A Housing Head Fake

Sadiq S. Adatia, CFA, FSA, FCIA

Chief Investment Officer (CIO)

Commentary

Market Recap

Equity markets slumped this week as the ongoing reality of higher-for-longer interest rates set in deeper.
The S&P 500 fell 2.9%, with all sectors in the red. Consumer discretionary posted the deepest decline, down more than 6%, while banks and technology were also weak.
Meantime, the TSX slid 4.1% as higher-beta sectors (see technology and health care) were down sharply, while rate-sensitives also struggled.

The Fed

The U.S. Federal Reserve (Fed) continues to keep people on their toes. While the decision to pause on interest rate increases was no surprise, the tone of the Fed’s comments was a little more hawkish than many analysts had expected. The dot plot generally gives guidance on what to expect going forward, and right now it suggests that there’s still another rate hike in the cards, and projected rate cuts for next year have been cut in half, from 100 basis points to 50. Markets reacted negatively to this news, with Technology in particular getting hit. The Fed’s comments reiterate what we’ve been saying for some time: that while inflation may be on its last legs, it’s not quite over yet. Think of it like running a marathon—it’s that last mile that is most difficult, even though the finish line is in sight. The Fed can see their 2% inflation goal, but they’re not getting there as fast as they’d like. The question they’re asking themselves is—can we reach that goal without further action, or will another boost be required to get across the finish line? The answer to that question is still up in the air.

Bottom Line: The Fed’s hawkish comments are a reminder that interest rates are likely to stay higher for longer, and that a pause does not necessarily mean that rate cuts are right around the corner.

Housing

There’s a housing head fake going on at the moment. In both Canada and the U.S., people believed that the market had stabilized, reaching a trough in advance of a likely bounce-back. While prices have rebounded somewhat, in our view that was largely the result of limited supply, particularly in Canada. Looking ahead, the impact of higher mortgage rates will continue to play out; so far, we’ve only had one year of them, which means that many homeowners that have yet to feel the crunch. As a result, we believe there may be another leg lower both in the U.S. and Canada, with builders having to be wary of a weakening consumer. If they project that demand may not be as strong, then it’s likely that supply will come off, as the nature of new builds means that decisions made today will only come to fruition three or four years down the road. In Canada, we expect this pullback to be a near-to-medium term trend, while in the U.S., it’s likely to be shorter-term, as their mortgage rates tend to be over a longer time horizon than in Canada and therefore the impact may be somewhat muted. China’s property situation has also been in the news a fair bit and has very much impacted consumer confidence. This situation is different than what we are seeing in North America, but it is an important reason why China’s economy has not bounced back and why the consumer is not spending as expected This is an issue worth monitoring.

Bottom Line: Across the board, higher interest rates are having a major impact on the economy, which is contributing to a weakening consumer.

Banks

Recently, banks have taken a hit globally, which is surprising since we’ve seen a rally in markets; it’s rare for Financials to get left behind in that kind of environment. It’s no secret that banks have been in the crosshairs since the Silicon Valley Bank (SVB) failure, which was tied to higher interest rates, developments in the bond market, and an inverted yield curve. In addition, consumers are beginning to weaken and banks are increasing their credit loss provisions, neither of which are positive. When it comes to large-cap Financials in both Canada and the U.S., however, it’s important to emphasize that their balance sheets remain healthy and their dividends seem secure. It’s unlikely that we’ll see a turnaround in the next one or two quarters—in order for that to happen, earnings will have to improve and businesses will have to be a little more cost efficient. But in the meantime, investors are getting paid to wait. Valuations are relatively attractive and yields are in the 4-5% range. Considering where Financials—and the broader economy—are at currently, that’s not bad at all, and covered call strategies are also an option for concerned investors. Headwinds are likely to continue in the near term, but since SVB, many of them have already been priced in. If and when interest rate cuts do occur, or we see a length pause from central banks, that’s likely to be a catalyst for a rebound.

Bottom Line: In the long term, we remain relatively unconcerned about the health of large-cap U.S. and Canadian banks.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Sidestepping Cracks in Uncertain Markets.

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.

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

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.

Commissions, management fees and expenses (if applicable) all may be associated with investments in mutual funds. Trailing commissions may be associated with investments in certain series of securities of mutual funds. Please read the fund facts, ETF facts or prospectus of the relevant mutual fund before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Distributions are not guaranteed and are subject to change and/or elimination.

For a summary of the risks of an investment in the BMO Mutual Funds, please see the specific risks set out in the prospectus. ETF Series of the BMO Mutual Funds trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.

®/™Registered trademarks/trademark of Bank of Montreal, used under licence.