price action will be driven primarily by news on the virus that can help investors understand how long the lockdown will last, and further monetary and fiscal measures. How deep the economy momentarily sink because of social distancing is not as important as how long these conditions last.  We now look for a late spring, early summer gradual restart of economic activity in Europe and North America.

Markets break down in March

Global stocks (MSCI ACWI) fell 13.4% in March. Regionally, Europe was the weakest with steep drops notably in Italy (FTSE MIB, -22.4%), at the epicenter of the European COVID crisis, and France (CAC 40, -17.0%). Canadian stocks also nosedived (S&P TSX, -17.4%), but that’s a lot better than the 31% intra-month maximum pain before retracing some losses. U.S. stocks outperformed most regions again as the S&P 500 fell 12.4%. Meanwhile, the tech heavy Nasdaq 100 lost only 7.6% to end the quarter down about 10% while several regional benchmarks are down between 20 and 30% year-to-date. Finally, EM stocks (MSCI EM, -15.6%) also endured pain as Brazilian stocks collapsed 30% in March.

The storm hit fixed-income markets as well across all segments until central banks took out their quantitative easing (QE) bazookas and a series of emergency rate cuts to calm markets. The yield on Canada’s 10-yr government bonds dropped 44bp in March, down 101bp for the year. The loonie, whose value heavily depends on the price of oil, lost 4.8% as investors scrambled for the USD (+0.9%) and oil prices registered their worse month (-54%) since futures contract began trading on Western Texas Intermediate (WTI) in 1983.

Equity factors: Severe dislocations bring dispersion

Global equity factors experienced a surge in performance dispersion in March, but the winner-loser themes were largely the same as during pre-COVID days: Value (-16.9%) and Small-Cap (-21.0%) lagged Quality (-9.0%), Growth (-10.4%) and Momentum (-10.8%). Value’s underperformance during both the bull and bear markets should be a good reminder to investors that structural forces are probably more influential on the relative factor performance than many investors recognize when calling for the Growth-Value rotation. The disruptive secular trends toward the New Economy are intensifying with social distancing (Source: McKinsey).

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, -14.4%) outperformed the broad market BMO S&P TSX Capped Composite Index (ticker: ZCN, -17.6%) by a good margin in March. Year-to-date, ZLB is ahead ZCN by 480bp as the low-vol factor in Canada strips away the energy exposure, which has suffered a lot this year (Chart 1). Our strategic and tactical overweight to Canadian low-vol stocks is intact.

Chart 1: Canadian low-vol stocks shine while energy suffers in 2020

Chart 1: Canadian Low-Vol Stocks Shine While Energy Suffers in 2020

Source: Bloomberg, BMO GAM (As of April 6, 2020)

Credit outlook: Don’t fight the Fed

Corporate bonds have fallen sharply, pushing yields and spreads relative to the risk-free rate to decade highs (Chart 2). The moves partly reflect heightened credit risk, as government-mandated shutdowns will make it difficult for companies to make timely interest and principal payments on their debt. Credit quality has also deteriorated as the share of the lowest credit grade (BBB or BAA) within the investment grade (IG) sector has grown to roughly 50% in the US and Canada. This raises fallen angel risk, i.e., downgrades to junk. But another reason is a need for liquidity, prompting heavy selling by investors and creating temporary market dislocations.

Chart 2: Default Fear and Poor Liquidity Cause Spike in Credit Spreads

Chart 2: Default Fear and Poor Liquidity Cause Spike in Credit Spreads

Source: Bloomberg, BMO GAM (As of April 6, 2020)

Taken together, we believe credit spreads, IG in particular, have scope to tighten from here, therefore creating opportunities for investors looking to benefit from a post-COVID recovery. For one, market dislocations will soon normalize as funding costs continue to improve, helped by central-bank liquidity facilities. Second, central banks like the Fed have opened facilities to buy IG credit in the primary and secondary markets, and fiscal packages have targeted funding for large and small enterprises. Finally, credit spreads usually peak before the economy troughs and defaults rise. Given that this recession is likely to be short-lived, IG spreads are likely near their widest and have priced in much of the pain to come (Chart 3).  

Chart 3: Nowhere to Hide in Credit Markets

Chart 3: Nowhere to Hide in Credit Markets

Source: Bloomberg, BMO GAM (As of April 6, 2020)

What Will it Take to Get the Bulls Back?

The upcoming economic data will reflect a deep recession, but investors are far more concerned with the duration of that recession than its depth. Timing when the U.S. and Europeans economies will re-open is the most important signal for investors, and that comes by first seeing a peak in caseloads that would signal the virus is getting sufficiently contained to allow for a gradual re-opening of the economy. Broad, rapid testing, and perhaps immunity passports, will also be part of the solution to getting back in business. To the extent the current recession sees much fewer bankruptcies, especially for large corporations, the permanent damage to the economy should be much smaller than the pain induced by the 2008-09 crisis. The rebound should also be quicker given the speed and size of the policy response.

Outlook and Positioning: Whatever-it-takes Policies Seeding the Next Bull Market

We downgraded a notch our stock overweight. However, we have been effectively buying stocks while selling bonds given that the March equity selloff was so brutal that it drove our portfolios to an underweight allocation to stocks versus bonds. Signs of peak caseloads (i.e., flattening the curve) in Europe and North America should leave stocks above their March lows in the near-term. While we expect volatility to remain high, peak fear, as measured the VIX index, should be behind us (Chart 4).

Chart 4: Implied-Fear Gauge VIX Signals Uncertainty Ahead, not Panic

Chart 4: Implied-Fear Gauge VIX Signals Uncertainty Ahead, not Panic

Source: Bloomberg, BMO GAM (As of April 6, 2020)

Within equities, we continue to prefer U.S. stocks vs EAFE, a long lasting trade that has continued to work well this year. Meanwhile, we remain overweight EM stocks while underweighting Canadian stocks, a trade we implemented last month. Even if OPEC+ countries agreed to cut oil production, we don’t think the energy complex would outperform on a sustained basis given how bad their profit outlook is with oil prices hovering below $30pb. Although we would expect the loonie to participate to the post-COVID recovery of global assets, it remains exposed to downside risk from the lingering weakness of oil prices and relatively high levels of debt, which will have a more lasting negative impact on Canada than COVID-19.

With central banks ramping their asset purchasing programs, duration remains attractive but that trade probably has a short shelf life left. Unlike monetary policy, fiscal policy rarely disappoints at creating an inflationary impulse and 2021 could shape up to be the year of the great underweight to bond duration.

Disclosures

*The performance for (ZLB) for the period ended March 31st, 2020 is (as follows: -8.67% (1 Year); 1.74% (3 year); 3.70% (5 year); and 10.64% since inception (on October 21st, 2011).

*The performance for (ZCN) for the period ended March 31st, 2020 is (as follows: -14.09% (1 Year);
 -1.92% (3 year); 0.90% (5 year); 3.61% (10 year); and 4.63% since inception (on May 29th, 2009).

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