ETF Portfolios

BMO ETF Portfolio Strategy Report, Second Quarter 2019: Staying Put in Quality

In this report, we highlight our strategic and tactical portfolio positioning strategies for the second quarter using various BMO Exchange Traded Funds (BMO ETFs). Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.
April 2019

Alfred Lee

CFA, CMT, DMS Director, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc.

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In this report, we highlight our strategic and tactical portfolio positioning strategies for the second quarter using various BMO Exchange Traded Funds (BMO ETFs). Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.

  • After a tumultuous fourth quarter, we anticipated a short-term relief rally in risk assets to start the New Year. As expected, the MSCI World Index and the S&P/TSX Composite Index yielded a total return of 14.2% and 17.2% (in C$ terms) respectively over the first quarter. However, this rally, as predicted in our last report, may be short-lived as investors become increasingly cautious that the bull market is well into its later stage.
  • The most troubling signal may be the recent inversion of the yield curve, as this tends to occur before a recession. The ten-year U.S. Treasury yield now sits below the three-month, marking the first time this has happened since May 2007 (Chart A). We view an inversion on the short end to be less worrisome than a full-out yield curve inversion, as it shows the market is more concerned about the short-term prospects of the economy rather than longer-term outlook.
  • The U.S. Federal Reserve (“Fed”) announced that it will hold interest rates steady for the remainder of the year. Interest rate futures are also implying that the Bank of Canada (BoC) will take a more dovish stance (Chart B). While holding rates steady is intended to stimulate the economy, switching gears so quickly from a hawkish policy may fuel the recessionary bias of the market.
  • As a further sign of de-risking in the market, we are seeing investors rotate out of more cyclical-oriented areas, such as high-yield bonds, and into safer investment-grade fixed income. Low-volatility stocks are also outperforming its broad market equivalent, further signalling a “risk-off” and overall more cautious sentiment.
  • While fears of a recession have grown, there are still positive take-aways. The U.S. economic backdrop still looks robust and there’s no evidence of more concerning systemic issues underlying a possible slowdown. In addition, a cold harsh winter in North America may be partly attributable to a recent slowdown in economic data. As lower expectations are priced into the market, positive economic surprises will be easier to come by. Furthermore, it should be noted that while a recession has always been preceded by a yield curve inversion, a yield curve inversion is not always followed by a recession.
  • Outside of North America, potential stumbling blocks remain. Political gridlock continues to be an issue in Brexit discussions, and trade talks between U.S. and China are ongoing. As a result, the ongoing theme for investors should be a “flight to quality” in their portfolios, along with more prudent risk-taking.
  • While the bond market has looked as if it has become bearish, the equity market has rallied to new highs. Even if the bond market proves to be correct, we don’t anticipate a significant slowdown. Furthermore, the combination of lower yields and a higher equity market could signal the market anticipates further reflation. Given the volatility in the fourth quarter, we’d like to err on the side of caution and remain positioned in higher-quality, defensive-growth areas.
Yield Curve Monetarily Inverts on Short End

BMO ETF Portfolio Strategy Report 2Q 2019 Chart 1 Yield Curve Monetarily Inverts on Short End

Source: Bloomberg, BMO Asset Management Inc.

Market Expectations for BoC Have Changed Year-to-Date

BMO ETF Portfolio Strategy Report 2Q 2019 Chart 2 Market Expectations for BoC Have Changed Year-to-Date

Source: Bloomberg (based on Canada OIS – Interpolated)

Things to Keep an Eye On

A year ago, the main concern for equity investors was valuation. At the end of 2017, the price-to-earnings (P/E) of the S&P 500 Composite and the S&P/TSX Composite were 19.8x and 21.7x, respectively. As investors became more risk averse over the last six months, however, equity prices moderated. Moreover, the recent inversion of the yield curve compelled investors to become increasingly cautious. Lower valuation of the markets also created opportunities for investors to pick up high-quality companies at lower prices. Blue-chip companies, for example, can be used as long-term cornerstone pieces to a portfolio, given the stability of their earnings and the competitive advantages they enjoy.

Recommendation: In our portfolio strategy, we already employ both the BMO MSCI USA High Quality Index ETF (ZUQ) and the BMO MSCI Europe High Quality Hedged to CAD Index ETF (ZEQ). For investors that desire a more global exposure, the BMO MSCI All Country World High Quality Index ETF (ZGQ), provides a one-stop solution to the best blue-chip companies in the world.

BMO ETF Portfolio Strategy Report 2Q 2019 Chart 3 Annual Total Return

Source: Bloomberg, as of December 31, 2018

In the last six months, cash has been increasingly employed by investors as a means to both de-risk a portfolio and also as a tactical tool to take advantage of opportunities. In the first three months of the year, cash and ultra-short-term bond ETFs attracted over $500 million in inflows in Canada. As cash and “cash-like” positions grow more prevalent in portfolios, how investors get that exposure is increasingly important.

Recommendation: In the first three months of the year, the BMO Ultra Short-Term Bond ETF (ZST) became one of the fastest growing ETFs in Canada due to its attractive yield to maturity of 2.5%, and the conservative nature of its underlying holdings. This ETF holds investment-grade Canadian corporate bonds that mature in one year or less. In recent weeks, we launched a US dollar equivalent for investors that want to generate a higher yield on US dollar cash positions in their accounts. The BMO Ultra Short-Term U.S. Bond ETF (ZUS.U) invests in U.S. investment-grade bonds that mature in less than a year, and have a yield to maturity of 2.9%. The ultra-short-term nature of the underlying bonds allows the ETF to be extremely liquid, even for larger creations and redemptions, and especially in comparison to GICs or ETFs that hold GICs.

BMO ETF Portfolio Strategy Report 2Q 2019 Chart 4 Fund Flows Jan-March

Source: Bloomberg

Last quarter, we initiated a position in the BMO Mid-Term U.S. Treasury Bond Index ETF (ZTM) to hedge equity market volatility in our portfolio. Given equity market volatility moderated in the New Year, ZTM was fairly flat with a total return of -0.4% in C$ terms, year-to-date. The intent of the Fed, which recently chose to hold its overnight rate steady for the remainder of the year, was to provide confidence to riskassets. However, with the yield curve already inverted, it may actually signal concern to the market instead. Knowing that equity market volatility can arise once again, we continue to maintain our position in this ETF as a hedge to risk assets.

Recommendation: Although we anticipate a slowdown, we do not envision a long, drawn-out recession. Overall, the economic data, particularly in the U.S., still looks fundamentally sound. Additionally, unlike 2008, there do not seem to be systemic issues in the economy. As a result, we do not envision a deep recession, should one occur. We also prefer to have exposure to the mid-part of the curve in U.S. Treasuries, rather than long-term, as a full inversion of the yield curve may not transpire.

BMO ETF Portfolio Strategy Report 2Q 2019 Chart 5 Total Return

Source: Bloomberg

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