Multi-Asset

MAST Asset Allocation Outlook: The Fed is the Stock Market’s Best Friend

July 2019

A recurring theme for us in the past months has been to emphasize key tailwinds for risk assets and argue that fundamentals were in better shape than fear-monger commentators like to claim. While global growth has cooled this year, recessionary calls have been exaggerated lately. We continue to expect some growth re-acceleration this year as consumer demand proves more resilient in key regions, notably the U.S. A couple critical forces at play should continue to support risk assets over our 6-to-12 month investment outlook: namely the willingness of central bankers to ease monetary policy and our conviction that trade wars will abate—though the latter is likely to come after Fed and ECB easing.

For investors that have failed to appreciate the influence of Fed policy on stock performance and that have shied away from risk assets this year following the December debacle, the cost of being on the sidelines has been staggering. Like the turtle, investors must ignore the incredible flow of pessimistic noise and stick their neck out to achieve their long-term capital appreciation goals.

 

Trade Truce and the Fed’s Dovish Shift Reignite Stock Rally to New Highs

After a dramatic May where investors dashed hope for a trade deal, June capped off a solid first half-year performance on renewed optimism regarding a U.S.-China trade deal while the Fed lost patience and signaled rate cuts were imminent.

June performance for global stocks (MSCI ACWI) was solid, rebounding 6.4% after a tough May. U.S. stocks regained their leadership last month as the S&P 500 and NASDAQ 100 rose 7.0% and 7.7%, respectively. For the NASDAQ 100, the year-to-date gains stood at an impressive 21.9%. After outperforming in May, Canadian stocks had a less impressive month with a more modest 2.5% gain, despite oil prices rebounding 8.5% in June. Elsewhere, the MSCI Europe Index advanced 4.3% while Japan’s Nikkei shares rose only 3.5%. Finally, emerging-market (MSCI EM) stocks rose 5.7% on renewed optimism for a trade deal and a falling U.S. Dollar.

The Fed’s change in tone, coupled with softening global production indicators, helped push yields on government notes lower with the yield on U.S. 10-year treasury notes ending the month at 2%, down 12bps. Meanwhile, the 2-10 yield curve steepened a little more as the Fed signalled cuts. In Canada, yields were little changed as key macro indicators continued to surprise to the upside, notably job creation and the GDP estimates. The recent green shoots for the Canadian economy gave the loonie some traction with a 3.2% gain in June, making it the performing G10 currency so far this year vis-à-vis the greenback.

 

Equity Factors: Small-Cap Stocks Fail to Embrace the June Rally

When equity markets rally hard, it’s often the case that dispersion in performance narrows as investors simply scramble to buy risk assets, which is what happened in June for global equity factors. Growth (+6.9%) and Quality (+6.9%) led the pack, but even the more defensive styles like High-Dividend (+6.4%) and Value (+6.2%) performed in line with the benchmark (+6.4%) and an equal-weighted factor-based portfolio (+6.1%). The Low-Vol (+4.8%) and Size (+5.6%) were the sole factor underperformers last month.

On a year-to-date basis, however, Value (+12.4%) remains the weakest performer relative to benchmark (+14.9%). An equal-weighted, factor-based portfolio would have outperformed the benchmark by 160bps so far this year, proving that effective portfolio diversification through a factor lens can help improve risk-adjusted returns. For small-cap stocks, we think they could continue to underperform large-caps as global growth cools and lending standards tighten. Large caps also tend to better maintain their margins when labour and material costs rise.

In Canada, Low-Vol (ticker: ZLB, +0.5%) performed more modestly in June but registered its sixth consecutive monthly gain for the year. Although Canadian low-vol equities lagged the broad market (ticker: ZCN, 1.8%) last month, they remain slightly ahead for the year (15.3% vs 14.4%) and are well ahead on a year-over-year basis (8.8% vs 0.0%).

 

Trade Wars: Time for Truce

U.S.-China trade relations took a necessary step forward with the conclusion of the G20 summit while Mexico was spared from new tariffs. Talks have resumed and President Trump made a couple of concessions as well, permitting U.S. firms to sell inputs to Huawei and postponing the imposition of additional tariffs. China also conceded to buy more agricultural goods, though this was not confirmed by Chinese authorities.

This is the best hoped-for scenario in our view given that odds of a full trade truce were always very low. Yet high hurdles toward a deal remain, and the bar is now higher as trust has been lost. Consequently, market reaction was muted and short-lived. Risks of more tariffs are still intact, though not our base as economic pain should work as an enforcement mechanism. Trade disputes beyond China are also still simmering in the background as the U.S. quietly imposed tariffs on the EU in retaliation to Airbus subsidies. With tensions still running high, tariffs on European autos still cannot be ruled out later this year.

 

Monetary Policy Easing Ahead: Insurance Cuts, Not a Full Easing Cycle

At its June Federal Open Market Committee (FOMC) meeting, the Fed formally capitulated to the bond market by downgrading its policy path and removing its “patient” guidance. The Fed has now penciled in one 25bps rate cut in 2020 and even lowered its estimate of neutral. Their outlook however is still well above market pricing, with four cuts priced by end-2020. We do not expect Fed policy to converge to the bond-market’s bearish view, but we do expect a 25bps cut this month, which is fully priced. We view one or two Fed cuts this year as an insurance policy, not a full easing cycle, that will help cushion the soft patch in global growth. Fed easing should also weaken the greenback this year and help ease U.S. financial conditions. What is still needed for a weaker USD, however, is a confirmation of a recovery in external demand and global growth, notably in Europe and China.

Chart 1: Canadian Macro-Data Surprises on a Tear

Chart 1 Canadian Macro-Data Surprises on a Tear

Source: Bloomberg.

Canadian Economy Holding up Better than Expected: Loonie to fly

Macroeconomic data surprises have been on a tear lately (Chart 1). We think that Canada’s better-than-expected economic performance in recent months should allow Governor Poloz to keep monetary policy on hold this year, whereas the bond market was fully expecting a cut until recently. If our Fed “insurance cut” scenario plays out in the next 12 months and Canadian growth hovers near 2%, the Bank of Canada should be able to keep interest rates on hold over this period and the Canada-U.S. interest rate differential should narrow further (Chart 2). In that context, we now think the loonie is set extend its recent rally and touch $0.78 this summer.

Chart 2: US-Canada Yield Differentials at Tightest Since January

Chart 2: US-Canada Yield Differentials at Tightest Since January

Source: Bloomberg.

Outlook and Positioning: Time to Overweight Canadian stocks

Our overweight to equities was unchanged last month, but we made a few tactical changes to our asset mix. While we remain overweight equities relative to bonds, we reduced our U.S. overweight and added an overweight on Canadian stocks. This tactical play reflects our rising concerns over risks of further targeted tariff measures by the Trump administration this year, notably on Europe.

With falling global yields, the relative attractiveness of stocks versus bonds has improved in recent months when looking at the equity risk premium (Chart 3), proxied by the earnings yield minus the yield on 10-year government notes. Another key tailwind for stocks is central bankers and their formidable willingness to ease when dictated by financial markets and a softening of the growth outlook.

Chart 3: Equity Risk Premia Have Improved

Chart 3: Equity Risk Premia Have Improved

Source: Bloomberg.

For fixed-income, we increased our duration underweight a notch on the belief that the bond market is too pessimistic on the outlook. While we have been wrong on our duration call this year, falling bond yields have been a key tailwind for stock prices and our gains from our equity overweight proved more beneficial than missing on the bond rally.

In credit, we also increased our underweight to high yield as we see credit spreads being quite tight  and therefore offering limited upside form current levels. We prefer expressing our cautiously bullish views through equities, which offer more upside in our view.

Our new bullish stance on the loonie and our confidence that the greenback is set for a broad depreciation increased as the Fed signaled an easing bias. For the loonie, the extent of its potential rally will depend on how long the string of positive data surprises can last. But the strong labour market and lingering labour shortages should underpin an above-trend pace of economic growth for the rest of the year.

 

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