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May Monthly MAST Commentary: Rising commodity prices continue to support the inflation outlook while supply-chains are still exposed to disruptions

May 26, 2022
  • Rising commodity prices continue to support the inflation outlook while supply-chains are still exposed to disruptions, notably in China, and should continue distorting the global growth and inflation outlook leaving investors with higher-than-normal macro uncertainty.
  • Monetary stimulus from the U.S. Federal Reserve (the “Fed”) and Bank of Canada (BoC) is getting removed at a quick pace to lean against excessive inflationary pressures. Rising rates should weigh on the growth outlook and equity valuation, but we do not expect a recession over the next 12 months.
  • We downgraded equities to neutral while remaining underweight of fixed income and raising our cash allocation. On a regional basis, we upgraded U.S. equities to a small overweight. We remain overweight of Canadian equities and underweight to Europe, Australasia, and the Far East (EAFE) and Emerging Markets (EM) equities. We trimmed our underweight of bond duration to neutral as yields spiked. Overall, we continue to expect short-term market volatility.
  • On a sector basis, we recently added an overweight to U.S. technology as play on Quality. Elsewhere, we remain overweight of U.S. financials, the energy sector, and the international travel sector.

The fishermen know that the sea is dangerous and the storm terrible, but they have never found these dangers sufficient reason for remaining ashore.

Vincent Van Gogh

The Fed’s Narrow Path Between Growth and Inflation

The Fed delivered its biggest rate hike since May 2000 by lifting its policy rate by 50bp to 1%. The decision was widely expected by markets while the language of Fed Chair Jerome Powell signaled that a quick march toward a neutral policy stance was necessary to bring down an inflation rate that is “too high”. Starting in June, the Fed will begin unwinding its balance sheet and increase the pace of reduction into September, at which time it plans to trim its $9tn balance sheet by $95bn per month. For major central banks including the BoC, quantitative tightening (QT) is already underway and is widely expected to accelerate during the year (Chart 1).

Chart 1: Revisions to 2022 Real GDP Growth Consensus Estimates Since September 1st, 2021

Revisions to 2022 Real GDP Growth Consensus Estimates Since September 1 2021

Source: Bloomberg, BMO Global Asset Management, as of May 5th, 2022

The earnings season delivered better-than-expected corporate revenues and earnings, especially in the U.S., led by strong performance from the Energy, Materials, Industrials and Healthcare sectors. Equities nevertheless struggled in April on i) rising rates and contraction of valuation multiples, and ii) increasing concerns that the Fed will fail to engineer a soft landing. Meanwhile, China continues to reel from the virus and the disruptive lockdowns imposed in several large cities, including Shanghai. Fear is also mounting that Beijing could face a similar path. China’s Zero-COVID policy is leaving the already fragile economy exposed to further weakness if the virus proves more difficult to eradicate than hoped by Chinese authorities.

Global Markets in April: Rising rates hurt

Global equities (MSCI ACWI, -8.0%) fell in April as Fed policy expectations continued to grind higher and earnings delivered mixed results. Losses were led by the tech-heavy Nasdaq 100 (-13.3%), as index heavyweights such as Amazon and Netflix reported disappointing earnings and signaled a weakening outlook. The S&P 500 (-8.7%) also registered heavy losses along with small caps (Russell 2000, -9.9%). Canadian equities (S&P TSX, -5.0%) outperformed, again supported by commodity price. Elsewhere, losses were slightly smaller, but currency fluctuations narrowed the gap across major equity markets. EAFE (MSCI EAFE, -6.4%) equities outperformed slightly after a couple months of turmoil in Ukraine. Emerging markets (MSCI EM, -5.6%) also outperformed as Chinese (MSCI China, -3.9%) equities registered more moderate losses in April.
The drums of the Fed and BoC grew louder, both delivering 50bp hikes and signaling the need for higher rates. Bond yields rose further in April, adding losses to an already challenging year for fixed-income assets. The yield on Canada’s 10yr bond jumped from 2.40% to 2.87% as inflationary pressures intensified. Oil prices climbed in April, from $100.28/bbl to $104.69/bbl despite efforts from the U.S. to secure near-term oil supplies by planning additional releases of oil from its Strategic Petroleum Reserves. Between rising investor risk aversion and an increasingly hawkish Fed, the U.S. Dollar (DXY Dollar Index, +4.7%) surged in April, gaining against all major currencies. While the loonie lost some ground to the greenback (-2.8%), the Canadian Dollar rose against EAFE majors such as the Yen (+3.8%), the Euro currency (2.1%) and the British Pound (+1.7%). Finally, the VIX volatility index rose from 20.6% to 33.4% as investor anxiety surged late in the month. While a VIX above 30% reflects an anxious equity market, we would need to see a VIX rise above 40% for a few days before interpreting an elevated VIX as investor capitulation and a technical buying opportunity.

Bank of Canada: Oil-fueled hawks leading the hiking charge

Although most developed economies are feeling the pain of high inflation, not every major central bank is ready to tackle inflationary pressures aggressively. For instance, the Bank of Japan is not showing any signs of hiking whereas the Bank of England, which recently hiked, is increasingly concerned about slowing economic growth. For Canada, we continue to expect above-trend growth into 2023, underpinned by a robust outlook for commodity prices and expectations that the housing market will cool from rising mortgage rates, but remain tight, especially with rising immigration levels. For the BoC, we think the path of rate hikes is likely to be less challenging than the Fed, which should support the loonie. After a 50 basis points (bp) hike in April, markets expect another 200bp of tightening by year end for the BoC, which would take the policy rate to 3%, the highest since 2008 (Chart 2).

Chart 2: BoC Market-Implied Hike Probabilities for 2022

BoC Market-Implied Hike Probabilities for 2022

Source: Bloomberg, BMO Global Asset Management, as of May 5th, 2022.

Equity Volatility: Tough year-to-date ride, but not out of the historical norm

The Nasdaq is well into a bear-market this year and, at the time of writing, the S&P 500 is down nearly 15%. By comparison to the history since 1950, equity investors have been unusually fortunate in recent years, experiencing very mild and short-lived episodes of volatility and drawdowns, except for the 2020 lockdown storm (Chart 3). While the bond and equity pain has been significant this year, the much higher yields are leaving fixed-income assets in a much better shape for the future. We think investors should start warming up to bonds over coming months as yields reach higher levels. For equities, the 20% decrease in valuation (i.e., falling price-to-earnings (P/E) ratio) is leaving equities more attractively valued to long-term investors.

Chart 3: Historical Drawdowns for the S&P 500

Historical Drawdowns for the S&P 500

Source: Bloomberg, BMO Global Asset Management, as of May 6th, 2022.

Although calling for market bottoms is not easy, the combination of excessive investor pessimism and more attractive valuations following sharp corrections such as the one we are currently experiencing tends to offer attractive investment opportunities. Looking at the largest (i.e., greater than 10%) S&P 500 drawdowns since 1950, we see that while investors should not expect to fully recover current losses over the next year, the ongoing equity pain is making it easier to expect positive returns from equities over the next year (Chart 4). At the very least, investors should warm up to equities as the storm brews and make plans to rebuild their equity exposure into the summer

Chart 4: Positive Performance Tends to Follow the Storms for the S&P 500*

Positive Performance Tends to Follow the Storms for the S&P 500*

Source: Bloomberg, BMO Global Asset Management, as of May 6th, 2022. * Note: 1-Year forward performance is calculated using daily total returns starting on the day where the 5&P 500 bottomed.

Outlook and Positioning: Stepping back to neutral on equities, upgrading U.S equities, expecting more headwinds for bonds

We continue to expect volatile markets as the Fed hikes and leans against inflation in 2022. Although the Fed aims for the proverbial soft-landing of the economy, we think the path between growth and inflation is narrowing, which is fueling the bearish market narrative of rising fear over a recession. While we see below 30% odds of a recession over the next twelve months, thanks to a tight labour market and healthy households and businesses balance sheets, we expect investor sentiment to remain lackluster despite evidence of a resilient U.S. economy and strong earnings.

Because of this backdrop, we downgraded equities to neutral but left bonds to an underweight, thereby increasing our cash allocation. Regionally, we upgraded U.S. equities to a small overweight while we maintain an overweight to Canadian equities and underweights on EAFE and EM equities. On a sector basis, we remain overweight of U.S. Financials, U.S. Energy, and International travel sectors. We recently added an overweight to large-cap U.S. technology (iShares US Technology ETF, ticker symbol: IYW). Within fixed income, we took our duration up to neutral.


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