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THIS WEEK WITH SADIQ

Is the Duration Trade Falling Apart?

January 22 to 26, 2024

THIS WEEK WITH SADIQ

Is the Duration Trade Falling Apart?

January 22 to 26, 2024

Commentary

Market Recap

  • Equity markets were mixed this week, but U.S. stocks powered higher with the S&P 500 closing at a record high. The index rose 1.2% on the week, led by a strong 4.3% rally in technology, while energy, materials and utilities lagged. The Nasdaq added 2.3% on the week and now almost 20% in the last three months alone.
  • Meantime, the TSX dipped 0.4% and continues to lag over the past three months.
  • As usual, it’s a story of little exposure to what’s working (tech), and a lot of exposure to what’s not (energy and materials).

Oil

Despite recent conflict in the Middle East, including the ongoing Israel-Hamas war and more recent attacks on shipping in the Red Sea and U.S. strikes on Houthis in Yemen, oil prices have held relatively steady. Frankly, we’re surprised we haven’t seen more movement—typically, we see some kind of oil shock when conflict flares up, though the spike in prices is usually short-lived. This time, however, the context is different; investors don’t seem to believe that the latest developments are material. This is likely because demand is coming off as a result of a gradually weakening consumer, meaning that potential delays are unlikely to upset the balance between supply and demand the way they did during COVID, when demand was higher. Additionally, oil supply isn’t particularly tight because not all OPEC nations are abiding by production restrictions and the U.S. is ramping up production. Looking at geopolitical risks more broadly, a number of important elections are coming up around the world, and as leaders change, so will alliances and trade relationships. The full impact of those potential shifts remains to be seen, but it is a situation worth monitoring.

Bottom Line: Periodic oil shocks are still likely throughout the rest of the year, but how long they last will likely depend on how regional conflicts evolve.

Consumers

The U.S. consumer continues to hold up better than expected—last week, unemployment claims came in lower than anticipated, and the job picture remains fairly healthy as well. 2023 was a surprisingly good year for markets in large part because the consumer remained fairly strong, which helped prop up the economy. We think the same may hold true for this year. The primary difference between 2023 and 2024 is that last year, many consumers depleted their excess savings, meaning that this year, they’ll be doing their spending with borrowed money like credit cards and other loans. Higher interest rates will take their toll, especially later in the year, and we don’t yet know when rate cuts will arrive to provide a cushion. But broadly speaking, we believe consumers do have the capacity and credit to meet their spending needs in 2024. If spending does largely hold up, the only downside is that inflation will not come down as quickly, which then pushes out potential rate cuts.

Bottom Line: U.S. consumers remain resilient, and we expect that relative strength to persist.

Bonds

Is there a risk that the entire duration1 trade—which many bond traders had been betting on prior to recent central bank comments—could fall apart? There’s always a possibility, but we don’t think so. Rate cuts are still likely to happen; the question is whether they will be concentrated in the second half of the year or if they will get started in the first half. We continue to believe that Q1 cuts are off the table, there’s a chance of cuts in Q2, and that cuts are likely by the end of Q3, both in Canada and the United States. As I’ve mentioned in this space previously, what happened was that markets priced in too many cuts too early. Investors benefitted off the duration trade in November and December before giving back a bit in January. As expectations get back to something more realistic, we’ll likely begin to see some movement in yields and the duration trade will continue to play out.

Bottom Line: We believe the duration trade will continue, which is why we currently have a slight overweight to duration with the intention of gradually increasing it over time.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Cracking the Fed’s Code.

2024 Outlook

On Wednesday, January 24, we’ll be releasing a special report and video featuring our outlook for 2024. It will include a recap of where markets are heading, risks and opportunities, as well as our team’s bullish or bearish ratings on bonds, dividends, and four specific sectors: Financials, Real Estate, Health Care, and Technology. Stay tuned to this space for more details on how you can access it.

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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