September Monthly MAST Commentary: Tech Keeps on Rocking While Fed Keeps Its Inflation Wish Alive

  • Equities powered forward in August as bond yields rose and U.S. dollar depreciation continued. U.S. leadership remained intact, consistent with continued outperformance in tech and Growth stocks.
  • European and Canadian stocks remained laggards despite better performance in cyclicals. Emerging Markets (EM) performance took a step back on tech wars. Republican election odds improved; going forward, polls may expose markets to increased volatility through November.
  • Even after an impressive rally this year, corporate credit remains attractive in our view. Credit purchases have room to be ramped up, and the Federal Reserve (the Fed) put is alive and well. But quality still matters as the economic recovery remains exposed to downside risks.
  • We remain modestly overweight stocks versus bonds and continue to prefer U.S. and EM markets over Europe, Australasia, and the Middle East (EAFE) and Canada as we believe these markets will still perform in a post-vaccine world. Within fixed income, we like bond duration but are closely watching incoming data and prefer Investment Grade (IG) to High Yield (HY).

One man with conviction will overwhelm a hundred who have only opinions.

Winston Churchill

The economic recovery is about halfway through, but we already have a good idea of the lasting societal changes emerging from the pandemic: the post-COVID-19 world will not only be digital, but change will happen faster. For investors, this leaves little time to assess the long-term revenue potential of an idea when multi-billion tech unicorns can emerge within a couple years. TikTok, the 4-year-old media platform that entertained kids during the COVID-19 lockdown and which President Trump is trying to get under U.S. ownership is probably worth north of $50bn as tech-mega caps are scrambling to buy units from ByteDance. Did you even know TikTok existed last Christmas?

It’s hard to get overly excited by the recent policy tweak of the U.S. Federal Reserve whereby “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” Such vague language is likely to leave investors scratching their heads unless the Fed formally establishes the parameters around what “moderately” and “some time” mean. The “we’re a long way from neutral” moment back in October 2018 was epic in spooking investors and we doubt the Fed will stick to fuzzy logic for long: markets will demand answers. But ultimately, this means lower interest rates for a lot longer, irrelevant of whether the Fed can run inflation above a target it has failed to meet for over a decade. This should represent a major tailwind to real assets such equities, real-estate, and commodities such as gold.

Relentless U.S. Tech Dominance

Global stocks (MSCI ACWI, +6.2%) added to their spectacular rally since the March COVID-19 storm. U.S. leadership was intact (S&P 500, +7.2%), led by strong performance in the Nasdaq-100 (+11.2%) which took its year-to-date performance to nearly 40%. This is in sharp contrast to tech-light European shares (Euro Stoxx 50, 3.2%) that remain broadly negative this year, and even worse for the U.K.’s FTSE 100 which lagged again this month (+1.8%) and remains deeply into the red for 2020 (-19.0%). Canadian shares (S&P TSX, +2.3%) also lagged global indices, held by weak performance in healthcare and consumer staples. Finally, EM shares (MSCI EM, +2.2%) were scratched into month-end by Trump’s anti-China rhetoric regarding Chinese tech companies, notably the TikTok affair.

A better-than-expected rebound in global economic indicators and a dovish Fed helped lift long-term interest rates. In line with the global uptick, the yield on Canada’s 10yr bond increased slightly from 0.46% to 0.62%. We continue to think the mid-term risks for long-term yields remain skewed to the downside given lingering uncertainty over the extent of the persistent economic damages from the shutdown. Better economic news also helped lift oil prices (WTI, +5.8%) along with risk assets. But unlike the S&P 500 which is breaking new highs, WTI prices are down 43% for the year. Meanwhile, Western Canada Select oil prices ended the month at $31.60 per barrel, which leaves the Canadian oil industry in a tough position. The greenback (DXY, -1.3%) weakened further in August as the Fed is taking the world’s most aggressive measures to stimulate growth.

Euphoric investor sentiment and improved terms of trade, thanks to stronger commodity prices, helped lift the loonie to $0.77 in August, back to its yearend level. While the move seems surprising, it’s largely driven by the broader USD move and spectacular recovery in risk sentiment. We don’t think it speaks to the relative economic strength of Canada as the loonie has lagged other main crosses in 2020 (Chart 1).

Chart 1: Strong Loonie vs the Buck but Not So Strong vs Other Majors

Chart 1: Strong Loonie vs the Buck but Not So Strong vs Other Majors

Source: Bloomberg, BMO GAM (As of September 2, 2020)

The CBOE VIX Volatility Index (VIX) remained above 20 despite better earnings, macro data and the strong equity performance. The post Great Financial Crisis (GFC) equity rally eventually became known as the most hated rally in history because investors complained about the macro backdrop not being ideal, from artificially low interest rates to perpetual fiscal deficits. A VIX lingering above 20 continues to reflect that investors are not blindly embracing equities and are willing to pay a high price to protect against downside risks. Are the same investors that were complaining post-GFC still complaining about this rally? Possibly. Things could be better about the macro backdrop, but the Fed is not about to turn hawkish, fiscal policy is not about to talk about balancing the books, and tech mega-caps have stellar earnings compared to the rest of the market.

Equity Factors: Calling the top for Growth and the bottom for Value is not easy

Global Growth (+7.9%) and Momentum (+8.1%) once again led equity factor performance in August. Low-Vol (+2.4%), High-Div (+3.3%) and Value (+4.1%) significantly lagged global stocks (+6.2%). While we’ve pushed back against a rotation play for Value vs Growth because of the lasting transformative impact of COVID, volatility associated with sector-allocation calls remains at cyclical highs (Chart 2). Investors should keep this in mind before playing reversals: mistakes can be costly.

Chart 2: Relative Equity Factor Volatility Pushing Higher

Chart 2: Relative Equity Factor Volatility Pushing Higher

Source: MSCI, Bloomberg, BMO GAM (As of September 2, 2020)

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, +1%)* lagged the broad market BMO S&P TSX Capped Composite Index (ticker: ZCN, +2.2%)** as the latter was boosted by strong performance in banks and energy. The BMO Equal Weight Oil and Gas Index ETF picked up (ticker: ZEO, +4.6%)*** while the BMO Equal Weight Banks Index ETF (ticker: ZEB, +9.7%)**** surged on better-than-expected earnings.   

U.S. Election Odds: Coming to the Forefront

What may have contributed to euphoric equities last month were rising Republican election odds. Biden’s advantage has narrowed to 8% in betting markets, alongside a rise in Trump’s approval rating and better economic data. But this masks limited improvement elsewhere, with FiveThirtyEight’s poll little changed at 7%, and online and tracking polls a mixed bag. Forecasts like FiveThirtyEight’s still place a 70% chance of a Biden victory. That said, Democrats’ odds of winning the Senate have also dropped, a development more relevant to markets (Chart 3). If odds of a Democratic sweep are indeed falling, this could be related to declining U.S. COVID -19 cases and will be closely watched as the election nears.

Chart 3: Republican Election Odds Have Improved But Democratic Sweep Still Favored

Chart 3: Republican Election Odds Have Improved But Democratic Sweep Still Favored

Source: Predictlt, BMO GAM (As of September 2, 2020)

Corporate Credit Outlook: Uncertainty rhymes with quality

Like equities, the impressive recovery in corporate credit has surprised investors. U.S. investment grade IG credit spreads have rallied 245 basis points (bps) since peaking at 3.7% in March, while HY spreads have tightened 625bps from its 10.8% peak. According to our calculations, current spreads imply a rosy economic outlook of 4% y/y Gross Domestic Product (GDP) growth in 2020. That compares to 1% y/y implied by the Treasury curve and -5% y/y expected by economists. Such a gap reflects the enormous central bank and fiscal support.  The Fed purchases now comprise over 30% of the U.S. bond market, a record high and up by nearly 15 percentage points this year (Chart 4).

Chart 4: Enormous Central Bank Support in a Short Period of Time

Chart 4: Enormous Central Bank Support in a Short Period of Time

Source: Bloomberg, BMO GAM (As of September 2, 2020)

With much optimism priced in, does it still make sense to overweight credit? We think so, as yield-starved investors will seek extra yield. Central banks have room to ramp up purchases (the Fed credit purchases remain muted at less than 1%), and markets continue to believe in the Fed-put (most of the rally occurred before purchases began). We expect real rates to remain low while bond issuance could ease in the coming months as firms work through their stockpiles of cash. Spreads are also still elevated relative to pre-COVID-19 averages, especially if the Fed remains on hold for a long time.

But we think investors should focus on quality. Fallen angels (downgrades of BBB-rated firms to BB) are likely to increase by yearend, though we expect this to be well received by the market. BBB firms represent the largest tier of the IG space and comprise 55% of the Fed credit purchases, while BB names are the largest in HY, creating a large buffer and source of demand absent in past cycles. HY buyers will also welcome access to better quality credits with larger capital structure. We continue to prefer IG over HY, as the latter sees greater risk of spread widening amid high uncertainty over the recovery.

Outlook and Positioning: Stocks rallying beyond our wildest expectations

The outlook is not without downside risks. Continued fiscal support is crucial to support consumers as COVID-19 uncertainty lingers and unemployment remains elevated. Vaccine delays and school reopening’s may complicate things, and the upcoming U.S. election poses risks. Monetary and fiscal policy is the most important tailwind to stocks where new highs are made almost daily while the unemployment rate is still in double-digit territory. We remain confident U.S. stocks will outperform, notably vs Canada and Europe, while we think our small EM overweight remains the best way to play a global-reflation scenario where the vaccine would remove the macro uncertainty and re-ignite mobility.

In fixed income, we prefer central bank supported IG corporate bonds to riskier high-yielding bonds. Bond duration remains attractive in Canada, but we are keeping a close eye on high-frequency macro indicators that would suggest Q4 growth reflects a V- rather than W-shaped recovery. Finally, the loonie seems to be flying a little too close to the sun. It’s not easy to rationalize a stronger loonie given the depressed level of energy prices and the size of the fiscal deficits.

Disclosures

*The performance for (ZLB) for the period ended August 31, 2020 is (as follows: -3.57% (1 Year); -5.45% (3 year); 5.74% (5 year); and 11.68% since inception (on October 21st, 2011).

**The performance for (ZCN) for the period ended August 31, 2020 is (as follows: 3.88% (1 Year);
6.04% (3 year); 6.79% (5 year); 6.07% (10 year); and 6.54% since inception (on May 29th, 2009).

***The performance for (ZEO) for the period ended August 31, 2020 is (as follows: -24.74% (1 Year);
 -14.48% (3 year); -9.87% (5 year); -7.31% (10 year); and -7.29% since inception (on October 20th, 2009)

****The performance for (ZEB) for the period ended August 31, 2020 is (as follows: 0.03% (1 Year);
3.18% (3 year); 8.12% (5 year); 8.94% (10 year); and 9.09% since inception (on October 20th, 2009)

 

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent simplified prospectus.

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the prospectus.  BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc., BMO Investments Inc., BMO Asset Management Corp., BMO Asset Management Limited and BMO’s specialized investment management firms. 

®/™Registered trade-marks/trade-mark of Bank of Montreal, used under licence.

 

Related articles

No posts matching your criteria
September 2020

Some COVID-19 Scars may Persist

While a vaccine might be on its way later this year, social distancing and mobility restrictions have inflicted severe pain on some sectors of the economy.

August 2020

Canadian Housing Holding up Against Bearish Fears

In line with our expectations, the Canadian housing market has held up despite the COVID shock.

August 2020

August MAST Commentary: Investors Building Herd Immunity Against COVID-19 Fear, But Economy Will Need More Fiscal Steroids

Equity gains continued in July as bond yields slipped, though performance remains uneven across regions, sectors and factors.

August 2020

A recession like no other

Unlike previous recessions, the value of a U.S. used car has risen sharply this summer as our daily lives are profoundly impacted by social distancing and the sudden COVID-induced de-urbanization wave.

July 2020

Bracing for bad earnings, not necessarily bad news

The earnings season kicked off last week and we are unsurprisingly seeing many firms facing steep contraction in revenues and earnings because of COVID.

July 2020

July MAST Commentary: Equities Healing Faster than the Economy

The road ahead is unlikely to continue as smoothly, especially for the U.S. labour market as the May and June job gains represent only about a third of the jobs lost in March and April.

July 2020

Second-Wave Headlines Make Investors More Nervous than Consumers

Since the middle of June, the world has seen a spike in COVID cases in some cities and U.S. states, which has caused renewed market volatility.

June 2020

Thematic investing and the Post-COVID world

In the third in our series of virtual mini-forums, we discussed thematic investing post-COVID in one session and the outlook for oil in another.

June 2020

U.S. Consumers Meet the Stock-Market V-Recovery

Last week we got another strong indication that the economy was catching up with the stock-market optimism when U.S. retail sales rebounded by 18%, reversing a 15% drop in April.

June 2020

Recovery by 2022? It's fiscally possible

In this session, the debate focused on why the global economy may pull out of COVID-driven recession more quickly than consensus believes.

June 2020

Off the Lows, but Seatbelt Fastened

An increasing number of indicators are confirming that the worst of the March-April economic contraction is behind us, but equity prices did not wait to see a bottom in economic activity and earnings before bouncing off their lows.

June 2020

June MAST Commentary: From Walking Near the Brink to Having Eyes on the Top

Investors have their eyes on economic and earnings normalization into 2021 and 2022, which, coupled with near-zero interest rates, is contributing to elevated forward multiples.