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CA-EN Institutional
CA-EN Institutional

The Inflation Slayer: The Fed will “Keep at it”

September 22, 2022
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  • U.S. economic data is sending mixed signals. The labour market remains robust with intense wage pressures. Meanwhile, housing activity is in correction mode because of rising interest rates while business surveys are softening fast. We expect the pace of economic growth in Canada to slow into yearend. The North American economy is cooling, not crashing.
  • Because of our concerns about the three-to-twelve-month economic outlook, our portfolios remain tilted defensively and we remain underweight to both equities and fixed income, alongside a small underweight to duration, leaving our asset mix overweight of cash.
  • Across regional equity markets, we are overweight of Canadian equities and remain neutral on U.S. and Emerging Market (EM) equities but underweight to Europe, Australasia, and the Far East (EAFE), which we think remains the most vulnerable to the ongoing macro backdrop as the energy crisis worsens in Europe. We downgraded high-yield credit in favour of investment grade credit.
  • On a sector basis within the U.S equity market, we remain overweight to the energy, healthcare, and tech. We have a currency hedge against the U.S. Dollar. Our fixed-income heavy portfolios are underweight credit exposure to reflect our more defensive views of the markets.

Restoring price stability will likely require maintaining a restrictive policy stance for some time. The historical record cautions strongly against prematurely loosening policy.

Jackson Hole
Chair Jerome Powell
August 26th, 2022

The Inflation Slayer: The Fed will “Keep at it”

U.S. Federal Reserve (the “Fed”) Chair Jerome Powell delivered a powerful market-steering speech in Jackson Hole, Wyoming (Source: CNN) where he insisted on the Fed being dedicated to slay inflation with high interest rates. While his speech was short, it was unambiguously clear and even alluded to what investors have believed for a while, that the battle against inflation would bring “some pain” for the economy: “reducing inflation is likely to require a sustained period of below-trend growth”.

Back in July, investors began entertaining the idea that the Fed was about to “pivot” away from its hawkish rhetoric and switch to a dovish policy stance. Because this market narrative largely fueled the equity rally into early August, the risk-off market reaction was severe as Powell delivered a wake-up call to the markets. Bonds yields and the U.S. Dollar rose while equities suffered heavy selling for the reminder of August. The European Central Bank and the Bank of England also joined the hawkish campaign with rate hikes in recent weeks, which sent global bonds into an historical rout, down over 20% from their January 2021 peak (Chart 1). Although we think fixed-income market probably underestimate the degree of tightening the Fed and other major central banks will have to deliver to slay inflation, we are nevertheless approaching the later innings of the hiking cycle, which means that 10-year yields have less upside when sitting above 3%. Overall, we think the risks remain titled for higher long-term yields, until the economy hits a major speed bump that sparks a wave of layoffs.

Chart 1: Global Monetary Policy Tightening Causing Epic Bond Rout

Graph with data
Source: Bloomberg, BMO Global Asset Management, as of September 8th, 2022.

Meanwhile, U.S. economic indicators have maintained their mixed tone as the labour market remains robust. Unsurprisingly, in the eye of the rate-hike storm lies the housing market, which is starting to correct as home-sales have tumbled in recent months.

Elsewhere, the Canadian economy ended the second quarter on a solid note with real gross domestic product (GDP) up 3.3% (annualized pace), buoyed by strong consumer demand and business investment. But here too the slowing of the housing market has started detracting from economic growth and we expect housing-related economic activity (e.g., construction, resales, renovations, and related big-ticket items) to inflict a greater drag on the growth into yearend as potential home buyers remain on the sidelines.

Global Markets in August: Equities and bonds feeling Powell’s pain

Global equities (MSCI ACWI, -3.6%) fell in August as global interest rates continued to surge. U.S. stocks underperformed with the tech-heavy Nasdaq 100 (-5.1%) giving back some of its strong July gains. S&P 500 (-4.1%) also fell as earnings expectations are starting to catch up with the downgrades of the economic outlook and the rise of the Dollar. U.S. small caps (Russell 2000, -2.0%) fell more modestly as the resilience of the labour market could cushion the U.S. economy a little longer. European equities (Euro Stoxx 50, 5.1%) retreaded on increasing financial stress in Europe because of the energy crisis, with banks feeling investor anxiety with a surge in their credit default swaps as investors purchase protection against risks of default. The overall Europe, Austral-Asian, and Far-East (MSCI EAFE, -4.7%) was pulled lower despite a positive performance from Japanese equities (Topix, +1.2%) and a modest loss in the U.K. (-1.1%), but EAFE currencies fell broadly. Canada’s TSX (-1.5%) was down but outperformed global equities despite falling oil prices. Finally, emerging markets (MSCI EM, +0.4%) were roughly flat for a second consecutive month as investors lack clarity on China’s economic outlook because of the lingering of COVID and a bruised real-estate sector.
The bond rout continued in August as most major central banks are signaling the need for higher policy rates over coming months. In Canada, the yield on the 10yr Federal bond rebounded from 2.61% to 3.12%, helped in part by a hawkish Bank of Canada, which also raised its key overnight policy rates to 3.25% in early September, the highest since 2008. Oil prices continued to bleed in August, dropping from $98.62/bbl to $89.5/bbl as the U.S. uses emergency oil reserves to temporarily alleviate supply concerns (more below). The Greenback continued its ascent (Chart 2) to a new cyclical high (DXY Dollar Index, +2.8%), making it a top asset year to date. The loonie also suffered from the strong appetite for the Greenback (-2.6%) despite the BoC being the most hawkish central bank this year. High-yield corporate spreads (vs Treasuries) only marginally rose during the month (from 4.69% to 4.84%) as U.S. economic data signals slowing, but positive growth into the third quarter, thereby diminishing fear of an imminent recession and corporate default. Finally, as the S&P 500 fell, the VIX volatility index rose slightly to 25.87%, showing that investors are not overly anxious about equities.

Chart 2: The Unstoppable Greenback

Graph with data
Source: Bloomberg, BMO Global Asset Management, as of September 8th, 2022.

Europe Outlook: Increasing risks for a winter chill

Europe’s supplies of natural gas are increasingly jeopardized as Russia weaponizes energy and turns to economic war in retaliation against economic sanctions (Source: Reuters). While European countries agreed to a 15% gas savings plan (Source: SP Global) and they seek to protect their industries from energy-supply disruptions, we nevertheless expect economic activity to be negatively impacted beyond the upcoming winter unless a peace deal is reached over Ukraine, but this optimistic scenario appears unlikely at this point. To help households and businesses avoid paying stratospheric spot energy prices (Chart 3), European countries are rolling out extraordinary subsidies (Source: Bloomberg). While subsidies will partially shield energy consumers from shocking energy bills, the true economic cost is likely to be measured in excess of $1tn, which will add to the inflationary dynamics and require governments to increase their projected deficits and bond issuance.

Chart 3: Soaring Natural-Gas Prices More Painful for Germany Than The U.S

Graph with data
Source: Bloomberg, BMO Global Asset Management, as of Sept 8th, 2022 *mmbtu: per million British thermal units.

Oil Outlook: What happens when the U.S. is done draining Strategic Petroleum Reserves?

Oil prices have struggled in recent weeks as the recession risk increases alongside China’s stop-n-go Zero-COVID policy, and as investors debate the demand/supply outlook for oil. While U.S. commercial oil inventories have stabilized recently, the depletion of U.S. Strategic Petroleum Reserves (SPR) are largely responsible for preventing oil inventories from collapsing, in our view (Chart 4). In April, the Biden Administration announced plans to release up to 260 (over one million barrel per day, for six months, expiring in October) millions of barrels of oil from its SPR to bring down inflation ahead of the Mid-Term elections. With the emergency oil release plan nearing its course and SPR are set to reach early 80s low, we think the oil market will soon shift back to focusing on the supply side, which should drive oil prices up. Lastly, the Organization of the Petroleum Exporting Countries (OPEC) has voiced its concerns over oil prices falling below 100$ and Saudi Arabia recently began curtailing output to steer oil markets higher.

Chart 4: Are Oil Inventories Set to Fall Once SPR Releases Expire?

Graph with data
Source: Bloomberg, BMO Global Asset Management, as of September 2nd, 2022 data.

Outlook and Positioning: Pulling out safety measures as markets remain turbulent

Our view on the equity and bond outlook calls for prudence in the near term and we remain underweight to both asset classes while maintaining a large overweight to cash. The economic outlook, while not suffering from a sudden stop, continues to cool as central banks are set to push interest rates higher, which should bring the pace of economic growth to a crawl and ultimately weigh on corporate earnings and profit margins as we roll into 2023.
Across regional equity markets, we remain overweight of Canadian equities as we continue to expect firm oil prices into year-end and think the slowing housing market will have a minimal impact on the relative performance of Canadian equities. We remain neutral on U.S. and EM equities and underweight to EAFE equities. Our outlook for Europe remains clouded by the energy supplies, which should weigh on earnings and European currencies.
On a sector basis within the U.S equity market, we remain overweight to energy, healthcare, and tech. We are maintaining a currency hedge against the U.S. Dollar. Within fixed income, we have a small underweight to interest rate duration while we reduced our exposure to the riskiest corporate bonds in favor of investment grade credit. Finally, our fixed-income heavy portfolios are underweighted to credit to reflect our more defensive view of the markets.


BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc. and BMO Investments Inc.

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. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

The portfolio holdings are subject to change without notice and only represent a small percentage of portfolio holdings. They are not recommendations to buy or sell any particular security.

Forward-Looking Statements Certain statements included in this news release constitute forward-looking statements, including, but not limited to, those identified by the expressions “expect”, “intend”, “will” and similar expressions. The forward-looking statements are not historical facts but reflect BMO GAM’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. Although BMO GAM believes that the assumptions inherent in the forward-looking statements are reasonable, forward-looking statements are not guarantees of future performance and, accordingly, readers are cautioned not to place undue reliance on such statements due to the inherent uncertainty therein. BMO GAM undertakes no obligation to update publicly or otherwise revise any forward-looking statement or information whether as a result of new information, future events or other such factors which affect this information, except as required by law.

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