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THIS WEEK WITH MARCHELLO

What’s Happening with Bonds?

February 20 to 23, 2024

THIS WEEK WITH MARCHELLO

What’s Happening with Bonds?

February 20 to 23, 2024

Commentary

Market Recap

  • Equity markets were little changed this week, with tough inflation news keeping the market in check.
  • The S&P 500 dipped 0.4% as gains in banks and energy were offset by weakness in technology and communication services. The index continues to hold above that closely-watched 5,000 level.
  • Meantime, the TSX rose 1.2% on the back of broad strength in energy, financials, consumer staples and industrials—some solid earnings hits helped. While not pushing record highs like its U.S. counterpart, the Canadian index has moved to the highest level since early 2022, and is climbing the ascending 50- and 200-day moving averages again.

Bonds

Recently, bond prices have slipped as U.S. inflation numbers have continued to come in hotter than expected, prompting questions about the fixed income outlook for the rest of the year. In our view, one of the key drivers of recent higher-than-expected inflation is start-of-the-year price increases (due to January wage increases) in labour-reliant categories—things like medical services, car insurance, and daycare. These increases are relevant for now, but their effects are likely to be temporary. It is also worth noting that core goods prices actually fell into deflation for the first time since the beginning of the COVID pandemic. This offset the seasonal price increases in labour-reliant categories, just not enough to cool inflation overall. We’re also experiencing positive base effects carrying over from last year; while inflation remains relatively hot, it’s not as hot as it was in 2023. We believe that U.S. inflation is still on track to fall below 3% in the first half of this year. That could potentially give the U.S. Federal Reserve (Fed) the data it needs to begin cutting interest rates in the summer. How does this translate to fixed income? We always knew that it wouldn’t be a straight line down for yields, which is why we took some duration1 off the table earlier this year. Now, as rate cut expectations have been tempered, it’s making duration look more attractive again.

Bottom Line: We believe we’re still on track for sub-3% inflation in the first half of 2024, which would give the Fed the justification for rate cuts—and be good news for bonds.

A.I.

So far this year, Nvidia and other artificial intelligence (A.I.)-related chipmakers have continued their spectacular ascent. Will this rally continue, or will the optimism around A.I. eventually run its course? Our belief is that the optimism will eventually fade, but not anytime soon. Nvidia remains one of the top holdings in our portfolios, and that’s because it still has scarcity value: there are certain things that it is able to do as a company that others aren’t just yet. Eventually, other companies will catch up, but for now, Nvidia is a clear leader in the A.I. space. Speaking more broadly about A.I.-related companies, there’s still overwhelming demand for their products. This is largely coming from public cloud (the offering of services and resources over the internet) companies like Meta, which need hardware to train and run their A.I. applications. At this stage, commercial software applications are supporting the surge in demand for A.I. tech. But we believe that a shift will occur as demand for non-commercial software like publicly-available, user-created A.I. applications picks up.

Bottom Line: With software development poised to boost demand for A.I. products even further, we expect investor optimism around A.I. to continue into 2025.

Labour

Strikes across various sectors made news in 2023, and last week, they returned to the headlines as rideshare drivers and delivery workers at companies like Uber, Lyft, and DoorDash pushed for better pay. While it’s still unknown if these labour issues could spill over into other industries, we expect the impact on U.S. economic growth to be limited. There are two reasons for this. One is that the U.S. economy is extremely well-diversified and driven largely by consumer spending. The second is that only about 10% of workers in the U.S. are unionized. This is a relatively small percentage compared to Canada and many other countries, and represents a steep decline from the hyperinflationary period of the 1970s. The lasting impact of strikes tends to be on profit margins, as wages are reset higher. However, that tends to be a company- and sector-specific risk in highly-unionized industries like automotives, rather than a broader economic risk.

Bottom Line: Strikes may have a modest short-term impact on the U.S. economy, but they are unlikely to be a significant drag long-term.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled The American Exception: How U.S. Markets Beat the Bears…Again.

Footnotes

1 Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).

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