- The resurgence of the virus in Europe and the threat of Omicron are causing concerns for renewed lockdown. While we think that scenario remains a tail risk for now, we are closely monitoring the situation and standing by ready to reposition our portfolios more defensively.
- Rate hikes are coming soon, in our view. We would not be surprised to see the Bank of Canada (BoC) hike as soon as January while the Fed could hike in March, with scope for quarterly hikes thereafter in 2022. Expectations for monetary-policy normalization explain why the Treasury yield curve has been flattening in recent months.
- Above-trend economic growth remains the most significant tailwind to equities, although the treat of the virus and Omicron poses a short-term risk.
- Our portfolios remain overweight equities versus fixed income, with a preference for U.S. and Canadian equities versus Emerging Markets (EM) and Europe, Australasia, and the Far East (EAFE). On a sector basis, we are overweight of U.S. financials, energy, and airlines. Meanwhile, we began a shift to a small, defensive, underweight in high-yield credit.
Markets Bracing for Rate Hikes, Another COVID-19 Wave, and Omicron
The virus has been making a surprising come back in recent weeks, most notably in Europe where the ongoing wave of new COVID-19 cases is running higher than previous waves (Chart 1). News by the World Health Organization of a new variant – Omicron, added to investors’ fear of seeing mobility restrictions return to slow the spread of the virus and help avoid overload in hospitals. While there are still question marks around the risks of Omicron and how the vaccines will perform against it, early data suggests symptoms are encouragingly mild, which would reduce the likelihood of hospitalization, and thereby lower the risk of disruption to the broad economy.
After sharing early guidance about its tapering plans, U.S. Federal Reserve (the “Fed”) Chair Jerome Powell signaled to markets that the course of monetary-policy tightening was accelerating slightly as the U.S. economy maintains strong momentum, which is fueling unseen inflationary pressures since the 1970s.
Chart 1: COVID surging in Germany, North America next?
The chart shows the historical moving average of new daily COVID-19 cases in Canada, U.S. and Germany. We see that Germany is facing a far more intense infection wave now than in previous cases, whereas Canada and the U.S. look have less worrisome infections in recent weeks. Source: Bloomberg, BMO Global Asset Management, as of Dec 2, 2021.
Global Markets: Inflation, Fed Tapper, and Omicron Spook Equities
Global equities (MSCI ACWI, -2.4%) fell late in the month on concerns over the virus and by the shortening of the timetable for the Fed rates liftoff. However, U.S. equities (S&P 500, -0.7%) continued to outperform their global peers, led by the tech heavy Nasdaq 100 (+1.9%), which was a rare bright spot last month. U.S. small-caps (Russell 2000, -4.2%) experienced a wild month, rallying sharply into the third week of November before suffering late-month steep losses on mounting headwinds from rate-hike expectations and the virus, which could slow the momentum on the more cyclical segments of the market. European shares (Eurostoxx, -4.6%) underperformed as expectations for economic growth are cooling due to the surprising resurgence of the virus, adding to an already challenging European outlook. EM equities (MSCI EM, -4.1%) also fell last month, dragged down by Chinese equities (MSCI China, -5.8%). In contrast to the strong performance of developed equity markets so far this year, Chinese stocks ended the month with a -25.3% year-to-date performance and are down 32.9% since their March peak. Finally, Canadian equities (S&P TSX, -1.6%) fell slightly, mainly dragged by the energy sector as oil prices tumbled.
Between investors’ concern over the virus and increasing market conviction on incoming rate hikes, long yields on government debt had another wild month. After reaching a 2021 high of 1.80% last month, the yield on Canada’s 10yr bond fell back to 1.57%. After sharply rallying this year, Western Texas Intermediate (WTI) oil prices collapsed by over $17/bbl to end the month at $66.18/bbl. With the Fed marching toward policy tightening, the U.S. Dollar benefited from that tailwind (Dollar Index DXY, +2.0%), but the Canadian Dollar suffered even more (-3.1%) because of the sharp drop in energy prices. Finally, the VIX volatility index rose to 27.2% (from 16.3%) as Omicron sparked late-month equity selling and risk aversion.
U.S. Small-Caps: Above-trend economic growth to provide renewed tailwind
U.S. small caps have been struggling since March despite the strong economic momentum. We don’t think the inflationary dynamics have peaked and inflation momentum could extend into next summer. Bullish growth and inflation expectations should support small caps stocks as Omicron fear abates. Relative to large caps and global equities, small caps are more sensitive to rising bond yields and rising inflation expectations because they are more geared to cyclical sectors such as industrials, energy and financials (Chart 2). Furthermore, forward operating margins have improved significantly amid the demand-fueled inflationary backdrop.
Chart 2: Small caps tilt toward cyclical sectors
The chart shows the relative sector weights of small caps stocks vs the S&P 500 and the MSCI ACWI benchmarks. We see that the small caps universe is more tilted toward industrials, healthcare, real estate and energy, and is less exposed to staples, communications and information technology. Source: Bloomberg, BMO Global Asset Management, as of November 19, 2021.
U.S. fiscal policy also likely lent a boost with the passage of the Bipartisan Infrastructure bill on November 5th. The $550bn in new spending targets companies with more domestically focused revenues which are leveraged to spend, including small caps. In addition, recent changes to the ‘Build Back Better’ stimulus package significantly reduced the tax bill on small businesses – a big win.
The case for longer term performance (+12 months) vs. large caps is more nuanced. Small caps perform best in the early phase of the cycle, outperforming when the yield curve is steepening, and stimulus is still accelerating. We are now in the mid-phase of the business cycle where central banks are starting to normalize monetary policy, fiscal stimulus is rapidly winding down and the yield curve has peaked. Despite their cyclical exposure, we don’t view small caps as an ideal inflation hedge due to their higher earnings volatility and weaker operating margins vs large caps. Historically, periods of high inflation see small caps underperform large caps at the expense of higher volatility (Chart 3). Looking ahead, above-trend economic growth, elevated inflation expectations, and fiscal policy developments suggest small cap performance can continue. However, worsening virus uncertainty, a rising inflation backdrop as well as mid-cycle growth would add to their recent headwinds.
Chart 3: Small caps underperform in high inflation periods
The chart compares the historical performance of small caps stocks versus large caps by inflation regime. We see that when inflation is higher than 4%, small caps tend to underperform large caps. Source: Bloomberg, BMO Global Asset Management, January 1980 to October 2021.
Central-Bank Policy Outlook: From crawling to walking toward rate hikes
The reconfirmation of Fed Chair Powell and the relentless momentum of the U.S. economy comforted fixed-income markets that the pace of monetary policy normalization must also catch up with the economic backdrop. Unless the virus causes wide lockdowns across major economies, we think the Fed could hike as early as March, and hike at least three times in 2022. As we get closer to policy normalization, the 2-10yr Treasury yield curve has flattened (Chart 4) as the market understands that while the Fed is slow to lean against inflation, the Fed has also been clear that it won’t keep rates on the floor forever. In Canada, we continue to think the bar is very low for the BoC to hike in January. The blockbuster job report of November, which saw another 157k jobs added to the economy, should comfort the BoC to move ahead with a rate hike.
Chart 4: Treasury yield (10 minus 2 year) curve flattening on expectation of policy and growth normalization
The chart shows the historical 10 minus 2 yr U.S. treasury yield curve. We see that the curve has flatten in recent weeks as the Fed is about to start hiking rates in coming months. Source: Bloomberg, BMO Global Asset Management, as of December 3, 2021.
Outlook and Positioning: Virus speed bumps
We remain bullish on the equity outlook while still expecting interest rates to drift higher, and we remain slightly overweight of equities versus fixed income. We think the risk of renewed disruptive lockdowns are low, but we are closely monitoring the evolution of the pandemic and we could de-risk our portfolios if Omicron proves to be a game changer for the outlook of the pandemic. Our preference remains toward U.S. and Canadian equities versus EM and EAFE. On a sector basis, we have a small overweight to U.S. small-caps, financials and energy. Last month we opened another theme to our portfolios with a small tilt on the U.S. travelling sector. We opened a position in the symbol JETS on expectations that pent-up demand for travelling will support the sector over the next 12-18 months. We also added to JETS following the negative reaction to Omicron. Finally, we also reduced our exposure to high-yield credit, shifting our portfolios to a small, defensive underweight there.
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