February MAST Asset Allocation Outlook: Pandemic Fear Bruises Stock Rally

As we continue to expect the economic damage from the virus to be short-lived and earnings to re-accelerate into 2020, we are maintaining our moderate overweight to stocks versus bonds, hedged with a small overweight to duration.
February 2020
  • Middle-East tensions and coronavirus fears spoiled the stock-market rally in January, but we think the economic and market impact will be short lived as a global pandemic will be avoided. European and EM stocks suffered the most from corona anxiety.
  • The outlook remains more fragile outside of North America and the tailwind from Phase One trade deal will be delayed. U.S. soft-landing economic outlook confirmed by near-trend growth. Company earnings surprised to the upside, notably in the U.S., setting the stage for 2020 re-acceleration, supported by Phase-One and loose monetary policy.
  • The Canadian economic outlook could remain weak enough to warrant reluctant BoC rate cuts. Canada needs a more pro-growth fiscal policy, not more cheap credit.
  • Our overall mid-term outlook remains intact believing coronavirus is not going global and will be mostly a First Quarter (Q1), China event. We remain overweight stocks versus bonds, hedged with duration. We continue to expect U.S. stocks to outperform EAFE. Energy stocks could be another Value trap for investors.

“If you’re afraid to fail, then you’re probably going to fail.”

– Kobe Bryant

Pandemic Fear Bruises Stock Rally

Just a month into 2020 and investor’s resilience continues to be tested. Kicking off the New Year, investors faced the killing of a top Iranian general by the U.S. Thankfully, de-escalation was quick. The biggest challenge, which remains ongoing, was the coronavirus outbreak in China that brought nearly a fifth of its economy to a halt after extreme lockdown measures were implemented. Many pundits have pointed to the market weakness around the 2002/03 SARS crisis as an analogue to the coronavirus.  However, we would note that markets were likely more burdened by the Iraq War while the U.S. economy was showing signs of fatigue in 2002 with a rising unemployment rate. Today’s backdrop is healthier with U.S. growth above trend and a record-low unemployment rate. However, China is a much greater influence to global Gross Domestic Product (GDP) and stocks than it was in 2002. Relying on previous pandemics to plot a potential roadmap for investors may therefore prove of little use to investors.

For China, the virus outbreak delays the tailwind of Phase One and will likely lead to very poor Q1 economic data. But what matters most for investors is that episodes of pandemic fear tend to have short-lived economic and market impact, unlike the more powerful forces of fiscal and monetary policy, which will remain a tailwind in 2020. For long-term investors, the challenge is to avoid distractions from this unpredictable noise. For us, this means a close monitoring of our core thesis of gradually improving fundamentals and earnings re-acceleration in 2020. We expect a short-lived impact and believe a global pandemic will be avoided, but we are closely watching the outbreak.

We note some key developments supporting our bullish base case. First, the U.K. finally left the European Union while the Canada-United States-Mexico Agreement (CUSMA) moved a step closer to ratification. U.S. Q4 real GDP growth surprised to the upside at 2.1%, whereas U.S. earnings came in about 2% better than expected along with positive guidance.

Earnings, Guidance Keep North-American Stocks in the Green in January

Global stocks (MSCI ACWI Index) had a bumpy month end, falling -1.1% in January and pulled down by weak performance in Europe and Asia. After a soft Q4, Canadian stocks outperformed most major markets in January (S&P TSX, +1.7%). When Asia or Europe struggles, Canadian stocks tend to benefit from their close U.S. ties. U.S. stocks were flat (S&P 500, 0.0%) last month, but stellar earnings for mega-caps firms propelled tech-heavy Nasdaq-100 stocks with a 3% gain. Corona anxiety shook European stocks (MSCI Europe, -1.3%) where the earnings outlook remains subdued. Emerging Markets (EM) stocks fell sharply (MSCI EM, -4.7%) as near-term expectations for China’s economic growth were heavily impacted by drastic measures to contain the virus.

After surging on year-end optimism, global government bond yields collapsed in January. In Canada, the yield on 10-yr government bonds ended the month at 1.27%, down 43bp, but still above the August 2019 low of 1.09%. While part of the move can be attributed to Governor Poloz’s dovish pivot (Source: Bloomberg), the majority of the move can be attributed to geopolitical and corona fears. The loonie got a gravity test (-1.9%) last month as the BoC lowered the bar to easing and investors flocked to the safe-haven assets. The U.S. dollar (DXY) remained king, gaining 1.0% as most major currencies were down. Finally, WTI oil prices fell 15.6% in January, and about 20% from their post Iran-flare top.

Equity Factors: Virus speed bump is (more) bad news for Value stocks

Equity-factors performed unevenly in January, mirroring the regional dispersion. Value stocks (-3.4%) suffered from a double-blow of global-growth uncertainty and strong earnings by tech companies, which helped Growth (+1.2%) stocks register a gain. Low-Vol (+2.0%) and Momentum (+2.3%) outperformed even more while High-Div stocks (-2.8%) fell as investors added to growth-seeking sectors.

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, 3.5%)* rebounded and outperformed the broad market BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN, +1.7%)*. While events like the coronavirus are unpredictable, our conviction on Canadian Low-Vol stocks remains intact to navigate uncertain markets and limiting the cyclical exposure of the energy sector.

Canadian Energy Stocks: What will it take to get back their mojo?

Global and Canadian energy stocks had a positive 2019 but still underperformed broad market benchmarks despite a 35% surge in oil prices. Since 2004, the Canadian energy sectors has rarely outperformed outside episodes of +50% spikes in oil prices (Chart 1). Because the underperformance has been so prolonged, identifying the catalysts for a reversal is not easy. While the carbon tax and the supply glut are negatives for the sector, the underperformance clearly predates these factors. Cheap money has led to an investment boom in energy extraction, thereby creating excess-supply, forcing OPEC+ members to try to artificially boost prices by restraining supply, but with limited success. The trends toward Environmental, Social, Governance (ESG) investing and de-carbonization mean long-term investors have less appetite for the sector. Oil demand is forecasted to peak before the end of this decade. Finally, the brutally volatile nature of the energy cycle means quality- or low-vol-focused investors will not seek to own the sector. For these reasons, we remain sceptical that the sector can outperform on a sustained basis and think investors should be cautious of those risks when considering an overweight to the sector. It could be another Value trap.

Chart 1: Lasting Relative Pain for Canadian Energy Sector

February MAST Asset Allocation Outlook - Chart 1 - Lasting relative pain for Canadian energy sector

Source: BMO GAM, Bloomberg

Fed Policy: Patience as virus fears wane

Market-implied odds of Fed rate cuts in 2020 jumped alongside the anxiety over the coronavirus. Meanwhile, the Fed’s recent communications signaled a policy shift toward inflation averaging, reinforcing our “lower-for-longer” interest-rate outlook. While the impact on Chinese growth from the coronavirus should be large but short lived, the impact on global and U.S. growth should be modest. This means the Fed has some room for patience. However, the bar for more pre-emptive cuts is relatively low given the lack of inflation coupled with scope for sub-trend growth into June. A further rate cut or two may be necessary as insurance to extend the cycle. Boeing’s production cuts will shave nearly 0.5% to Q1 U.S. GDP growth (Chart 2), but manufacturing surveys are finally showing signs of expansion (Source: Bloomberg).

Chart 2: Soft Landing in the US, Muddling-Through in Canada

February MAST Asset Allocation Outlook - Chart 2 - Soft landing in the US, Muddling Through in Canada

Source: BMO GAM, Bloomberg

Canadian Outlook: 2-speed economy to persist

Our base-case for the Canadian economic outlook remains a muddle-through scenario, but depending on the region or the employment sector, perception of growth may vary. The divide is most evident when breaking down the employment data. Employment in the service sector has remained bullet proof in recent years whereas goods-producing jobs have struggled to gain traction since 2014 (Chart 3). A similar phenomenon is observed when comparing employment in the largest metropolitan areas of Canada versus non-urban areas. While recent economic growth performance has been lackluster, we continue to argue that a credit-constrained economy needs more pro-growth fiscal policy rather than rate cuts. Still, the growth re-acceleration might prove too slow in coming months and maybe Governor Poloz will get to reluctantly cut before leaving the Bank in June.

Chart 3: No Cracks in Service-Sector Jobs

February MAST Asset Allocation Outlook - Chart 3 - No Cracks in Service-Sector Jobs

Source: BMO GAM, Bloomberg

Outlook and Positioning: Looking through the corona

As we continue to expect the economic damage from the virus to be short-lived and earnings to re-accelerate into 2020, we are maintaining our moderate overweight to stocks versus bonds, hedged with a small overweight to duration. Regionally, we remain overweight U.S. stocks versus EAFE. We also continue to prefer safer investment grades corporate bond to riskier and higher yield debt.

The loonie has undone some of its exuberating strength, falling back closer to $0.75. The scope for BoC cuts while the Fed and other major central banks are on pause means the loonie should weaken more, but breaking through $0.73 this quarter would require a surprising deterioration of the Canadian outlook along with sub $45 oil prices.

For the near term, confirmation that the coronavirus is largely contained to the Hubei province of China will be key, but we expect transitory collateral damages to global supply chains followed by a strong V-shaped recovery in China.


*The performance for (ZLB) for the period ended January 31st, 2020 is (as follows: 18.79% (1 Year); 10.69% (3 year); 8.69% (5 year); and 13.72% since inception (on October 21st, 2011).

*The performance for (ZCN) for the period ended January 31st, 2020 is (as follows: 14.95% (1 Year); 7.17% (3 year); 6.50% (5 year); 7.19% (10 year); and 7.18% since inception (on May 29th, 2009).

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