March Monthly MAST Commentary: Helicopter Money and Reflation Hype Fuels Bond Tantrum

The vaccine rollout is accelerating, and further U.S. fiscal stimulus remains on track to be delivered soon, which is helping lift growth expectations.
March 2021


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  • The vaccine rollout is accelerating, and further U.S. fiscal stimulus remains on track to be delivered soon, which is helping lift growth expectations. Our highest conviction call remains the overweighting of equities versus fixed income (Source: Bloomberg).
  • Because the rise in long-term interest rates has been largely driven by fast improving expectations for economic growth rather than hawkish central banks, we think equities can endure some upside in interest rates.
  • Within equity factors, we continue to prefer small-cap stocks to benefit from fiscal stimulus and the strong position of households, most notably in the U.S.
  • We remain overweight to strong economic growth markets such as U.S. and Emerging Markets (EM) equities over Canadian and Europe, Australasia, and the Middle East (EAFE) markets, while overweighting IG corporate bonds versus low-yielding government.
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I’d throw dollars out of helicopters if I had to, to stimulate the economy.

Ben Bernanke (2012)

Long-dated government bond yields surged last month as U.S. economic momentum keeps surprising to the upside. Meanwhile, fiscal stimulus (between $1.4 trillion to $1.9 trillion for the U.S. alone) and helicopter money is feared to drive the economy into overheating. Although the better-than-expected earnings and economic data comforts our overweight to equities, the sudden spike in long-term government bond yields was surprising and caused some equity turbulence. That said, the backup in real yields (with 10-year U.S. real yields rising roughly 30 basis points (bps) in February) has not led to a sharp tightening in financial conditions. Instead, the move coincided with higher oil and equity prices and tighter credit spreads while the dollar is little changed. This is by definition a reflation trade and in that case, the main concern to investors appears to be the speed of the move, not the direction. While we expect U.S. economic growth to clock perhaps as high as 7% in 2021, the uneven nature of the recovery and amount of labour-market slack that might persist into 2022 limits the scope for a sustained overshoot of inflation via wage inflation, although ongoing supply-chain disruptions may continue to put upward pressure on some prices. However, we expect base-effects to momentarily drive the year-over-year pace of headline inflation in the vicinity of 3% to 3.5% by the summer, but this is also well expected by the consensus (Source: BMO GAM).
Higher inflation can hurt equities from two angles: i) negative pressure on profit margins from higher production costs and/or ii) tighter financial conditions that slow the pace of economic growth as central bank respond to the threat of rising inflation expectations. But with the Fed aiming to achieve maximum employment before tightening policy on inflation, rate hikes are unlikely until the Fed is confident that longer-term inflation expectations have shifted up and they have confirmation that the economy and labour market have truly reached peak capacity. For Canada, long-term yields on federal debt are already in the lower range of the Bank of Canada’s terminal-rate assumption (1.75%-2.75%), which should act a headwind against a sustained upward trend in long-term interest rates as the labour market remains in healing mode.

Global Markets: Upside despite storming bond yields

Global equities (MSCI ACWI, +2.3%) registered a decent positive month despite facing some late-month turbulence from surging long-term interest rates. Most regions were up in February, led by Japanese (Nikkei, +4.8%), continental Europe (Eurostoxx, +4.5%) and Canadian (S&P TSX, +4.4%) equities as these more value-oriented regions are less negatively exposed to rising interest rates than growth-oriented regions like the U.S. That dynamic was well reflected within U.S equities as Nasdaq 100 shares were flat on weak mega-cap tech performance in February while the S&P 500 gained 2.8% on breadth outside the mega-tech, most notably from smaller companies (Russell 2000, +6.2%). Emerging equities (MSCI EM, +0.8%) were little moved as the rally in Chinese shares stalled as high-frequency macro indicators point to a peak in growth momentum.
After only gradually rising since the pandemic lows, long-term interest rates in Canada and the U.S. spiked in February. The yield on Canada’s 10yr bond jumped to 1.36% (from 0.89%) after a stunning intra-month peak of 1.46%. For fixed-income heavy investors, the benchmark was down (BMO Aggregate Bond Index ETF, ticker: ZAG, -2.6%) for a second consecutive month and is now down -3.7% year to date. Oil prices jumped to $61.50pb (from $52.20) as demand improved and inventories continued to normalize while freezing weather also disrupted production in the U.S. The strong U.S. economic performance helped drive the Greenback (Dollar Index, +0.3%) a little higher for a second consecutive month, while solid commodity prices helped the loonie climb 0.3% versus the USD, and 0.8% versus the Euro as interest rates remain well anchored in Europe. The VIX volatility index remained higher than normal but was down in February, ending at 28% (from 33%). We continue to think the VIX points to cautious equity positioning, which should help support further equity upside as stronger economic growth and earnings are confirmed into 2022.

Global Equity Factors: Reflation hope giving Value a shot in the arm

The bond turmoil created some action across global equity factors. Small-Cap (+3.3%) stocks, our favourite cyclical play within equity factors, maintained their outperformance versus global stocks (MSCI ACWI, +2.3%). Value (4.5%) was the best performing global equity factor in February as the reflation theme grew louder. Momentum (-2.1%) reversed its strong January while Low-Vol (-1.6%) stocks registered a second negative month and continue to lag other factors as expectations point to strong economic growth. Finally, Growth (+0.2%) was flat while Quality (+1.1%) and High-Div (+1.3%) were up but also lagged global equities given their less cyclical nature.
Canadian Low-Vol (BMO Canadian Low-Volatility Equity ETF, ticker: ZLB, +1.1%)* stocks underperformed the broad BMO S&P TSX index (ticker: ZCN, +4.1%)** in February as reflation turbo-charged the energy complex (BMO Equal Weight Oil and Gas Index ETF, ticker: ZEO, +13.2%)***. Bank earnings were strong as we expected, which drove banks to a strong month (BMO Equal Weight Bank Index ETF, ticker: ZEB, +8.0%)****, but certain tailwinds like trading activity or real-estate activity could be running on a high plateau from here, rather than grow much further.

Can too Much Bond-Yield Optimism Derail the Equity Rally?

While equity prices were quick to recover from the pandemic lows, North American bond yields only found their V-shaped recovery since last August and mostly surged since late January as improving expectations of economic growth have stoked fears of accelerating inflation. An even more pronounced move has taken place in the slope of the 2-30yr North American yield curves as central banks are not expected to raise their policy rates for a long time while economic activity is expected to run hot into 2022 given the aggressive fiscal stimulus, especially in the U.S.. Unlike cycles where bond yields are pressured higher by hawkish central banks (e.g., 2018), this time around the move in yields is entirely driven by good economic news, which is why we believe the equity rally can endure some upside in interest rates.

Gold: A dimmer outlook but still room to shine

Gold has struggled in the face of rising interest rates and despite of higher inflation fears. While gold can be viewed as an inflation hedge, it is its correlation with real yields that matters more. We have flagged higher real yields as the greatest threat to gold performance given its relatively high correlation since 2018. Negative interest rates sharply reduce the opportunity cost to holding gold, and even though real yields are still negative, reflation hopes are raising concerns that they may soon turn positive. We think these concerns are overdone as the labour market is unlikely to rebound sharply back to pre-COVID-19 levels even with the lifting of mobility restrictions this year. The Fed’s dovish stance—with a QE taper unlikely to be announced until the end of this year– is therefore likely to keep real rates capped in negative territory for now.

Meanwhile, the decline in the U.S. dollar, which shares a steady negative correlation with gold over time, has levelled off so far this year as the reflation trade has pushed up higher-yielding currencies like the loonie at the expense of low yielders like the Euro. U.S. growth outperformance may also limit the extent of U.S. Dollar weakness. A more nuanced U.S. Dollar outlook is thus another headwind for gold this year. Taken together, real yields and the U.S. dollar, the key tailwinds for gold in 2020, are now set to be headwinds this year. But given limited scope for much higher real rates along with uncertainty over inflation, we are arguably still in the expansion phase of the cycle which argues for a small, diversifying allocation to gold, which we think is best funded by fixed-income, notably by government bonds.

Should Investors Fear the Warning of Buffet’s Favourite Stock Market Indicator?

The stock-market-cap-to-GDP ratio, known as the Buffett Indicator, is analogue to the price-to-sales ratio for the entire country. The Buffet Indicator for the U.S. equity market has been steadily rising in the past year as the economy shrank and stock prices surged to record highs. Meanwhile, the ratio for Global or Canadian equities also rose in recent months, but they remain well within their historical norm, suggesting U.S equities are in rich territory vs Canadian or Global equities.

We think three key reasons help explain this relative difference. First, monetary policy has been the most aggressive in the U.S., with the M2 monetary aggregate surging by 24.6% in 2020, compared to 18.2% in Canada, and only 10.9% in the Euro-area and 9.1% in Japan. Second, the global dominance of the U.S. tech sector has allowed them to capture global market shares and they have a much higher share of sales (60%) from abroad than the share of foreign sales for S&P 500 companies’ total revenues (30%). Finally, growth expectations for the U.S. economy are well ahead of other major developed economies, which should support a stronger earnings outlook, and thereby a higher valuation.

Outlook and Positioning: Staying the course on the recovery

Vaccination remains the tide that will lifts all markets into 2022 as COVID-19 lockdowns soon become a thing of the past. U.S. fiscal stimulus will also provide extra fuel to ensure a strong recovery. Our highest conviction call therefore remains the overweighting of equities versus fixed income given the strong macro backdrop. We remain slightly overweight U.S. and EM equity markets versus Canadian and EAFE markets. Our steady pro-risk stance maintains an overweight to IG corporate bonds to Federals although spreads are quite tight. Finally, we are hedging against downside surprises with a small duration overweight to our equity-heavy portfolios, whereas our more fixed-income oriented portfolios are underweight duration to reflect our pro-risk stance.

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* The performance for (ZLB) for the period ended February 26th, 2021 is (as follows: 3.09% (1 Year); 7.29% (3 year); 7.93% (5 year); and 11.75% since inception (on October 21st, 2011).

**The performance for (ZCN) for the period ended February 26th, 2021 is (as follows: -14.90% (1 Year); 8.77% (3 year); 10.35% (5 year); 5.38% (10 year);  and 7.22% since inception (on May 29th, 2009).

*** The performance for (ZEO) for the period ended February 26th, 2021 is (as follows: -2.42% (1 Year); -6.93% (3 year); -4.38% (5 year); -7.79% (10 year); and -5.38% since inception (on October 20th, 2009).

**** The performance for (ZEB) for the period ended February 26th, 2021 is (as follows: 17.73% (1 Year); 6.48% (3 year); 13.09% (5 year); 9.44% (10 year); and 10.52% since inception (on October 20th, 2009).


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