- The Delta variant creates renewed concerns over COVID-19, but its impact is likely to be highly asymmetric across countries. Developed economies are better positioned than emerging ones because of the greater progress on vaccination rates, in our view.
- We think the global economy is nearing peak growth and earnings momentum, but macro and virus uncertainty are improving enough to support a moderate equity overweight.
- Policy headwinds have intensified in China and could continue to negatively impact Chinese equities. Chinese economic growth is expecting to cool further on COVID-19 resurgence.
- Economic normalization has made substantial progress in North America when looking at economic activity as there remains very few restrictions on the economy. While the U.S. labour market still has some COVID-19 scarring, we expect strong payrolls growth into year-end, which should support the U.S Federal Reserve to announce tapering later this year and support interest rates.
I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But know I would like to come back as the bond market. You can intimidate everyone.
Media have recently been concerned by the spike in COVID-19 cases in several well-vaccinated countries because of the more infectious Delta variant. Despite some healthy bouts of market volatility last month, equity investors have focused on the efficacy of the vaccines at preventing hospitalization, which should help avoid renewed broad economic lockdowns. After celebrating Freedom Day, the U.K. saw a Delta-fueled wave sweeping along Euro-2020 euphoria. But data on the virus is comforting our view that the situation, while uncertain, is far more manageable for healthcare systems and far less lethal than earlier waves because of vaccines (Chart 1). However, for countries with much lower vaccination rates, predominantly across emerging economies and even Japan, we fear the situation could prove more challenging in the months ahead. For most Western economies, we think the ongoing shift in the policy response will continue to favour the implementation of vaccination passports to ensure the risks of economic lockdowns are minimized, which is a positive for the market outlook. For the bond market, despite the lingering risk of the pandemic, the U.S. Federal Reserve (Fed) remains on track to announce tapering by yearend reflecting confidence in the economic outlook.
Chart 1: Vaccines Successful at Reducing COVID-19 Mortality in the U.K.
Source: U.K. Government, Bloomberg, BMO GAM, as of August 3rd, 2021
In addition to fear over Delta, July also saw the market narrative shift toward peak growth after embracing the “Roaring 20s” narrative earlier this year. While a few small segments of the economy remain constrained by the pandemic, the overall level of economic activity has recovered to pre-COVID levels in North America. We think we are progressing toward a more traditional expansion phase of the cycle and gradually exiting the recovery or re-opening phase of the past year.
For markets, the transition toward the mid-cycle argument is even more apparent. First, equity prices are rallying on strong earnings while valuation multiples are compressing slightly. Second, spreads for corporate bonds have narrowed to pre-COVID tights. Lastly, the yield curve has flattened, which is to be expected when central banks are on path to start normalizing policy as the economy exits from the abyss.
Global Markets: Strong earnings adding gas to the stock-market rally
Another stellar earnings season pushed global equities (MSCI ACWI, +0.7%) up for a sixth consecutive month even as well-vaccinated countries saw a surge in COVID-19 cases while supply-chain disruptions are constraining sales in some sectors. After rising in tandem for several months during the re-opening phase, global equities have resumed displaying idiosyncratic performance. The persistence of U.S. leadership, supported by a less constrained economy and a leading tech sector, have led U.S. equities (S&P 500, +2.4%; Nasdaq 100, +2.8%) to outperform their global peers in July, despite some concerns over earnings guidance by some mega-cap tech companies. Meanwhile, peak-growth concerns weighed on U.S. small-caps (Russell 2000, -3.6%). The steepest losses were registered in emerging markets (MSCI EM, -6.7%) as China (MSCI China, -14.1%) intensified its actions against several domestic tech companies. Finally, Canadian (S&P TSX, +0.8%) and European equities were marginally higher (Eurostoxx, +0.7%) while Japanese shares fell in July on COVID concerns (Nikkei 225, -5.2%), leaving Japanese equities lagging significantly year-to-date.
The combination of sustained Fed accommodation, peak growth, and variants concerns weighed on interest rates in July. North American long-term interest rates fell back to mid-February levels after peaking in March. The yield on Canada’s 10yr bond ended the month at 1.20% (from 1.39% in June) which helped the performance of safe-haven Federals and bond duration. Western Texas Intermediate (WTI) oil prices were little changed just below $74 per barrel of oil (bbl) last month as the resurgence of the virus in some parts of the world weighed on the demand outlook, although the supply backdrop remains constructive for energy prices. The U.S. Dollar was roughly flat last month against most major currencies and the loonie fell slightly (-0.6%). Finally, the VIX volatility index (at 18.2%) rose a bit in July after falling steadily in recent months along with diminishing macro uncertainty. A VIX hovering below 20% is indicative of a high degree of investor confidence about the macro and market outlooks.
Global Equity Factors: Quality back in focus with peak growth and variants
The brief global equity factor rotation than began last year from Growth and Quality to Small-Cap and Value stocks faced the twin headwinds of peak-growth and Delta in July. While Quality (2.1%) and Growth (1.4%) outperformed their global peers (MSCI ACWI, +0.7%), Low-Vol (+2.7%) equities registered the strongest performance in July after a challenging year-to-date performance. Value (-0.1%) and Momentum (0.0%) lagged global equities as investors’ apprehension of economic normalization into 2022 means greater selectivity by investors seeking greater earnings visibility.
Canadian Low-Vol stocks (BMO Canadian Low-Volatility Equity ETF, ticker: ZLB, +3.3%)* also outperformed in July as the energy sector (BMO Equal Weight Oil and Gas Index ETF, ticker: ZEO, -4.9%)** retreated on expectations of peak earnings momentums and the threat of Delta.
Peak Growth: Transitioning from recovery to mid-cycle narrative
The peak-growth narrative is weighing on bond yields as incoming economic data supporting a transition from early to mid cycle, such as July manufacturing Purchasing Manager Indices (PMIs), which slowed further in the U.S. and China. As we head into the fourth quarter, we think investors should reassess their positioning. Peak growth does not mean late cycle or the end of above-trend growth but does have implications for portfolios going forward. We remain overweight of equities over fixed income as we expect policy support, above-trend economic growth and earnings momentum to remain robust.
At the same time, progress on economic reopening have become largely priced, fiscal stimulus is moderating (and will even turn to drag next year in the U.S.), and central banks are starting to normalize policy. The Fed is on track to announce a taper in asset purchases by year end, after which bond markets will shift more squarely on pricing rate liftoff (in 2023 or earlier). In general, the yield curve flattens ahead of the first Fed hike and thereafter (Chart 2).
Chart 2: The Yield Curve Tends to Flatten Before & After First Fed Rate Hike
Source: Bloomberg, BMO GAM. As of January 1977, to July 2021.
Similarly, Fed normalization also caps the rise in inflation break evens. The Fed’s actions at its June policy meeting, when they reacted to higher realized inflation, also reinforce this. So, although elevated inflation is expected to linger in the near-term, inflation risk premia on bonds are likely to be dampened by Fed policy expectations and the peak-growth narrative.
For investors, we think portfolios should lean toward growth and quality. High inflation in the near term means pricing power and strong balance sheets are important. Normalizing growth and stimulus suggest limited room for a steeper yield curve and rising break evens. For sectors of the S&P 500, those most exposed to growth and least correlated with value and break evens are IT, communication services and consumer discretionary (Chart 3). On the flip side is energy, financials and materials which are least attractive if the yield curve and inflation break evens have indeed peaked. Industrials, which rank higher on growth and pricing power, might be the best hedge for cyclical exposure.
Chart 3: S&P 500 Sector Betas vs. 10-year Inflation Break evens
Source: Bloomberg. Growth and Value betas based on Bloomberg calculations. Inflation breakeven beta based on weekly changes since 1 June 2009 to 30 June 2021.
Our overweight to Canadian equities, funded by emerging markets (EM), reflects our cyclical views where Canadian equities offer a balanced tilt to robust economic growth, supported by an economy and banking sector that has proven more resilient than expected during the COVID-induced recession, while are also benefiting from strong U.S. linkages. In general, we see Canadian banks having a higher quality (steady dividend payers) tilt to them by contrast to the more macro-cyclical U.S. banks. Whereas EM equities face a more challenged economic recovery thanks to moderating Chinese growth, slow vaccination and the rising threat of COVID-19, and an increasingly negative policy risk-premium targeted against certain tech companies. As we move beyond the V-recovery part of the cycle, we expect to see increasing opportunities across global equity markets as old-fashioned macro-policy and economic divergence return.
Outlook and Positioning: Increasing immunity of economy and markets to COVID-19
Last month we upgraded our equity outlook, not on expectations that the 12-month forward returns of equities would match their exceptional returns of the past year, but because we are increasingly confident about the resilience of the economic outlook over the next 12 to 18 months. We are closely monitoring the evolution of the virus and we think developed economies are well positioned to face the ongoing Delta wave. The efficacy of the vaccines and increasing immunity should prevent a critical overload of intensive care units and minimize the risks of economically damaging lockdowns. Second quarter earnings have confirmed our bullish expectations and while we think we have seen peak economic growth and earnings momentum, our view remains that we expect above-trend growth into 2022, which solidifies our bullish expectations for equities.
* The performance for (ZLB) for the period ended July 30th, 2021 is (as follows: 28.39% (1 Year); 11.84% (3 year); 9.65% (5 year); and 13.27% since inception (on October 21st, 2011).
** The performance for (ZEO) for the period ended July 30th, 2021 is (as follows: 55.12% (1 Year); –5.72% (3 year); -2.90% (5 year); -2.96% (10 year); and -1.78% since inception (on May 29th, 2009).
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