MAST Asset Allocation Outlook - Prophesy, but always hedge

Cold showers keep pouring for investors. While yields on government debt keep breaking new cyclical lows, the S&P 500 is just shy from its record high despite lingering trade-wars.
October 2019
  • Trade tensions deteriorated and we doubt the U.S. and China will reach a deal this year. It could get worse before it gets better. The negative economic impact from tariffs will more than offset the benefits of earlier tax cuts.
  • We continue to think Canada looks well positioned to navigate lingering trade uncertainty. We remain overweight Canadian stocks, in particular Low-Volatility stocks. A deeply inverted yield curve will continue to weigh on financials.
  • We expect Governor Poloz to be late to the central bank easing party, whereas we expect the Fed to deliver more than “mid-cycle adjustment.” This dynamic should lift the loonie as the Canada-U.S. interest rate differential narrows.
  • We remain modestly overweight stocks versus fixed-income as a lack of clarity on trade policy clouds the outlook. We continue to like North American stocks versus EAFE, where the growth pain is more acute.
Prophesy as much as you like, but always hedge

– Oliver Wendell Holmes

President Trump: From a Tailwind to a Headwind for Growth

Cold showers keep pouring for investors. While yields on government debt keep breaking new cyclical lows, the S&P 500 is just shy from its record high despite lingering trade-wars. Thus far, the direct impact to U.S. growth has been muted because U.S. consumers are benefitting from a strong labour market and falling interest rates. However, it’s becoming hard to assign a high probability that the U.S. and China will make a deal this year or even ahead of the 2020 U.S. presidential elections. We think trade uncertainty will drag into 2020 as parties dig in while the benefits of earlier tax cuts and the fiscal boost from the recent two year budget deal will be more than offset by tariffs, which are a tax on U.S. consumers.

Last month, President Trump’s Twitter feed hit like a Category 5 storm, providing little comfort to anxious investors looking for clarity. The outlook remains clouded by trade negotiations but we continue to think the U.S. will avoid a recession in the next 12 months. However the margin of error has shrunk considerably because of supply-chain disruptions. Ultimately, that means more central-bank easing will be necessary to offset slower growth, along with some fiscal stimulus, notably in Europe. On balance, central banks flooding the world with cheap money should support risk assets. We expect continued easing with a third Fed rate cute later this year.

With rising worries over the global economic outlook alongside a relatively resilient U.S. economy, the U.S. is now the country with the highest interest rates in the G10 for the first time in modern history.

Tit-for-Tat Trade-Wars Spooking Investors

The relentless flow of bad news sent global stocks down last month (MSCI ACWI, -2.6%), but Canadian stocks managed a modest 0.4% gain as the country is better positioned to navigate trade uncertainty. In the U.S., the S&P 500 fell 1.6% in what was a tweet-driven, volatile month. The weakest area for stocks was emerging markets (MSCI EM, -5.1%), which nearly erased their yearly gains. Japanese stocks also struggled (Nikkei, -3.7%) while the U.K.’s FTSE 100 index fell 4.1% on rising concerns over a no-deal Brexit, pulling European shares down (MSCI Europe, -1.7%).

Throughout August and just a day after the disappointing Fed decision, Trump single-handily added fuel to the bond rally by “taxing-the-hell-out-of” China and furiously ranting about Powell’s policy stance. Between the 2yr-10yr inversion of the U.S. Treasury yield curve and the collapse in yields, August was violent for fixed income. The 10-year yield on U.S. Treasuries collapsed 52bps whereas yields on Canadian federal debt dropped 31bps. The yield on the U.S. 30-year bond also touched a record low of 1.95%. With rising worries over the global economic outlook alongside a relatively resilient U.S. economy, the U.S. is now the country with the highest interest rates in the G10 for the first time in modern history (Figure 1). This backdrop has taken the greenback to cyclical highs and the Dollar Index (DXY) is up over 2% this year.

Figure 1: U.S. Yields Post Largest Monthly Decline since 2011

U.S. Yields Post Largest Monthly Decline since 2011

Source : Bloomberg, BMO GAM

Equity Factors: Low-Volatility Finds Upward Path in Wild Environment

Dispersion returned in equity-factor performance in a volatile month. Every style was down last month, except for Low-Volatility which gained 1.7%. Value and Size continued to struggle, each falling 3.5%. We maintain a bias for global large caps versus small caps as the macro cycle shows little sign of an upswing yet. We also like Low-Volatility stocks in this uncertain, late-cycle environment, especially in Canada. The BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, +1.9%)¹ rose for the eighth month in row. It also outperformed the broad market BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN, +0.45%)² by a wide margin in August, giving it a solid year-to-date lead (17.0% vs 20.2%).

Brinkmanship Rules U.S.-China Trade Negotiations

Trade negotiations aren’t exactly moving well and have gotten worse lately. While it’s becoming hard to have a strong conviction on whether the China-U.S. trade relations will improve or deteriorate from here, the economic drag from higher tariffs will intensify going into year end. We continue to see the odds of a recession over the next twelve months at no more than 30%, but Trump’s trade wars are increasingly putting the economy at risk of an accident. We believe it would be a risky gamble for Trump to campaign during a recession, which is why we think the economy must be handled with care. Although a trade deal is unlikely this year or at the next round of scheduled talks in October.

Fed Outlook: Markets enforcing more than “Mid-Cycle Adjustments”

Fixed-income markets continue to expect a lot of easing from the Fed with “about one more cut” priced for this year and a couple more for 2020. Rising trade-tensions and evidence that global growth is slowing, particularly in Germany where the economy is most likely in recession, have kept the demand for safe-haven assets elevated and made duration king this year. The recent escalation in trade tensions has led us to change our Fed outlook. We expect continued Fed easing with a third Fed rate cut later this year.

Canada: Under the Sun, Less Exposed to Trade Tensions

With most equity markets experiencing rising volatility because of trade tensions, Canada stands apart. Among the G10, Canadian equities outperformed again, just as in May when trade wars erupted (Figure 2). What’s more, the outperformance is captured by large-cap companies, which have outperformed small caps this year.

Figure 2: Canadian Equities Outperform Globally in August

Figure 2: Canadian Equities Outperform Globally in August

Source: MSCI, Bloomberg

We have liked an overweight to Canadian stocks on the view that Canada will outperform during times of heightened trade tensions. This is because Canada is no longer a key target for Trump’s trade wars. And despite the country’s relatively high trade openness, its equity exposure to China, the current target of trade tensions, is limited. Canadian international trade flows also stand to benefit from tariff diversion.

Recent domestic data also support our bullish view of Canada. Economic growth rebounded sharply in Q2 (+3.7%), while manufacturing activity has been more resilient compared to other developed economies. Home sales are also heating up thanks to new cyclical lows in interest rates and strong wage growth. The global outlook certainly looks bleaker following the latest wave of tariffs on China, but Canada still has been on better footing heading into year end. Although we expect housing activity to support growth and credit demand, the severely inverted yield curve in Canada will continue to weigh on financials (Figure 3).

Figure 3: Extreme Yield-Curve Inversion is Negative for Canadian Financials

Extreme Yield-Curve Inversion is Negative for Canadian Financials

Source: Haver, BMO GAM

Bank of Canada: Arriving Late to a Party is Chic

The growth outlook for the second half will be heavily supported but the housing market. Furthermore, households probably carry as much debt as they can. Overall, this backdrop gives Governor Poloz some room for patience on rate cuts. Unless the loonie flies too close to the sun and breaks the 80 cents level, we think the Bank of Canada will remain data dependant, at least for a couple more Fed cuts.

Outlook and Positioning: Slippery Road Conditions Warrant Caution

Our core positioning was little changed last month with a modest overweight to equities versus bonds, as trade-wars linger and the earnings outlook deteriorates. In this context, we continue to like U.S. and Canadian stocks while underweighting EAFE, where the growth pain is more acute.

Although the move in government bond yields looks overdone, its magnitude has surprised us this year and demand for safe-haven assets could run further despite the awful valuation resulting from inverted curves and negative yields. Clearly, the worsening of trade tensions is keeping risk more elevated than we had anticipated earlier this summer. We therefore trimmed our duration underweight.

Elsewhere, our views were unchanged on credit and the loonie. We continue to think the narrowing of the Canada-U.S. interest differential will support the loonie to climb toward $0.78 over the next 3-6 months.

¹ The performance for (ZLB) for the period ended August 30th, 2019 is (as follows: 15.32% (1 Year); 8.85% (3 year); 10.61% (5 year); and 13.79% (since inception on (October 21, 2011)

² The performance for (ZCN) for the period ended August 30th, 2019 is (as follows: 4.32% (1 Year); 7.16% (3 year); 4.08% (5 year); 6.56% (10 year); and 6.81% (since inception on (May 29, 2009).

Commissions, management fees and expenses (if applicable) all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus.  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

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.

This commentary has been prepared by BMO Asset Management Inc. the portfolio manager. This update represents their assessment of the markets at the time of publication. Those views are subject to change without notice as markets change over time.

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.

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.

Related articles
No posts matching your criteria