- The Q3 earnings season has delivered solid beats in revenues and earnings, propelling equity performance. A strong earnings backdrop and rising profit margins have insulated equities against rising inflation fears and hawkish central banks, which have pulled forward rate hikes.
- U.S. large cap and tech stocks outperformed in October, reflecting robust revenues and superior margins. Mega cap tech companies continue to grab market share, with their revenues rising faster than both the economy and top Value companies.
- The Bank of Canada pulled forward interest rate hikes into the first half of 2022, in line with our expectations but surprising the bond market as 2yr yields rose sharply and the yield curve flattened. While we think earlier interest rate liftoffs are warranted, we do not expect central banks to hike aggressively or past terminal rates achieved in past cycles. Such an outlook should keep risk assets supported.
- Cyclical sectors have regained momentum on the recovery in bond yields and high inflation, but we think sector performance is best explained by margin improvement. Going forward, we are biased to sectors with pricing power in the face of rising cost pressures.
- With U.S. economic growth momentum to continue into 2022, risk sentiment should remain well supported. We remain overweight of equities versus fixed income, with preference for U.S. and Canadian equities versus Emerging Markets (EM) and Europe, Australasia, and the Far East (EAFE). On a sector basis, we are overweight of U.S. financials and energy.
Equities Surge Back to New Highs
While negotiations around U.S. fiscal stimulus and the debt ceiling were dragging, investors were comforted by a solid earnings season in the U.S. where revenues and earnings beat expectations. Profit margins also held up better than expected against fears of inflation eating away at margins, but on aggregate firms have been able to pass on higher costs to customers as demand remains stronger than normal. The solid earnings backdrop is helping stocks advance even as rate-hike expectations are brought forward at an accelerating pace. With the U.S. and Canadian economy largely healed from the COVID-19 shock, the need for emergency monetary stimulus is no longer justified and that’s why the tapering of quantitative easing by the U.S. Federal Reserve (Fed) has caused little concerns to investors. Finally, the situation around the pandemic continues to improve, although it remains far from over.
Global Markets: Equities lacking oxygen at the top
A wave of short-term headwinds shook off global equities (MSCI ACWI, -4.1%) from their top and sent them lower in September. After a challenging year-to-date performance, Japanese equities (Nikkei 225, +5.5%) were a rare bright spot last month as investors cheered the arrival of a new prime minister that promises to accelerate public spending to support economic growth. In the U.S., tech stocks (Nasdaq 100, -5.7%) lagged the broader benchmark (S&P 500, -4.7%) while small-caps (Russell 2000, -2.7%) outperformed. Canadian equities (S&P TSX, -2.2%) outperformed their global peers as rising oil prices gave a booster shot to the energy sector. European equities (Eurostoxx, – 3.4%) outperformed slightly despite mounting evidence of rising inflation and slowing growth in Europe. Finally, emerging market equities (MSCI EM, -4.0%) were once again dragged lower by negative news from China.
It took some time to get there, but the Fed signalled it was almost time to start reducing the pace of bond purchases, most likely starting in November, which helped send U.S. and Canadian bond yields higher during the month. After a few months stuck in a narrow range, the yield on Canada’s 10yr bond surged last month (1.51% from 1.22% in August). Increased concerns about energy supplies helped Western Texas Intermediate (WTI) oil prices reach their highest level since 2014 at $75.03/bbl (from $68.50/bbl). A hawkish Fed and a risk-off mood in global markets lifted the U.S. Dollar (+1.7%) in September, but the loonie retreated more modestly (-0.5%) as oil prices jumped (+9.5%). Finally, the VIX volatility index (23.1%, from 16.2%) rose as market anxiety increased, but the spike in implied volatility seemed more contained than the depth of the S&P 500 September drawdown.
Global Markets: Robust economic growth propels earnings
Global equities (MSCI ACWI, +5.1%) rebounded in October to break new record highs. U.S. equities (S&P 500, +7.0%) rose the most, led by the tech heavy Nasdaq 100 (+7.9%) as the revenues of mega-cap tech companies continue to rise much faster than both the economy and the top Value companies (Chart 1). Meanwhile, U.S. small caps (Russell 2000, +4.2%) continued to lag as profit margins trail those of large caps. Canadian equities (S&P TSX, +5.0%) climbed on strong performance from energy and financials. European shares (Eurostoxx, + 5.2%) performed in line with global equities, while Japanese shares (Nikkei 225, -1.9%) retreated after a surprising rally the previous month. Emerging market (EM) equities (MSCI EM, +1.0%) were the weakest regional block in October, although the main laggard this month was not China (MSCI China, +3.1%), but Brazil (Bovespa, -6.7%).
Chart 1: Mega-Tech Companies Continue to Increase Economic Market Share
The chart shows the historical share of revenues to nominal Gross Domestic Product since 2003. We see that the top Value companies have loss not gained any economic market share since 2003, while top tech companies have seen their economic market share rise from 1% to 18%. Source: Bloomberg, BMO Global Asset Management. As of November 1. Value symbols = BRK, BAC, DIS, INTC, VZ, JPM, XOM. Tech symbols: FB, MSFT, AMZN, GOOG/GOOGL, NFLX, TSLA, AAPL.
Oil prices extended their rally with the price for Western Texas Intermediate (WTI) oil rising to $83.57/bbl (from $75.03/bbl). The U.S. Dollar was flat last month (-0.1%), but that hides the strong dichotomy between higher-yielding commodity currencies such as the Canadian Dollar (+2.4%) and Australian Dollar (+4.0%) versus currencies whose central bank are not about to tighten policy, namely the Euro currency (-0.2%) and Japanese Yen (-2.4%), which helped to further weaken the Europe, Australasian, and Far East (EAFE) equity block. Finally, the VIX volatility index fell back to 16.3% (from 23.1%) as investors cheered the stronger-than-expected earnings of U.S. large caps. Risk sentiment was also helped by diminishing concerns over the virus and U.S. fiscal policy.
Rate Hikes Incoming: How fast, how many?
The Bank of Canada (BoC) shook the Canadian bond market by bringing forward rate hikes to Q2 2022, which helped the yield on Canada’s 10yr bond to jump to 1.72% (from 1.51%, and a low of 1.22% in August). The most impressive move was on the monetary-policy sensitive 2yr yield, which spiked the most since 2009 as investors recalibrated their timing for rate hikes (Chart 2). From an economic standpoint, our long-held view has been that the BoC would likely hike in early 2022 (Source: BMO GAM). The biggest question regarding monetary policy for 2022 will be how much and how fast they can hike. While the pace of rates normalization could be swift given the state of the economy, hiking beyond the previous cycle (1.75% for the BoC and 2.50% for the Fed) will be far more challenging, in our view, especially as economic growth cools to a trend-like pace in 2022.
Chart 2: Fast-Forwarding to Fed and BoC Rate Hikes in 2022
The chart shows the historical yield on Canada and U.S. 2-year notes since 2015. After being very since March 2020, they both have spikes sharply since October. Source: Bloomberg, BMO Global Asset Management. As of November 3.
Global Equity Factors: Momentum, Quality and Growth shine on earnings
Momentum (+6.7%) stocks lead global equity factors in October, while Quality (6.2%) and Growth (+6.1%) stocks also outperformed their global (MSCI ACWI, +5.1%). High-Dividend (+2.6%) and Small-Caps (+4.3%) were the laggard last month as intensifying inflationary and margin pressures weighed on these factors. Scope for sooner-than-expected rate hikes is signaling slowing economic growth momentum, which could be a headwind for the more the cyclically oriented equity styles.
Equity Sectors: Stick with strong margins
After a pause since May, select cyclicals have regained momentum. Sector returns over the past three months show energy and financials at the top (Chart 3). It is not a clear cyclical vs defensive divide, however, as materials and industrials have underperformed. Meanwhile, information technology continues to outperform the overall index even after its significant outperformance over the summer months and since the pandemic. One catalyst for the recent price action has been a more hawkish Fed, which in September gave the green light on tapering asset purchases in Q4 in addition to pulling forward rate hikes. The other has been supply chain disruptions, which have intensified as demand is not slowing as fast as expected while the pandemic continues to constrain supply. These developments have pushed up bond yields and commodity prices as worries over more persistent inflation increase. Sectors with inflation-proof margins like financials, energy and tech are therefore outperforming, while other cyclicals more exposed to supply chain stress (materials and industrials) and defensives with weaker margins are underperforming.
Chart 3: S&P 500 Sector Performance: Energy & Financials Lead as Inflation Hedges
The shows the ranked performance of the U.S. equity sectors over the previous 3-months, with energy and financials leading, and consumer staples and healthcare lagging. Source: Bloomberg, BMO Global Asset Management. As of October 29, 2021.
The rise in commodity prices has been particularly acute for energy. Natural gas and coal prices have surged on shortages, particularly in Europe. Gas-to-oil switching as well as OPEC+ supply discipline and a limited supply response among U.S. shale producers, due in part to the push toward renewables, point to oil supply deficits through early 2022. As a result, higher oil prices have led to outsized performance in energy stocks on improved margins and cashflows. We see upside risks for oil prices on rising demand (e.g., a cold winter and further reopening in international travel). Oil futures are deeply in backwardation (long-dated futures are of supply deficits and bullish for oil prices in the near term. For exposure to an improving outlook for energy companies, we have implemented a tactical long position in the S&P 500 energy sector in October.
Forward earnings continued to rise through the Q3 earnings season, which has delivered solid earnings beats, with the largest surprises in financials. We expect earnings-per-share (EPS) to continue to drive stock returns, while we believe margins will be an increasingly important factor for earnings and performance as well (Chart 4). Remarkably, S&P 500 operating margins have continued to increase, with energy, real estate, and consumer discretionary leading the improvement in the past three months. While financials have seen the least improvement, note that the sector already sees the highest margins in the overall index. The sector is also best geared to rising interest rates, which help net interest margins. In September, we initiated a tactical long position in the S&P 500 financials sector to hedge against elevated inflation, rising input costs and higher interest rates. However, we are mindful of the stage of business cycle, which we believe has transitioned to mid-cycle, as well as hawkish central banks, both of which flatten the yield curve and can limit the rise in long-term yields. But overall, we prefer sectors with superior margins (quality-like attributes) to help insulate earnings going forward, such as tech and real estate in addition to energy and financials.
Chart 4: Margins Driving Recent Sector Performance
The chart compares the quarter-to-date returns vs the 3-month change in operating margins. We see a positive correlation, which means sectors with improving operating margins have seen better price performance. Source: Bloomberg, BMO Global Asset Management. As of October 29, 2021.
Outlook and Positioning: Back to macro after a solid earnings season
As the solid third quarter earnings season moves to the rearview mirror, the key risks for investors in coming months will be around the peaking of the inflationary cycle considering the worse-than-expected supply disruptions. U.S. fiscal remains in flux, but fiscal uncertainty should remain a micro risk for investors into year end. With U.S. Gross Domestic Product (GDP) growth tracking above 6% for the fourth quarter, risk sentiment should remain well supported in coming months and therefore we remain overweight of equities versus fixed income. Our preference on equities is on U.S. and Canadian equities versus EM and EAFE. On a sector basis, we are overweight U.S. financials and energy. Finally, we closed at a profit our overweight trade on provincial bonds vs federals, which we initiated during the turmoil of March 2020.
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