- The conflict in Ukraine keeps on raging, but fear of an escalation has come down. However, the impact on commodity prices will continue as prices remain elevated and long-term supply remains an issue, most notably for Europe and other commodity importing countries.
- We expect the ongoing regional macro divergence to continue into 2023 as the economic outlook of North America remains more resilient than Europe, Australasia, and the Far East (EAFE) and Emerging Markets (EM) China’s growth concerns are persisting as COVID-19 spreads and lockdowns weigh on economic activity.
- We remain modestly overweight equities versus fixed income. On a regional basis, we remain biased toward Canadian equities, neutral on U.S., and underweight to EAFE and EM equities. We remain underweight on bond duration. This is a longer-term call as we still expect short-term volatility.
- On a sector basis, we remain overweight U.S. financials, the energy sector, and the international travel sector.
“Those who keep learning will keep rising in life.” — Charlie Munger
Fear of War is Coming Down, but Fear Over the Fed’s Soft-landing is Rising
Although war keeps raging with brutality in Ukraine, fear over an escalation of the conflict have steadily come down in recent weeks. For investors, the number one concern now is whether the Fed can successfully achieve a soft-landing of the economy while leaning against the hot inflation. We expect the recession narrative to get louder into the summer, but we think this could be another moment where investors turn too bearish when eying the flat 10yr-vs-2yr U.S bonds. Treasury yield curve as a predictor of recessions. We agree that headwinds to global growth are mounting, especially in Europe, but we see more resilience from the U.S. economy. We think Canada’s economic outlook growth could surprise to the upside, thanks to what could be a multiyear commodity boom. Meanwhile, China is struggling with COVID-19 and its zero-COVID policy has led to renewed lockdowns, which will weigh on growth.
Global Markets in March: Equities bounce from the lows while yields continue to push higher
Global equities (MSCI ACWI, +2.2%) managed to rebound as the fear of an escalation in Ukraine has abated. Canadian equities (S&P TSX, 4.0%) outperformed as commodity prices continued to rise because of tensions with Russia. U.S. equities (S&P 500, +3.7%) also outperformed despite mounting expectations for Fed rate hikes into 2023. Tech leaders (Nasdaq 100, +4.3%) helped the rebound while they continue to lag year to date. Meanwhile, U.S. small caps (Russell 2000, +1.2%) underperformed as mounting fear of a Fed-induced recession weighed on the more economically sensitive area of the market. EAFE (MSCI EAFE, +0.7%) equities lagged their global peers as they are negatively exposed to rising commodity costs and the economic sanctions against Russia. The weakest area of global equities in March was emerging markets (MSCI EM, -2.3%), which suffered both from the marked down to zero of Russian equities and the spreading of COVID-19, which drove Chinese equities (MSCI China, -7.8%)
to steep losses.
As central bankers at the Fed and Bank of Canada (BoC) warm up to a steep hiking cycle, bond yields continued to rise in March, leaving fixed income assets off to one of their worse quarterly performance. The yield on Canada’s 10yr bond jumped from 1.81% to 2.40% while rate-hike expectations rose on hawkish remarks from the Fed and BoC. Fear over oil supplies help push oil
prices higher from $95.72/bbl to $100.28/bbl but touched a high of $130bbl during the month. Although risk sentiment improved in March, the U.S. Dollar (DXY Dollar Index, +1.7%) continued to climb along with commodity exporting currencies as the themes of monetary-policy tightening and commodity-inflation penalized commodity-importing currencies such as the Japanese Yen or the Euro-area currency. The Canadian Dollar gained an impressive 7.3% vs the Yen and 2.7% vs the Euro, which added to the weakness of EAFE assets. Finally, the VIX volatility index enjoyed a rollercoaster ride along with investor fear during the month, peaking at 36% before ending the month at 20.6%, reflecting a prudent but constructive outlook on expected equity risk. We continue to foresee higher-than-normal market volatility as the expected degree and pace of monetary-policy tightening remains uncertain, while inflationary pressures show little signs of cooling.
Global Markets: Inflationary Cycle Fueling Renewed Macro Divergence Diverging economic trajectories from commodity cycle
The COVID-induced macroeconomic cycle created a largely synchronized wave across major developed economies, which limited cross country opportunities until mid-2021. As we exit the COVID-induced economic cycle and NATO/Russia tensions challenge the global economy with elevated commodity prices and supply disruptions. We expect regional divergences for economic growth and earnings expectations to continue playing into 2023. The impact of rising commodity prices is being felt unevenly across countries, depending on whether a country exports or imports commodities.
For countries like Canada, Australia, or Brazil, whose economy heavily depends on commodity exports, the current backdrop provides a powerful economic tailwind. By contrast, heavy commodity importers such as Japan, EM/China, Germany, or the U.K., face a deteriorating trade balance, and thereby, a slower growth outlook. This is well reflected by the more meaningful negative revisions to Bloomberg consensus estimates for 2022 economic growth (Chart 1) where large commodity importers have seen their growth expectations revised lower, except for the already slow-growth Japanese economy. Meanwhile, Canada has only seen minor growth revisions and we suspect consensus estimates to err too pessimistically as the Canadian economy maintains strong momentum. News of approval of Bay du Nord oil field also points to renewed commodity-related activity (Source: Global News).
Chart 1: Revisions to 2022 Real GDP Growth Consensus Estimates Since September 1st, 2021
Source: Bloomberg, BMO Global Asset Management, as of April 7th, 2022.
Diverging monetary policies and yields
Strongly diverging macro trends have translated into diverging market performance. One major divergence has been the rise of the 10-year U.S. Treasury yield as the Fed has begun a battle against inflation, whereas China’s 10-year bond yield has been falling on disappointing economic growth since 2021 (Chart 2). We expect U.S. and Canadian yields to continue push higher as
both the Fed and BoC have room to hike and lean against inflation. Meanwhile, China remains set to ease monetary policy whereas the European Central Bank (ECB) will struggle to keep up with the Fed or BoC in its upcoming tightening cycle.
Chart 2 Diverging Economic Trend Causing Converging Yields Between the U.S. and China
Source: Bloomberg, BMO Global Asset Management, as of April 8th, 2022
Diverging earnings trajectories
Since global growth expectations have begun cooling, regional equity markets have largely aligned with the relative growth concerns. With Europe’s economic outlook more at risk of an imminent recession, the outlook for European equities will remain subdued while most other EAFE countries will face similar headwinds. In EM, China’s economic performance remains a concern and with a weight of about 28% in the MSCI EM index, we expect the performance of Chinese equities to continue weighing on the EM complex.
Chart 3: Asynchronized Regional Equity Markets (in CAD$ terms) Since September 1st, 2021
Source: Bloomberg, BMO Global Asset Management, as of April 8th, 2022
Outlook and Positioning: Growth outlook slowing, not derailed
As the Fed hikes and leans against inflation in 2022, we think concerns over the Fed realizing a soft-landing of the U.S. economy will keep risk sentiment in a more cautious stance into the summer. We expect the U.S. earnings season to deliver strong revenue growth, thanks to high inflation, but profit margins could shrink modestly as cost pressures mount and the strength of consumer demand peaks. For fixed-income assets, we still expect some pain ahead as yields have yet to peak. This backdrop leaves our asset mix with a modest overweight of equities vs bonds.
Regionally, we continue to prefer Canadian equities. We are neutral on the U.S while we remain underweight of EAFE and EM equities. On a sector basis, we remain overweight of U.S. financials, U.S. energy, and international travel sectors. Within fixed income, we are underweight interest-rate duration.
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