Multi-Asset

July MAST Commentary: Equities Healing Faster than the Economy

The road ahead is unlikely to continue as smoothly, especially for the U.S. labour market as the May and June job gains represent only about a third of the jobs lost in March and April.
July 2020
  • The global economy is healing, but the COVID-induced disruption is ongoing. The labour market could be slow to fully recover, which may amplify the apparent disconnect between asset prices and the economy.
  • We think investors should be cautious when expecting a reversal from underperforming stocks, sectors, or factors this year. Disruption is not dislocation. Some relative performance trends are more secular than cyclical and rotation warrants patience.
  • We think North American banks are well positioned to weather the crisis given high capital ratios, less reliance on short-term wholesale funding, and sizeable increases in credit provisions, although they will test consumer resilience when extraordinary unemployment benefits later run out and interest rates are stuck near zero.
  • We remain modestly overweight stocks versus bonds, with a preference for U.S. and Emerging Markets (EM) markets while underweighting Europe, Australasia, Far East (EAFE) and Canada. Within fixed income, we like bond duration, and prefer Investment Grade (IG) to High Yield (HY).

A person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.

Daniel Kahneman

Macro indicators broadly continue to reflect the economy is healing across major countries with economic surprises running at the highest since 2017. The road ahead is unlikely to continue as smoothly, especially for the U.S. labour market as the May and June job gains represent only about a third of the jobs lost in March and April. We will be closely watching U.S. Unemployment Claims data over the next couple months to assess the impact of fading unemployment benefits on job gains. It could be at least a couple years before the job market is back to its pre-COVID level, especially as firms remain cautiously focused on cutting costs to protect their balance sheet. Such dynamics might amplify the apparent disconnect between the economy and equities, but investors should keep an open mind about rising stock valuations as zero-interest-rates policies leaves investors to expect higher long-term returns from equities than government bonds.

Markets Plowing Through Fear

Global stocks (MSCI ACWI, +3.2%) gained in June and registered their best quarter (+19.4%) since 2009, fueled by optimism over the economic recovery and resilience over fear of a second wave. EM (MSCI EM, +7.4%) led the regional gains as South-East Asian economies are leading the post-COVID economic recovery, followed by European shares (Eurostoxx, +6.4%). North American stocks underperformed with the S&P 500 climbing 2% while Canada’s S&P TSX rose 2.5%. Meanwhile, the tech heavy Nasdaq 100 gained 6.5% in June and is now up 21.6% year-to-date as COVID is causing a wave of tech disruption. Finally, U.K.’s FTSE 100 (+1.7%) was the weakest region as lingering Brexit uncertainty is adding to investor’ concerns.

Although the economic recovery is underway, the vast amount of economic slack and debt is keeping yields on government debt under downward pressure. The yield on Canada’s 10-yr was stable at 0.53%. Oil prices (WTI, +10.7%) gained another $4pb as the rebound in economic activity is supporting oil demand while OPEC+ countries are keeping supply curtailments in place. Continued investor optimism helped weaken the U.S. Dollar (-1.0%), which fell against every major currency except for the Japanese Yen, while the loonie gained 1.5% versus the USD. Although equity markets are trending up, investors are far from complacent with the VIX ending the month at 30.4, which implies that investors are bracing for nearly 9% monthly swings.

Equity Factors: Ongoing digital disruption is bad news for Value stocks

The COVID-induced disruption theme remains intact as global Growth (+5.1%) and Momentum (+7.2%) significantly outperformed global stocks (+3.2%) in June. All other main equity factors lagged their global benchmark, with significant underperformance for Low-Volatility (-0.3%), High-Dividend (+0.6%) and Value (+1.2%). For Growth vs Value, investors should remain cautious on expecting a reversal as the COVID-induced digital disruption is not a traditional macro dislocation, but part of a secular trend of intensifying digitalization and technology adoption.

Chart 1: Disruption is not Dislocation: Growth leadership accelerating

Chart 1: Disruption is not Dislocation: Growth leadership accelerating

Source: MSCI, Bloomberg, BMO GAM (as of June 30, 2020)
Past performance is no guarantee of future results

In Canada, appetite for tech companies weighed on the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, -0.3%)*, which lagged the broad market BMO S&P TSX Capped Composite Index (ticker: ZCN, 2.6%)** in June even as the BMO Equal Weight Oil and Gas Index ETF (ticker: ZEO, -1.8%)*** underperformed. Indeed, the emergence of the tech giant, Shopify, within the TSX, has weighed on the underperformance of Canadian Low-Vol stocks this year even as the energy sector has underperformed year to date (ticker: ZEO, -27.7%)***. Shopify’s performance has helped boost TSX by 6ppt in 2020. Looking forward, we continue to like Low-Vol stocks to help reduce portfolio volatility while delivering similar long-term returns.

Patience on Banks: Too early in economic recovery to play mean reversion

Financials continue to lag the equity rally since late March and underperform on a year-to-date basis. Within the TSX, the BMO Equal Weight Banks Index ETF (ticker: ZEB)**** financials saw a relatively mild underperformance versus the broad market (ZCN)** during the Q1 selloff (Chart 2), but they lagged during the rebound as investors feared upcoming bad news for banks as defaults could rise into 2021.

Chart 2: Canadian Banks Lagging on Rebound

Chart 2: Canadian Banks Lagging on Rebound

Source: Bloomberg, BMO GAM (as of July 6, 2020)
Past performance is no guarantee of future results

In the U.S., however, banks (BMO Equal Weight US Banks Index ETF, ticker ZBK) have underperformed more year-to-date (Chart 3). Banks have borne the brunt of the crisis with a massive decrease in interest rates that is compressing net interest margins (NIMs) while the economic shutdowns propped up credit loss provisions. But with the recession in the rear-view mirror, will the underperformance continue? Investors appear to be weighing medium-term concerns, suggesting that the recovery rally is different from that during the Global Financial Crisis (GFC), which saw banks outperform on the rebound.

Chart 3: U.S. Banks Lagging Performance Worsened by COVID

Chart 3: U.S. Banks Lagging Performance Worsened by COVID

Source: Bloomberg, BMO GAM (as of July 6, 2020)
Past performance is no guarantee of future results

We believe banks will weather the crisis given high capital ratios, less reliance on short-term wholesale funding, and sizeable increases in credit provisions. In contrast to the GFC, they are unlikely to require financial assistance whereas central-bank emergency lending facilities were an important backstop to maintain credit flows during the COVID panic.

Another positive note for U.S. banks is that corporate and commercial real estate (CRE) lending—a key vulnerability in the post-COVID environment with the work-from-home trend—is a significantly smaller share than residential real estate, which is the largest category of lending. CRE loans have also shifted away from riskier categories (e.g., construction) toward non-residential commercial. Exposure to CRE is also modest among the largest banks (5%) compared to small and medium-sized banks (25-30%). In addition, household lending is less of a concern in this crisis as balance sheets are much healthier with debt ratios well below pre-GFC. But meanwhile in Canada, household balance sheets have deteriorated since 2008 and the Bank of Canada expects arrear rates to peak at 0.8% in 2021, above GFC highs.

While we think banks are better positioned than in traditional recessionary environments, they nevertheless face certain challenges—in particular, elevated unemployment and lower-for-longer interest rates, which tends to weigh on bank profitability. Uncertainty will also persist in coming quarters over how things will unfold once mortgage deferrals are ended. Lastly, the intensifying tech disruption caused by COVID may continue to weigh on Value stocks, of which banks are the largest sector (+15%) in the U.S.

Outlook and Positioning: Whatever-it-takes policies anchoring bullish bias

Our stock-bond asset mix remained unchanged last month with a modest stock overweight. Whatever-it-takes fiscal and monetary policies remain highly supportive of risk assets as the earnings and economic outlook, albeit improving, remain clouded by COVID.

We remain overweight of U.S. equities while underweight of Canadian stocks. Our view that Canada could lag the U.S. economic and earnings growth over the medium term is intact. We also remain overweight of EM equities while underweighting EAFE and expect outperformance across South-East Asia versus Europe and Japan.

In fixed-income, we prefer IG corporate bonds to riskier HY bonds. We expect the wave of defaults to run into 2021, which should weigh on corporate funding spreads despite central-bank buying. Bond duration remains attractive in Canada where debt and the woes of the oil sector will weigh on growth for many quarters, thereby capping the yield on the 30-year federal bond.

The loonie’s value continues to be driven by global risk sentiment rather than the usual fundamental drivers of currency fluctuations such as interest-rate differential, growth expectations, and commodity prices. The broad U.S. Dollar weakness remains in line with global risk appetite, but we think currency markets will eventually revert to back to pricing currencies more in relation to their domestic drivers. Moreover, we would expect the loonie to weaken if market gyrations resumed.

 

Disclosures

*The performance for (ZLB) for the period ended June 30, 2020 is (as follows: -6.26% (1 Year); 3.61% (3 year); 5.56% (5 year); and 11.20% since inception (on October 21st, 2011).

**The performance for (ZCN) for the period ended June 30, 2020 is (as follows: -2.07% (1 Year);
 3.91% (3 year); 4.45% (5 year); 5.90% (10 year); and 6.00% since inception (on May 29th, 2009).

***The performance for (ZEO) for the period ended June 30, 2020 is (as follows: -29.25% (1 Year);
 -15.76% (3 year); -12.25% (5 year); -7.47% (10 year); and -7.64% since inception (on October 20th, 2009)

****The performance for (ZEB) for the period ended June 30, 2020 is (as follows: -12.20% (1 Year);
 -0.32% (3 year); 5.30% (5 year); 8.44% (10 year); and 8.16% since inception (on October 20th, 2009)

 

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. 

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

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