Sidestepping Cracks in Uncertain Markets
For the past several months, we’ve emphasized that the near-term economic outlook is relatively healthy, and that it’s not yet time to shift to a more defensive stance.
While we’re remaining relatively neutral at the asset allocation level, we have implemented several strategies to beef up the defense in our portfolios. The goal is to be prepared if a weaker autumn for markets materializes as we expect. For one, we’ve implemented call options on the Energy sector, which has moved up significantly following production cuts by Russia and OPEC and generated more attractive premiums. We’ve also entered a put spread on our Industrials position, which has paid off due to the recent pullback. We continue to maintain our allocation to gold, and in some of our more conservative portfolios, we’ve tilted a bit more defensive as extra protection against market uncertainty.
“With seasonal risks coming to the fore and a mild downturn still likely in 2024, we’re taking a slightly more cautious approach this month than we have previously.”
Our approach this month is to crystallize and gather profits where we can. A more challenging market environment may be on the horizon, so if we can earn a few extra percentage points in the meantime, we’ll happily do so.
A Tale of Two Economies
The U.S. economy shows little sign of slowing down, seemingly remaining bulletproof to rate hikes. In Canada, however, cracks begin to show as the impact of rate hikes is felt and evidence of a cooling economy emerges.
Recent economic indicators in the United States confirm the reacceleration of consumer spending in Q2 heading into Q3. This is not merely a speed bump—it’s a sign of economic resilience that could have ramifications for future interest rate decisions from the U.S. Federal Reserve (Fed). Real wage growth has become positive, which helps households, and a state of full employment has been reached. Together, these represent a strong economic backdrop. The only thing that may hurt consumers at the margins is an increase in energy prices; there may be some pain at the pump, but even that is more manageable than what we saw in 2022.
It’s a different story in Canada, where the big surprise was an economic contraction in Q2 (when measured by real gross domestic product [GDP]). On a per capita basis, the situation is even gloomier, with the economy shrinking despite the population growing by approximately 80,000 per month. This demonstrates that the Bank of Canada’s (Boc) rate hikes have had an effect in spite of a healthy labour market—175,000 jobs were created between January and August, and wage growth remains strong. Canadians do have to cope with higher mortgage rates, however, as well as the last whisps of inflations, so the overall outlook is increasingly challenging. The good news is that the housing market remains in a state of stabilization; if people didn’t have jobs, they’d struggle to pay for the high cost of living, but the strong job market allows them to avoid being forced to sell their property due to higher mortgage rates. Why has the job market remained so strong? In a word: immigration. While many analysts were worried about a recession, employers were more worried about labour shortages, with over 700,000 jobs still vacant in the country. New Canadians entering the workforce means more people available to fill those roles, which is a relief to companies that had been struggling to keep up with demand.
The economic outlook for Europe continues to be challenging, as a combination of interest rate hikes and high energy prices has restrained economic activity. While we aren’t as concerned about the continent’s energy landscape as we were last year—they have made important adjustments over the past 12 months—energy-intensive industries are still likely to be affected. Depending on how severe the winter is (and therefore how in-demand energy is), more headwinds could be on the horizon. On top of the aggressive hiking cycle and sticky inflation, the Eurozone is also struggling with China’s diminishing appetite for European industrial goods. Japan is the one brighter spot within EAFE—its economy has been resilient, and wage increases have fuelled a drive toward monetary policy normalization. The country appears to be turning a corner, but it will continue to contend with negative demographics; unlike Canada, it is unlikely to see significant population growth due to its stricter immigration policies.
In Emerging Markets (EM), the bad news continued for China over the summer, with challenges including the Real Estate sector and weakening external demand. But that could be turning around soon, especially in light of resilient U.S. demand—U.S. manufacturing indicators are signalling a bottom and a small recovery beginning to take place. It’s early, but the situation has stabilized following the deterioration we saw last year. That, as well as international demand starting to bottom, could be a key ingredient in rebound for Chinese markets.
BMO GAM House View
• Pockets of inflation persist, but it’s no longer broad
• There is still a risk of a second wave of inflation, in large part due to energy, but it is more manageable now than it was last year
• We may see another rate hike from the Fed, but the end of the cycle is near
• In Canada, it’s likely approaching and may already have arrived, though it should be mild
• The U.S. will have to wait a while longer
• The U.S. consumer is resilient
• The Canadian consumer is starting to struggle
• The market has survived the rate hiking cycle
• Now, the risk is layoffs, but that should be manageable
Equities continue to be ruled by Tech’s dominance, while a resilient U.S. economy is pulling away from the pack, sustaining high valuations in the near term. We remain neutral (0) across asset classes, but with short-term yields still attractive, we are slightly partial to cash instruments.
Canada and the U.S. seem to be on different paths at the moment. The gearing of the Canadian mortgage market to interest rates is a lot more direct than it is south of the border, and we are seeing signs of that emerge now. Meanwhile, the almighty U.S. consumer continues to be the goose that keeps on laying golden eggs: cars, housing, jobs—all indicators appear solid. There may be incremental cracks at the margins, like hours worked or upward wage pressure, but there just doesn’t seem to be anything new or looming on the horizon that is nefarious. In terms of global recession, Germany is pretty much there, which is why we’re underweight Europe. But even there, the consensus seems to be for a soft landing that pushes potential rate cuts further down the road. In terms of U.S. rate policy, right now the focus is more about whether the Fed will do another hike or not this fall. Our view is that it is somewhat immaterial—it’s a coin flip. For the most part, inflation is calming down. Even if we see another slight uptick in core CPI, we believe it is not going to get the Fed or even Bank of Canada terribly upset at this point.
We’re neutral (0) across all three asset classes, but in the short term, we’re probably a little predisposed to cash. Longer term, having a little more duration at these levels isn’t a bad idea. But when the two–year yield is nearly 5%, it is difficult to complain about shorter-term bonds. For Equities, it remains a very bifurcated market by most measures, both technically and fundamentally, with mega-cap “Tech-plus” stocks continuing to heavily influence sentiment and market movement.
U.S. earnings are holding up surprisingly well, but we are watching margins closely with revenue growth falling behind wage gains and interest expenses. We also see appealing pockets in Canada, as well as some EM economies.
We’ve seen a resilient economy, and resilient earnings. That’s clouded, however, by elevated valuation multiples. That resilience versus high multiples and a narrow market rally are keeping us neutral (0) overall on U.S. equities. There is some seasonality at play—September is not a great month generally for stocks. But at the end of the day, macro factors drive markets. We are closely watching for margin sustainability in the U.S., with companies at a point where revenue growth is slowing but wage growth is not. At the same time, interest expenses are rising, which could also eat into margins. Revenues have kept up, for now.
We are neutral (0) on Canada, but there are pockets we like such as Banks and Energy. What is keeping us neutral is that on one side, you have a slowing economy, and on the other, you have some very attractive valuations in the market.
Globally, the problem with Europe is they have slowing growth and high inflation, which is why we are slightly bearish (-1) on the region. They are effectively in a stagflation regime. On China, their central bank and government are a little bit more flexible compared to other economies because they don’t have an inflation problem. You’re likely to see continued stimulus and other measures to prop up growth. But we’re not expecting anything huge. Outside of China, there are some EM that are equally if not more poised for growth. Brazil, for example, has managed their inflation situation relatively well and recently cut interest rates. India is also growing quite robustly.
The Fed and BoC are headed in opposite directions, leading us to favour Duration north of the border over U.S. fixed income. However, we have upgraded our view on U.S. High Yield credit based on unexpectedly low default rates.
Let’s start with the Fed, which likely has at least one more hike to go. There is sustained pressure on Jerome Powell (Chair of the Federal Reserve of the United States) to do more as GDP and other indicators continue to surprise to the upside. Job growth continues to remain robust—we are actually seeing jobless claims slowing. Third-quarter growth, meanwhile, is currently tracking above trend. So long as the economy remains this resilient, the Fed will be under pressure. Our view is one or two more hikes is going to be the ceiling—we do not think they want to cross that 6% threshold.
The BoC is in a more complicated situation with the growth outlook more clouded. The Canadian economy contracted last quarter, and we are tracking for below-trend growth this quarter, making the odds of a hike far lower for the BoC. We may see the opposite situation that the Fed is in, where the market starts pulling expectations for rate cuts forward rather than further out. If this economic deceleration continues, cuts in Canada will be brought ahead. We remain neutral (0) on Duration overall, but it is fair to say we favour Canada over U.S. Duration at the moment.
This month, our fixed income ratings have not changed with one exception: we have moved from slightly bearish (-1) to neutral (0) on High Yield credit. We upgraded for a few reasons, but first and foremost, the U.S. economy is proving to be more resilient than expected. That bodes well for High Yield, which is a risk-on fixed income market. Another factor is that although bankruptcy filings are increasing, they are still at very low levels.
Style & Factor
Growth has regained its market leadership, which has us looking to Japan and elsewhere to sidestep concentration risk. We are overweight Quality, including Canadian Banks which we believe the market has mispriced.
In terms of relative performance, Growth has certainly bounced back aggressively. Looking at the spread between the Russell 1000 Value and Russell 1000 Growth Indexes, Growth valuations have popped back to about two standard deviations above the average since 2010. Valuations are tracking near the highs seen in 2020, when Tech ruled markets. This idea that Growth stocks can only benefit from falling rates isn’t really proven out over history, and on a relative basis, it is hard to argue that it is a screaming buy at this point. So, we are neutral (0) on Value versus Growth.
We are still overweight Quality, which is a reflection of our somewhat more defensive posture given the seasonality weakness we’ve seen. It’s also a reflection of some of our overweight holdings, which we’ve expressed via some sector positions, including in Canadian Banks, Energy and Japan. The noise around Canadian Financials is about increasing loan loss provisions. We have run some charts and the loan loss provisions as a percentage of overall tier-one capital are only going back to normal, or where they were before COVID-19. To say that they’re elevated is a bit misleading, in our view, and the market is mispricing the sector.
With Energy, we prefer to express that view through U.S. Energy, and did open up that trade this month, rotating half of our U.S. Industrials positions into that sector. Japan is a position we took in April as a distinct “like” for the Japanese market. We still have the position, but it is probably more so because of a “dislike” for Europe at this point, and it’s still a fairly well valued position. From a momentum standpoint, it has slowed down, but we do like the overweight for the diversification. That Value tilt, particularly with Japanese Banks, is a nice offset to U.S. Technology within the portfolios.
We are using puts and calls tactically to add portfolio protection and generate some added income. We’ve also gone equal-weight or looked for other diversification options to address our over-concentration concerns.
One important implementation tool we’ve used over the past several months is options. We are implementing some of these positions as buying protective puts, and some as added income through option writing. In the case of Energy, we wrote a covered call about 3% out of the money, one month out. So, not only have we benefitted from a grind higher in Energy, but we’ve also collected a bit from option premiums along the way.
The flip side of that is on our Industrials position, we’ve entered into a put spread. We are concerned that it might consolidate a little bit, but if we do see an uptick in inflation, or if there’s any pullback in U.S. equities, we’ve got a little bit of downside protection.
The third implementation tactic we’ve employed relates to our equal weight exposure, namely equal-weight S&P 500. While we’re neutral equities overall, we do have portfolios that are taking different measures of protection, like equal weight or sector diversification away from the over-concentration of the S&P 500. Other portfolios are taking a straight underweight to equities to avoid some seasonality declines. In each case, we are taking our House View and tweaking it to that particular portfolio’s circumstance.
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