MAST Asset Allocation Outlook - “The only way to Avoid Mistakes…”

Positioning was unchanged in July, reflecting lingering trade uncertainty while expecting central-bank easing to extend the cycle.
August 2019
  • Federal Reserve (Fed) policy and trade tensions disappointed investors but intervention by global central banks will remain a key tailwind to stocks.
  • Global manufacturing is cooling but we expect U.S. consumers to remain a pillar of growth given a strong labour market and their solid balance sheets.
  • We remain modestly overweight to equities, preferring U.S. and Canadian equities versus EAFE. We continue to think Canada is better positioned for navigating trade war uncertainty.
  • We still expect the Bank of Canada to keeps rates unchanged this year while trade wars and market pricing will pressure the Fed to deliver further. Some degree of policy convergence between Canada and the U.S. should help lift the loonie by year end.


Powell-Trump Duo Holds the Key for Equity Upside

After getting cold-showered by the “mid-cycle adjustments” of Fed Chair Powell, investors got ice-bucketed from President Trump’s “beautiful” tariffs early this month. Stocks fell while yields on government bonds touched fresh lows. What matters most for our twelve-to-eighteen month investment outlook and for long-term investors is that the cooling in global growth should not lead to recession in the next year and that central bankers will continue to support the economic outlook with policy accommodation in an attempt to reboot the cycle.


It’s Always Windy at the Top

While global stocks barely rose (MSCI ACWI, +0.2%) last month, U.S. leadership was intact with the S&P 500 climbing 1.4%, sending it to new highs. Nasdaq 100 shares rallied (+2.4%), which took their impressive year-to-date gains to 24.7%. Canadian (+0.3%) and European (MSCI Europe, +0.2%) shares flat-lined last month while emerging-market (MSCI EM, -1.7%) stocks struggled on concerns over softening global demand and the resilience of the U.S. dollar. Finally, Japan’s Nikkei rose (+1.2%), mainly supported by the Bank of Japan’s accommodative tone.

Growing evidence that growth is slowing more than expected in Europe kept a lid on yields of global government debt. However, resurging trade-war drama early this month drove yields on 10-year government debt in the U.S. and Canada to their lowest levels since 2016. Powell’s “mid-cycle-adjustment” remarks were badly received by investors who saw increasing risks of a Fed policy error by failing to recognize the need for rate cuts, which pressured the 2-10 yield curve down by 10bp last month. The steady re-acceleration of the Canadian economy was not enough to lift the loonie (-0.75%) in July, but it remained the best performing G10 currency as the Buck held strong.


Equity Factors: Quality Shines in Uncertain Times

With little dispersion in global equity markets, equity factors also saw muted dispersion. Quality (+1.7%) did well again in July, along with Growth (+1.0%) and Momentum (+1.0%). Meanwhile, the High-Dividend factor fell slightly (-0.6%). Year-to-date, a simple equal-weighted, factor-based portfolio has outperformed the benchmark by 230bp. We continue to expect large-cap stocks to outperform small ones as small-cap profit margins struggle from strong labour markets feeding into wage pressure and tighter lending standards, resulting in worsened credit availability.

July was another good month for Canadian Low-Vol (ticker: ZLB, +1.6%) stocks, the seventh consecutive monthly gain. Year-to-date, Low-Vol stocks are now ahead the broad market (ticker: ZCN) by roughly 150bp (16.5% vs 18.0%). We like strategically and tactically owning Low-Vol Canadian stocks.


Negatively-Yielding Debt Sky Rocketing

With global yields falling quickly since last October, the world’s stock of debt that carries negative interest rates has sky rocketed from $6 trillion to a staggering $15 trillion (Chart 1). For investors, it’s increasingly difficult to get positive returns from fixed-income assets. With negative interest-rate policies set to expand, we believe investors will be forced to trim their fixed-income allocations in favour of stocks and other risky assets.

Chart 1: Global Negative-Yielding Debt Reached $15 trillion

The only way to avoid mistakes - Chart 1 Global Negative-Yielding Debt Reached 15 Trillion

Source: BMO GAM, Bloomberg

Trump: “Taxing the Hell out of China”

The “simmer” in trade-war tensions proved short-lived after Trump’s surprise tariff escalation, levying a 10% tax on the remaining Chinese imports of roughly $300bn starting on September 1. China retaliated by blocking U.S. agriculture imports and allowing its currency to depreciate. Farmers are seen as Trump’s supporting base while currency intervention strikes a nerve for Trump, who promptly labeled China a currency manipulator. While about half of the threatened tariffs will be delayed until December 15, odds of a deal are still low ahead of the Presidential election.

We estimate that the cumulative impact of tariffs will offset the U.S. fiscal boost, with the latest tariff round trimming another 0.1 to 0.2% to GDP growth. However we expect the U.S. consumer to hold-up given their solid balance sheets, low unemployment, strong wage growth, and lower interest rates. A recent spike in refinancing applications indicates that U.S. consumers should soon realize the benefits of substantially lower mortgage rates.


Should we Fear a CAPEX Slowdown?

Going forward, U.S. business investment and job growth will be key to watch. In recent years, however, the capex cycle has been a poor predictor of job growth (Chart 2). A reason for this is that compared to the 1950s, U.S. manufacturing as a share of GDP has shrunk from about 25% to less than 12% today as the service sector has steadily expanded.

Looking at the top 20 companies of the S&P 500 index, which account for 35% of the index’s market cap, only 3 have manufacturing capacity, all others are entirely service-based. We therefore think the impact of a cyclical capex slowdown should be less concerning compared to previous cycles, especially in relation to the job market and stock market performance. In Canada, we continue to expect solid job growth as labour shortages will limit downside to job creation.

Chart 2: Capex Cycles are a Poor Predictor of Post-Crisis Job Growth

The only way to avoid mistakes - Chart 2 Capex Cycles are a Poor Predictor of Post-Crisis Job Growth

Source: BMO GAM, Haver

Fed Outlook: “What we’ve got here is Failure to Communicate”

Although FOMC policy communications are usually well scripted, the messaging by Chair Powell has been less than ideal for investors. From his “long-way-from-neutral” moment, to transient inflation, Powell’s latest remarks that trade tensions had returned to just a “simmer” proved ill-timed as Trump announced tariffs on China the next day.

Long-term investors should discount Fed language and instead focus more on market expectations, which have been successfully calling the bluff on the Powell’s Fed. Moreover, it’s becoming increasingly evident the Fed will have to do more beyond the “insurance” cut in July. For equity investors, the recent collapse in yields and the scope for more easing should be seen as a key fundamental tailwind to stocks (Chart 3).

Chart 3: Equities Generally Benefit from Insurance Rate Cuts

The only way to avoid mistakes - Chart 3 Equities Generally Benefit from Insurance Rate Cuts

Source: BMO GAM, Bloomberg

Summer Heat Wave for the Canadian Housing Market

With strong population and job growth and falling mortgage rates, it’s not surprising the Canadian housing market is heating up with key metropolitan areas seeing a solid recovery in construction, resales and prices. Resale activity is a key indicator to watch and the 6-moving average of sales is picking up (Chart 4).

Chart 4: Canadian Home Sales Soar on Low Rates and Pent-up Demand

The only way to avoid mistakes - Chart 4 Canadian Home Sales Soar on Low Rates and Pent-up Demand

Source: BMO GAM, Haver

Outlook and Positioning: Keeping it Close to Home until the Fog Clears

Positioning was unchanged in July and our overweight to equities versus bonds remains modest, reflecting lingering trade uncertainty while expecting central-bank easing to extend the cycle. We like U.S. and Canadian stocks while we underweight EAFE, where we think upside is more limited due to lack of economic growth and lingering trade uncertainty.

Our underweight in rates duration has been a difficult call this year with the relentless collapse in government yields. The yield on the 10-year Canadian Federal government bonds down by nearly 150bp from the October peak and is now 50bp below the overnight interest rate. While we think global central banks will provide a liquidity boost to markets, we don’t think the Bank of Canada is in a hurry to join the easing party as it probably wishes to avoid seeing households rush for further debt-financing of consumption.

We did not change our view on credit last month, but in a scenario where stocks struggle to make new highs and stay range bound, credit could become interesting for earning extra yield and carry. The relative scarcity of positively yielding debt should support Canadian and U.S. credit.

Finally, the Canadian economy should perform better than expected going into year end, which should help Governor Poloz keep his powder dry for a few Fed rate cuts. Some degree of policy convergence between Canada and the U.S. should lift the loonie to $0.78 by year end.

This commentary has been prepared by the BMO GAM Multi-Asset Solutions Team (MAST) and is intended for informational purposes only. 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. 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. Past performance is no guarantee of future results.

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 the brand name for various affiliated entities of BMO Financial Group that provide investment management, retirement, and trust and custody services. BMO Global Asset Management comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms. Certain of the products and services offered under the brand name, BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations.

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

Related articles

No posts matching your criteria