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. Emerging Markets (EM) and U.S. stocks outperformed along with Growth and Momentum, underpinned by a stronger quarter for tech earnings.
  • Gold prices soared to record highs as real bond yields plunged and the U.S. dollar weakened. We expect strategic interest to build amid high uncertainty over the labour market recovery, consumer behavior and bankruptcies. We recommend staying long gold.
  • We explore the potential for European equity outperformance. While several near-term factors are favourable, we believe European equities are unlikely to derail U.S. outperformance thanks to structural issues as well as lack of tech leadership and growth-oriented, high Return on Equity (ROE) companies.
  • We remain modestly overweight stocks versus bonds, with a preference for U.S. and EM markets while underweighting Europe, Australasia, Far East (EAFE) and Canada. Within fixed income, we like bond duration, and prefer Investment Grade (IG) to High Yield (HY).

We went from being the Flintstones to the Jetsons in 9 months.

Dan Schulman

The consumer-oriented segments of the economy continue to hold up relatively well. Government programs aggressively supporting income and pent-up demand are propelling U.S. and Canadian retail sales to pre-COVID levels in a V-shaped pattern. Where the V might look more like a swoosh is business investment as we expect firms to remain cautious, which means capex and hiring plans could be disappointing into year end. With U.S. weekly initial jobless claims still hovering near 1.4 million as layoffs and furloughs continue, the job market is also set for a swoosh rather than a V. Second quarter real GDP growth for Canada will also show a historical drop, likely even larger than the 32.9% U.S. growth collapse. Underneath this historical turmoil hides a major reallocation from the old economy to the new, digital economy, which has contributed to a strong increase in sales in the digital champions, including Canada’s Shopify which doubled its revenues during the quarter. Crises create opportunities.

Regional Turbulence Dominates in July

Global stocks (MSCI ACWI, +5.3%) climbed in July, but the stock market recovery remains highly uneven across regions and largely disappointing in Europe. Year-to-date performance of U.K. equities (FTSE 100, -20.3%) is the weakest region, mainly because of the FTSE’s higher weighting to energy and financials with very little exposure to technology, in sharp contrast to the Nasdaq 100 whose companies are leading the digital revolution (Chart 1).

Chart 1: Not all equity markets are healing fast

Chart 1: Not all equity markets are healing fast

The regional performance in July largely extended the persistent trends of EAFE underperformance, most notably for the U.K. (FTSE 100, -4.2%). Canadian stocks (S&P TSX, +4.5%) registered a solid performance which for once was not driven by Shopify, whose share price rose “only” 6% in July after surging +119% in Q2. U.S. equities (S&P 500, +5.6%) outperformed global peers with solid tech earnings coupled with a dovish Fed and scope for another heavy dose of fiscal stimulus. EM stocks (MSCI EM, +9.0%) had a strong month, led by Asia and Latin regions. In Europe, the burst of outperformance in June was not replicated last month despite the $750bn euro recovery fund. Finally, the Nasdaq 100 gained 7.4%, taking its year-to-date performance to 25.6% as revenues and earnings crushed expectations vs old-economy stocks.

Another persistent trend in July was the downtrend of long-term interest rates even as equities continued to recover. The yield on Canada’s 10yr bond drifted lower to 0.46% while the yield on the 30yr bond collapsed to 0.92%. Oil prices (WTI, +2.6%) climbed as mobility recovered, but OPEC+ countries are maintaining aggressive supply curtailment measures to support prices. The greenback fell over the cliff in July as the U.S. Dollar Index (DXY) lost over 4% as the Fed is set to continue flooding global markets with liquidity. The loonie benefited from the USD’s downfall but underperformed its peers, gaining only 1.2% as the British Pound (+5.5%) and the Euro (+4.8%) led the gains. Finally, better-than-expected earnings, receding fears over second waves and macro data confirming the recovery have helped drive the VIX volatility index down to 24. A CBOE Volatility Index (VIX) above the 17-20 range reflects a higher than normal degree of market anxiety as investors are willing to pay a relatively high premium to protect against downside protection.

Equity Factors: The recovery tide isn’t enough to raise the Value tide

Global Growth (+7.4%) and Momentum (+8.3%) continued to lead in July, again outperforming global stocks (+5.3%). Other equity factors also rose but lagged their global benchmark, with more modest gains in Low-Vol (3.9%), High-Dividend (+2.5%) and Value (+3.0%). One key driver of the Growth outperformance last month was earnings among the top tech names, which smashed expectations across the board as structural change and tech disruption powers forward.

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, +4.6%)* had a better month, in line with the broad market BMO S&P TSX Capped Composite Index (ticker: ZCN, +4.5%)**. The BMO Equal Weight Oil and Gas Index ETF (ticker: ZEO, -1.8%)*** fell for a second month, while its value-oriented counterpart, the BMO Equal Weight Banks Index ETF (ticker: ZEB, +1.5%)****, also underperformed. These two industries could continue to struggle even in a post-COVID recovery.   

Gold Shines as Investor Confidence Wanes: More room to run?

Gold has soared to record highs, and a key driver of the recent performance has been real interest rates, or TIPS. 10yr real yields have fallen 40 basis points through the end-July, led by a pickup in inflation expectations (breakevens) whereas nominal yields have been relatively stable. Meanwhile, gold’s negative correlation with real rates has tightened (Chart 2). We attribute the move in real yields to a recovery in the short-term economic outlook, with improving indicators on mobility, spending and production. Lower for longer central bank guidance and record levels of stimulus also contributed. Moreover, and somewhat counterintuitively, gold is benefiting from improving growth expectations, albeit because of ample stimulus, and reaffirming its role as an inflation hedge.

Chart 2: Gold Soars on Real Yield Rally

Chart 2: Gold Soars on Real Yield Rally

(Past performance is no guarantee of future results)

A weakening U.S. dollar also supported gold in July as the global outlook improved. Over the longer term, the dollar shares a negative correlation with gold, though during periods of stress the correlation can turn positive, as in 2019. As with real rates, gold’s negative correlation with the dollar has recently strengthened (Chart 3).

Going forward, we think the gold rally has room to run. Near-term consolidation is possible because of positioning and limited scope for inflation expectations to rise further. But we expect economic uncertainty to remain high as the labour market recovery plateaus, consumers remain cautious and bankruptcies pick up. Over the medium term as the global economy recovers, we expect the U.S. dollar to weaken further, supporting gold. All in all, strategic positions are likely to continue to build in an indebted, low interest rate world. For investors under the dense fog of COVID uncertainty, we recommend staying long gold.

Chart 3: Gold Sees Another Tailwind Resurface

Chart 3: Gold Sees Another Tailwind Resurface

(Past performance is no guarantee of future results)

European Outlook: Resisting the temptation to rotate in

Europe has gotten a lot of attention of late. The European Union (EU) recovery fund and a relatively successful COVID containment have been key catalysts in reducing Europe’s risk premia. Is now the time to overweight European equities? Not so fast. Short-term developments do support sentiment relative to other regions such as the U.S. in the coming months. These include U.S. election uncertainty, the probability of a Democratic sweep and greater U.S. tech regulation, European green initiatives, and a stronger near-term rebound due to more contained virus outbreaks. However, we think these factors are unlikely to derail U.S. outperformance vs Europe.

First, near-term prospects could be fleeting. More stringent lockdowns in Europe suggest a much larger peak drag on growth and greater permanent scarring, with scope for a further deterioration in earnings expectations. Euro appreciation should also weigh on Earnings Per Share (EPS) in the export heavy regions. Second, structural issues (e.g., rigid labour markets, falling working-age population) will continue to plague Europe and keep its potential growth rate below the U.S, which won’t be solved by recent stimulus packages.

Finally, lack of tech leadership and growth-oriented, high ROE companies will limit scope for European outperformance over the medium term (Chart 4). By one metric, the share of companies with ROE greater than 15% on a consistent basis over the past 10 years is 40% in the S&P 500 vs only 25% in Euro Stoxx 600 (and just 5% in the “deep value” oriented Topix!). So while overweighting European equities may sound attractive ahead the U.S. election, investors may be disappointed if the trade is not well-timed.

Chart 4: One Way Train: European Equities Track Value Performance

Chart 4: One Way Train: European Equities Track Value Performance

(Past performance is no guarantee of future results)

Outlook and Positioning: Whatever-it-takes policies anchoring bullish bias

For investors, the macro backdrop remains far from ideal even with the economy bouncing back. If investors must have a high conviction view somewhere, we think it’s the resolve of policymakers to get the economy back on track with whatever-it-takes measures. Printing large amounts of money while keeping interest rates near zero remain a phenomenal tailwind for equities, even as the healing of the economy could take longer than expected. The other area of high conviction we have is the persistent outperformance of U.S. stocks, notably vs Europe, and recent mega-cap tech earnings have reinforced our conviction.

We are maintaining our modest stock overweight with a strong preference for U.S. stocks and a small overweight to EM, while remaining cautiously underweight Canadian and EAFE equities. In fixed income, we prefer central-bank supported investment grade (IG) corporate bonds to riskier high-yielding (HY) bonds. Bond duration remains attractive in Canada as the BoC will allow the large fiscal deficit to be financed at a low cost. Finally, the loonie could appreciate further as the U.S. dollar weakens, with the easiest part of the recovery behind us. But because Canada’s economic performance will lag the U.S. and other regions in the next 6-12 months, the loonie is exposed to downside risks.

Disclosures

*The performance for (ZLB) for the period ended July 21, 2020 is (as follows: -2.85% (1 Year); -5.74% (3 year); 5.89% (5 year); and 11.66% since inception (on October 21st, 2011).

**The performance for (ZCN) for the period ended July 21, 2020 is (as follows: 1.95% (1 Year);
 5.46% (3 year); 5.43% (5 year); 5.98% (10 year); and 6.37% since inception (on May 29th, 2009).

***The performance for (ZEO) for the period ended July 21, 2020 is (as follows: -29.91% (1 Year);
 -16.70% (3 year); -11.16% (5 year); -7.86% (10 year); and -7.74% since inception (on October 20th, 2009)

****The performance for (ZEB) for the period ended July 21, 2020 is (as follows: -12.10% (1 Year);
 -0.09% (3 year); 5.57% (5 year); 7.81% (10 year); and 8.22% 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.

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.

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