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Prices Cool in a Scorching Summer: What Happens Next?

BMO GAM’s Monthly House View

August 2023
CIO STRATEGY NOTE

Prices Cool in a Scorching Summer: What Happens Next?

As the end of the summer approaches, the biggest story in markets is economic resilience.

Despite aggressive interest rate hikes and months of speculation about a possible recession, the economy remains fairly healthy—the labour market is reasonably strong, and consumers continue to hold up their end of the bargain. As a result, we see little reason to shift to a more defensive asset mix at this time. We do concur that there are some signs of softness. But those have been evident for several months, and so far, they haven’t proven to be overly detrimental.

Another important consideration is that we’re likely approaching the end of the interest rate cycle. We’ll be listening closely to messaging from central banks for indications of what the exact timing will be, and for hints as to whether they intend to cut rates or stay on the sidelines for a while. Regionally, central bank decisions, labour market conditions, and the state of the consumer will be important to monitor, as they may vary from area to area. On the sector level, Technology has had a great run and Energy has bounced back somewhat as the recession has been pushed further out. Health Care and Financials, on the other hand, have had mixed results, meaning that opportunities could emerge. Again, we don’t think too much tinkering with our asset mix is warranted until we see more evidence of a downturn across the board. That said, we are on the cusp of the fall season, when markets are traditionally a bit softer, and we’ve already seen something of a selloff in early August. For that reason, we do have some defensive plays in our portfolios, including our allocation to gold.

“We see little reason to shift to a more defensive asset mix at this time.”

Going forward, we’ll remain on the lookout for three potential signs of a more rapidly cooling economy: a bigger drop in employment numbers, more weakness on the consumer front resulting in earnings disappointment, and hawkish comments from central banks. Until one or more of those potential catalysts materialize, we believe a relatively neutral stance remains the wisest course.

ECONOMIC OUTLOOK

A Little Higher, a Little Longer

North American economies and labour markets continue to show resilience, providing ammo for central banks to keep rates elevated over the near term. Beijing, meanwhile, is seen stepping in further to lift China out of its economic doldrums.

U.S. Outlook

Cracks in the U.S. labour market are still not forming as expected, given the latest jobs report for July and the recent jobless claims numbers. Second quarter GDP growth also registered a better-thanexpected 2.4%. All of it suggests economic momentum heading into the third quarter. We’ve also received another piece of good news on the inflation front with core CPI inflation moderating in June and July. We see disinflation continuing in the months ahead outside of energy and food prices. That said, it is the overall economic activity and jobs data that is most important for the U.S. Federal Reserve (Fed). The resilience we’ve seen in the labour market means another hike is still on the table. How we phrase it is, “a little higher, a little longer.” We are close to the top but we are not comfortable saying this is it just yet. But it’s very incremental from here.

In terms of recession risk, the likelihood is still there as long as the yield curve remains inverted and the Fed is still far away from cutting rates. If inflation falls more quickly, that will allow the Fed to start normalizing rates, which would definitely relieve pressure on the economy. As long as rates stay high, recession fears will persist.

Canada Outlook

The latest jobs report was weaker than expected—but it was an odd number that we wouldn’t place too much emphasis on, following a very long period of strength. In general, Canadian growth is showing more signs of that cooling-not-crashing trend we’ve been discussing for several months. Second quarter growth is tracking closer to 1%, whereas the U.S. came in above 2%. In the short term, strong population growth underpinned by immigration remains a solid backbone for the economy going forward. It is providing a boost in demand in the housing market and big lift to the labour supply.
We do expect the job market to remain resilient like the U.S., and that will likely allow for another hike by the Bank of Canada (BoC) this fall. We’re leaving that on the table. In relative terms, Canada will probably reach its peak rate before the Fed, given the greater interest rate sensitivity among households and the economy.

International Outlook

EAFE continues to see the weakest economic outlook. The Eurozone Manufacturing Purchasing Managers’ Indexes (PMIs) continued to fall to new lows in July, whereas in other regions, such as the U.S., we are seeing signs of bottoming. Yet concurrently we have seen service PMIs in Europe as well as the U.K. remain in positive territory, while labour markets are still holding up. Turning to the European Central Bank and Bank of England, we think both still have more work to do. Inflation is still seeing too much breadth in those regions.
Looking at Japan, the Bank of Japan made headlines by adding another tweak to their yield curve control framework. We think future changes are going to be very incremental in order to not derail Japan’s growth outlook, which remains relatively stronger than elsewhere.

Sentiment in Emerging Markets (EM) has improved marginally on the back of stimulus announced in China, and rate cuts commencing in Brazil and Chile. On top of that, we are seeing signs of international trade bottoming out with the post-COVID goods demand normalization likely behind us. Going forward, with Chinese incoming data remaining weak, we think further stimulus measures as well as monetary policy easing will underpin growth in the second half of the year.

Key Risks
BMO GAM House View
Inflation

• Further disinflation through the second half of 2023 will help take pressure off the Fed

• Core inflation will remain sticky

Interest rates

• Delaying the recession means a higher range for the Fed’s neutral rate

• The bar is high for a negative rate surprise over the next few months

Recession

• You cannot have a recession without labour market pain

• Canada and the U.S. are still creating jobs, pushing downturn further out

Geopolitics

• U.S.-China relations can be expected to remain strained

• U.S. has moved to restrict investment in parts of the Chinese economy

U.S Politics

• Rising government debt issuance will result in higher term premia in U.S. rate market

• Lack of clarity around who will run in 2024 is creating uncertainty

Consumer

• Wage growth is outpacing inflation

• Recession won’t likely be triggered by consumer, but rather businesses

Housing market

• The market is bottoming out sooner than expected

• In Canada, there is still a huge imbalance between supply and demand

Banking crisis

• Fresh downgrades for regional lenders weigh on sector outlook

• Smaller banks tend to be more exposed around recessionary cycle

PORTFOLIO POSITIONING

Asset Classes

Fitch’s downgrading of the U.S. credit rating and interest rate hikes by the Fed and BoC do little to change our longer-term outlook. Continuing uncertainty about a recession, however, keeps our asset class ratings neutral (0) across the board.

After a big rally over the past several months, it seemed like equities were looking for a reason to take a knee, and that’s what we’ve seen since the end of July. In this case, the Fitch downgrade of the U.S. credit rating seemed to fit the bill as the catalyst for a selloff that the market was looking for. In general, volumes in August tend to be fairly light, so it’s likely too early to claim that this is a high-conviction pullback. Q2 earnings were good, but the reaction to positive surprises was muted, with beats on revenues and earnings per share (EPS) below the historical norm. Many strategists are predicting that Q2 earnings will be the bottom in terms of year-over-year declines, and Q3 estimates are holding up well so far. The big difference has been a reversal in Tech—we’ve seen some of the big names coming back down, with Nvidia being the primary example. That’s been driven, in part, by the U.S. 10 Year Treasury yield popping up quite a bit on U.S. Treasury Secretary Janet Yellen’s higher-than-expected announcement of the refunding activity and issuance of new U.S. treasuries that will be happening over the next 12 months. Markets never move up in a straight line, and with as many positive days as we had in July, some negative days in August could be expected. Is this the start of a Fall pullback? Maybe, maybe not. Typically, markets don’t start to really move until after the Labour Day weekend. It is worth noting, however, that the VIX index briefly popped up to the 16-17 range in the first week of August before coming back to around 15. In our view, it would have move even higher for this to herald a true market correction.

On the fixed income front, July’s interest rate hike by the Fed hasn’t necessarily changed our outlook—as they remind us often, they are “data dependent,” which makes their move coincident rather than forward-looking. We suspect that this pop in interest rates is a short-term phenomenon with rate cuts a little further out on the horizon, and we’re still optimistic on the value that bonds offer, with a “soft landing” scenario becoming more and more of a possibility. That doesn’t mean that recession risk is down to zero, however, which is why we’re staying neutral (0) in our allocation of bonds versus equities.

In terms of cash, we may not be at a peak in short-term rates just yet, but we’re certainly closer to the top than the bottom. If we see headline inflation pop back up, that could make markets a little more nervous.

EQUITIES

FIXED INCOME

CASH

PORTFOLIO POSITIONING

Equity

Europe remains an area of concern while the U.S. economy continues to demonstrate its resilient and potential opportunities emerge in China.
Regionally, we remain most concerned about international markets (EAFE), and the Eurozone and U.K. in particular. The inflation outlook there remains more complicated than in other markets, while uncertainty around the Russia-Ukraine war persists, and some countries, including Germany, have entered a recession; when consumers are not spending, companies are going to see revenues decline. Energy prices are down materially from the winter, but they’re still relatively high, and much of Germany’s competitive advantage evaporated when it lost access to cheap Russian gas. Other regions have also become more competitive in spaces where Germany has traditionally excelled, like automotives. Together, those factors are dragging down our score on EAFE, which remains slightly bearish (-1). Japan, for its part, has been a positive, as it begins to emerge from decades of economic and financial lethargy. Changes in flows can happen very quickly when investors notice a meaningful change in policy, and with that happening in Japan, support for Japanese equities can be justified.

We remain neutral (0) on U.S. markets, as the economic backdrop and job picture continue to demonstrate resilience. The only issue that prevents us from going slightly overweight is valuation multiples, which we believe are approaching fully valued. Only a small handful of companies—the so-called ‘Magnificent Seven’ Tech names—have been leading markets higher, and while we’ve started to see a bit of a rotation to other companies, that narrow market breadth has pushed some of the U.S. indices higher than others around the world.

This month, we’ve moved to slightly bullish (+1) on EM and neutral (0) on Canada, reversing our ratings from last month. This doesn’t represent a major shift, but rather a re-evaluation at the margins. We still like Canada, but we simply like EM a little more, based largely on our belief that investors have become a little too pessimistic on China following an underwhelming economic re-opening. Of course, we’d like to see Beijing be a bit more proactive in terms of stimulus. But even with that being the case, EM simply looks oversold.

CANADA

U.S.A.

EAFE

EM

PORTFOLIO POSITIONING

Fixed Income

As economic data holds firm and the onset of a recession gets pushed further out, we continue to prefer Investment Grade credit to High Yield, while downgrading our view on Duration to neutral (0).

The big story of the month in fixed income has been the U.S. government’s credit rating being lowered by Fitch. This move reflects concern about the growth of government debt and the ability of Congress and the Biden administration to control spending. We have already seen financial markets experience some volatility as a result of the downgrade, and that may continue in the short-term. But the main takeaway is that bonds issued by the U.S. treasury remain among the safest investments on the market, and treasury yields may even rise as a result of the downgrade. It is important to consider that there are three main rating agencies for U.S. bonds: Standard & Poor’s (S&P), Fitch, and Moody’s. S&P downgraded U.S. credit from a AAA rating to AA+ all the way back in 2011, while Fitch just made the same move, and Moody’s has yet to do so. Like the 2011 decision, we expect this downgrade to have minimal long-term impact—in short, we don’t think it’s as significant a story as some news outlets have made it out to be.

With economic data remaining fairly strong, we’re staying slightly bullish (+1) on Investment Grade (IG) credit and slightly bearish (-1) on High Yield. We are also holding firm at neutral (0) on EM debt. Our one significant change this month has been bringing Duration back to neutral (0) from a previous rating of slightly bullish (+1). A potential recession continues to be pushed down the road, which in turn has pushed back the timeline for interest rate cuts. In that environment, a neutral rating on Duration makes sense. There will come a time when investors will want to have Duration in their portfolio, but now is not that time.

IG CREDIT

HIGH YIELD

EM DEBT

DURATION

PORTFOLIO POSITIONING

Style & Factor

With many crosswinds in the market, we continue to hug the benchmark fairly closely while narrowly preferring Value over Growth.
Quality’s a bit like love: it means never having to say you’re sorry. There’s rarely a bad time to own Quality, and with some market risks still evident—including a possible recession, the Russia-Ukraine war, and rising energy prices, which could lead to higher headline inflation and lower consumer sentiment—we remain slightly bullish (+1) on that factor.
The big change this month is that we have upgraded Value versus Growth, moving to slightly bullish (+1) on the former while remaining neutral (0) on the latter. Part of that shift is due to relative performance, while the other part is tied to the interest rate story—the inflection in the U.S. 10 Year Treasury Note and additional rate hikes favour Value over Growth regardless of past performance.
Though we don’t often have a chance to mention them, we do implement sector positioning and individual trades in some portfolios. At this time, for example, we have Japan and U.S. Industrials trades in place. Another tilt in some of our portfolios, however, is toward equal weight versus market weighting indexes, which addresses concentration risk. It’s worked out well so far despite the headline S&P 500 index potentially being fully valued or even overvalued; the S&P 500 Equal Weight Index, in comparison, is only trading at a price-to-earnings (P/E) ratio of around 161, which is very reasonable.
Volatility remains lower than average. We don’t see a catalyst on the horizon to cause it to spike up, nor do we expect it to go lower any time soon, which is why we’re comfortable with a neutral (0) rating for now.

VALUE

QUALITY

GROWTH

VOLATILITY

PORTFOLIO POSITIONING

Implementation

With the softening of the U.S. dollar (USD) slowing, we remain neutral (0) on the CAD while continuing to like Gold as a long-term hedge.

There are no significant changes in our implementation this month. Interest rates creeping back up is likely a positive for the USD—it had been softening earlier in the year, but that has slowed down a bit. We haven’t implemented any hedges in our portfolios, so we’re not taking big stances either way.

Meanwhile, we remain slightly overweight (+1) Gold. We view it as great long-term hedge. It’s currently stuck in a trading range, but if we do see an upside surprise on inflation, it will be nice to have in our portfolios.

CAD

GOLD

1 As of August 11, 2023.

Disclosures

The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.

 

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.

 

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.

 

BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.

 

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