Betting on cautious optimism – Q4 “five lenses” update

Fred Demers

Director, Multi-Asset Solutions

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As autumn turns to winter, both upside and uncertainty hang in the air. The market recovery, which began on March 23, has caused a divergence in performance between sectors, asset classes and geographies. For timely guidance on asset allocation, Fred Demers, Director of the Multi-Asset Solutions Team (MAST), delivers an update on markets using BMO’s proprietary “five lenses” approach.

More people lost money waiting for corrections and anticipating corrections than the actual corrections.

Peter Lynch

Lens 1: Asset classes

When looking at investment performance year to date, the results are a mixed bag. Equities, particularly in the United States, experienced a sharp recovery in the spring once the initial shock of economic shutdowns wore off. Meanwhile, hard hit currencies like the Canadian and Australian dollars bounced back in a V-shape pattern, and even commodities found their footing – with the notable exception of oil.

U.S. crude futures remain heavily discounted as a result of lower travel demand. Airlines that were grounded in the early months of the pandemic are still operating below capacity, and with many offices still closed, there are fewer commuters on the road going to and from work. If lockdown measures resume during December, an oversupply of oil could weigh on prices through the first quarter of 2021. 

What’s been truly interesting is the policy consequence of low interest rates, which central banks have kept near the zero lower bound in an attempt to stimulate the economy. To be sure, the Bank of Canada and the U.S. Federal Reserve did stabilize fixed income assets when they entered the market as “buyers of last resort” in April; however, the intervention had the additional effect of compressing yields across the universe. With policymakers unlikely to change direction until after labour markets have normalized, Advisors may need to look elsewhere for ways to satisfy return targets in their client portfolios.  

Recommendation: Maintain equity overweight; underweight fixed income.

The recovery is well under way, and fiscal and monetary policy remain supportive of risk assets despite a second wave of COVID-19 cases.

Lens 2: Equities

While minor cracks have emerged between asset classes, the real dispersion has been within equity markets. Sectors such as information technology and healthcare have led the gains since March 23, yet manufacturing and retail lagged behind due to low demand and structural headwinds. What explains the lopsided performance?

U.S. Retail Sales (%)

Source: Haver Analytics.

Interestingly, the split appears to be between “old economy” and “new economy” assets. COVID-19 accelerated our transition to a digital landscape, and at the same time reduced our dependence on companies rooted in traditional industries. For example, we’ve been aware that brick-and-mortar retail has been trending down in the U.S. and Canada for more than a decade, but social distancing rules have expedited the migration of consumers to e-commerce platforms like Amazon. These habits will not be undone once the pandemic is over. Even with some degree of normalization, we’re not going to see the composition of the economy spring back to what it was last year. Case in point: When Netflix introduced the world to streaming, Blockbuster outlets became extinct.

As another example, consider manufacturing as a share of the economy, which has been shrinking in North America for almost 20 years. From 30% in 2000 to approximately 10% today, it plays a much smaller role in the employment sector and that trend has only magnified since the pandemic began.

In terms of asset allocation, we typically separate our client accounts into fast and slow moving depending on the level of risk sensitivity in the portfolio. Given that the bulk of our Canadian business is slower moving, we’ve been overweight equities for the previous three quarters and would continue to hold that position until the election-related volatility has passed, at which point we would consider building more exposure of risk asset as we head into the new year.

Recommendation: Maintain overweight U.S.; slightly overweight emerging markets; underweight Canada, and Europe, Australasia, and the Middle East. 

U.S. Employment Shares (%)

Source: Haver Analytics.

As the old economy dies, the new economy thrives.

Lens 3: Fixed Income

The biggest factor for fixed income assets is the overwhelming amount of monetary support that central banks have pledged to deploy if necessary. The Bank of Canada has already been making bond purchases since April, and will likely continue to do so for another 12 months, suggesting federal and provincial yields will be anchored to their current levels for the foreseeable future.

Meanwhile, on the equity side, the earnings picture has proved resilient in some sectors, recovering faster than we would have expected given the depth of the recession. Focusing on higher quality corporate bonds in this scenario is an interesting play for the next year, especially considering that interest rates will be extremely difficult to normalize until unemployment is closer to 6% in Canada, and perhaps 5% in the U.S.

In general, we think the industry needs to be more open minded about taking risk on the fixed income side of the portfolio. Rather than owning dull government bonds that yield next to nothing, longer-term investors can go further out on the risk curve and put capital into real assets.    

Recommendation: Maintain overweight duration and investment grade corporate credit; slight underweight government debt.  

Central banks will buy bonds and keep interest rates near the floor until the economy is back to normal – whatever that will look like.

Lens 4: Currency

I mentioned earlier that currencies like the Canadian dollar had recovered tolerably well during the summer. It’s important to note that this development was somewhat surprising to me and my colleagues in the Multi-Asset Solutions Team, because the rebound happened while the energy sector was down 40% to 50%. We take this as an indication that fundamentals are not really at play right now; it’s about sentiment and the relative strength of the US dollar that is determining our exchange rate.

Moving forward, we see the Canadian economy lagging behind the U.S. for the next year or two. The main drag will likely be the energy sector, which despite being less than 10% of the economy continues to be a major driver of capital investment, foreign revenues and export power. Bottom line: it’s still an engine of growth and therefore our dependency on it will leave more scarring than in the U.S.

Recommendation: Maintain underweight the Canadian dollar and the British Pound; overweight the Japanese yen and the euro. 

The Canadian dollar’s rapid recovery through the summer was a surprise given that oil prices lost nearly half their value year-to-date.

Lens 5: Factors

We continue to believe that low volatility is an essential factor for Canadian investors, even though the backdrop of 2020 was a perfect storm for sectors not held within the fund. Excluding technology stocks, for instance, explains why the factor trailed the broader market in returns this year. Nevertheless, our domestic economy is highly concentrated in a handful of industries, which means there’s value in stripping out areas that are prone to cyclicality – such as energy – in order to focus on companies with stable earnings and ironclad balance sheets.

Investors should remember only a tiny segment of the market has led equity gains since the March sell-off, and that most industries are living in a world of lower revenues. Against this backdrop, we can make the case that low volatility helps your clients stay diversified at a time when the future is unknown. Yes, Value has been in a lot of pain this year and Growth and Momentum have done well, but we believe it’s still too early for a full rotation trade. You want to avoid playing mean reversion in the factor space, because the economy is simply not going back to where it was, even in a post-COVID world.

Recommendation: Maintain slight overweight low volatility and fixed income duration.

Fear incites human action far more urgently than does the impressive weight of historical evidence.

Jeremy Siegel

Fighting against instinct and emotion

When I hear investors talking about normalization, I remind them that two years ago the Chairman of the U.S. Federal Reserve said the central bank was a “long way from neutral.” The statement was viewed as affirmation of more rate hikes down the road, and it caused valuations to focus where they should have been all along: on fundamentals. Then came the coronavirus pandemic.

As confirmed cases skyrocketed, we saw multiple economic shutdowns, market crashes, recoveries, unprecedented monetary support, sweeping fiscal stimulus, and increased rhetoric over the 2020 U.S. election. Unsurprisingly, emotion replaced fundamentals as the primary driver of investment performance.

However, we feel these risk factors are temporary. There will be some long-term scarring, to be sure, but overall, we envision a return to strong economic growth as noise from the U.S. election dies down. Valuations should return to their original trajectories in due time, and despite the road to economic normalization being long and steep, the recovery should indeed remain on track.

 

For more insights and market commentary, contact your BMO Regional Sales Representative.

 

Disclosures

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms.

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