- Inflation remains a concern for investors, but we think the aggressive rate-hiking cycle of central banks will push major developed economies into a recession in 2023. Meanwhile, the U.S. labour market remains tight, which supports the need for more Fed hikes, but there too hiring is on a cooling trend.
- Because of our concerns about the three-to-twelve-month economic outlook, our portfolios remain tilted defensively. We recently increased our underweight to equities while upgraded fixed income to neutral. We remain overweight of cash.
- Across regional equity markets, we remain overweight of Canadian equities and neutral on U.S. and Emerging Market (EM) equities, but we increased our underweight of Europe, Australasia, and the Far East (EAFE) equities, which we think remains the most vulnerable region to the ongoing macro backdrop.
- On a sector basis within the U.S equity market, we remain overweight to energy, healthcare, and tech. Within fixed income, we reduced our credit exposure.
Will the Fed and Major Central Banks Tighten Until Something Breaks?
September was another eventful month for investors as global equities and bonds were rattled by hawkish central banks and the twin rout of equities and bonds continued. The most disturbing market events of the month came from the U.K. where the proposal for a budget tabling on an inflationary, debt-financed mix of higher spending and tax cuts created a flare of sudden sovereign risk. The shock even forced the Bank of England to temporarily resume its bond purchasing program to support a bid-less Gilts market. Meanwhile, the resilience of the U.S. labour market, with strong job gains of nearly 3.8 million jobs year to date, is leaving the economic outlook in a delicate balance because the stronger the job market performs, the more the Fed needs to “keep at it” with its hiking cycle. This dynamic is gradually ruling out the odds of a soft landing, in our view. Adding to the global grind has been the unstoppable rise of the US Dollar against every major developed and emerging currencies this year, which is contributing to the tightening of global financial conditions while exporting inflation out of the U.S.
While the economic outlook continues to darken because of the fast pace of monetary tightening, coupled with a large energy shock, there are increasing financial strains in the global economy, especially in the U.K. and Europe where stress is rising (Chart 1). This means the window for central-bank hikes and balance-sheet reduction could narrow as market forces risk exaggerating the tightening cycle. Because of inflation concerns, major central banks could continue with rate hikes into early 2023 but plans to reduce their balance sheet could be paused to avoid an escalation of the market turmoil in sovereign bonds (Chart 2).
Chart 1: Financial Strains Are Emerging in European Banking Sector*
Source: Bloomberg, BMO Global Asset Management, as of October 12, 2022. *Calculated as the average of BNP, Credit Suisse, Deutsche Bank, Unicredit, Societe Generale, Barclays.
Chart 2: Fast Rising Global Sovereign Starting to Cause Broader Turmoil
Source: Bloomberg, BMO Global Asset Management, as of October 12, 2022.
Global Markets in September: Powell is not a friend to equities and bonds
Global equities (MSCI ACWI, -9.5%) fell sharply in September as the economic outlook continues to darken because of the aggressive monetary policy tightening. In local terms, U.S. equities were the weakest with broad weakness across segments of the market. The S&P 500 fell 9.2% while small caps (Russell 2000, -9.6%) and tech-heavy Nasdaq 100 (-10.5%) registered similar losses during the month as rising rates pressured valuations while earnings expectations continued to fall. Elsewhere, European and U.K. equities (Euro Stoxx 50, -5.5%; FTSE 100, -5.2%) outperformed although currency fluctuations shaved some of the relative outperformance. Emerging market (MSCI EM, -11.7%) equities fell the most in September, again pulled lower on weakness from China (MSCI China, -14.5%). Finally, Canadian equities (S&P TSX, -4.3%) outperformed as banks barely fell during the month.
Although yields on government debt jumped across most major Western economies, the yield on Canada’s 10 year Federal bond only modestly rose from 3.12% to 3.18% as Canadian economic indicators disappointed, revealing a faster-than-expected cooling of the economy. With the Fed expected to hike rates above 4.5% and an economy that remains “too hot”, the Greenback (DXY Dollar Index, +3.1%) rose for a fourth consecutive month, the eighth month this year. The USD Dollar has gained 17% year to date. The loonie (-5.1%) registered its steepest loss since 2015 as weakening Canadian data and falling oil prices weighed on the currency. Oil prices (Western Texas Intermediate, -11.2%) fell sharply as fear of a global recession rose.
While equity performance is deeply negative this year, we have not seen panic selling in markets and this slow grind lower of equities has left the VIX volatility index above 20%. But because equities have bled, not crash, the VIX has thus far avoided the large, panic-driven spikes above 40-50% which often leads to investor capitulation and market bottom. The VIX ended the month at 31.6%, up from 25.8%, which signals that investors remain cautious as the macro backdrop slowly worsened this year.
Canada Outlook: Housing market is a manageable concern
So far in this hiking cycle, the housing market is in the eye of the hiking storm as prices and resales activity continue to cool sharply in Canada and the U.S. For Canada, housing is a key concern for investors given its contribution to the Canadian economy in recent years, and because of how much prices have increased since 2019. The elevated debt load of households (Chart 3) is a well-known vulnerability for Canada and the ongoing interest-rate shock will inflict pain on households via a rising debt-servicing ratio, which will amplify the “discretionary” recession. However, the tight labour market is a key factor that should allow those households with variable or resetting mortgages to absorb the severe shock. As the Canadian economy is increasingly likely to roll into a recession in coming months, we continue to expect a mild wave of layoffs as firms struggle to find and retain workers. Having a paycheck remains the best cushion against the inflationary and interest-rate shock. For the Bank of Canada, the lingering inflation means that it should hike above 4% by year-end, perhaps even to 5% into 2023, but the policy path will largely depend on how fast the economy responds to the crushing interest rates.
Chart 3: Canadians are Carrying Elevated Debt Load for Several Years
Source: Bloomberg, BMO Global Asset Management, as of 2022 Q2 data.
Equity Outlook: Short- vs long-term considerations
The S&P 500 index fell nearly 25% January and September, largely through cheapening valuation because of rising interest rates and rising odds of recession. In most market environments, a 25% drawdown would lure dip buyers, but the current context remains very different than the previous couple decades where inflation was low and relatively stable, which gave the Fed ample way to steer the economy and markets in a smoother, more balanced way. Although we expect the global economic outlook to worsen into early 2023 and equity markets to remain choppy as monetary policy remains highly uncertain, we think longer-term equity investors should slowly warm up to equities as they tend to bottom early through the recession cycle, not late. Similarly, fixed-income investors can also expect a more encouraging outlook now that yields have backup so much since their 2020 lows.
Outlook and Positioning: Safety continues to rule asset allocation
Our portfolio positioning remains defensive in this very challenging environment. We increased our underweight of equities, but because we think we are approaching peak expectations for monetary-policy tightening, we upgraded fixed-income to neutral, while remaining overweight to cash. 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. We increased our underweight to the EAFE block. Our outlook for Europe remains clouded by 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. Finally, within fixed income, we are underweighted to the riskiest corporate bonds.
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