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

  • Macroeconomic and earning releases will deteriorate further in coming weeks. We think the economic cycle has sequentially bottomed in April with the gradual re-opening of the economy initiated in May and accelerating into June.
  • 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.
  • We think QE and fiscal policy will remain the preferred tools in the year ahead. We expect the Fed and BoC to push back against negative interest rates. The mountain of debt will make it hard for policy rates to get off the floor.
  • Our portfolio positioning continues to modestly overweight stocks versus bonds, with a preference for U.S. and Emerging Markets (EM) markets while underweighting EAFE and Canada. Within fixed income, we like bond duration, and prefer IG to HY.

One cannot manage change. One can only be ahead of it.

Peter Drucker

From Walking Near the Brink to Having Eyes on the Top

Investors walked into May with cold feet after the strong April rally with re-opening efforts well under way, turbo-powered stimulus flowing, money nearly free, and high hopes for a vaccine. The S&P 500 made it back above the 3000 mark faster than most expected. We think the economic cycle has sequentially bottomed in April with the gradual re-opening of the economy initiated in May and accelerating into June.

The Canadian economy contracted 8.2% (annualized) in Q1, but Q2 will likely show an even more severe contraction of at least 25%, perhaps as much as 40%. Meanwhile, Q1 U.S. growth fared much “better”, contracting “only” 5% as the U.S. imposed a less stringent economic lockdown, but there too Q2 will show an epic contraction that could reach as much as 40%. The good news is that Q3 data should show a double digit rebound. However, we doubt macroeconomic data releases will have much impact on investor sentiment for a little while still, despite the upcoming shocking figures. Investors are mainly eyeing an economic normalization (i.e., recovering the lost output) for late 2021, early 2022.

V-Shaped Rebound for Stocks Intact

Global stocks (MSCI ACWI, +4.4%) rose for a second consecutive positive month with broad regional gains, with a notable rebound for the most battered markets. Japan (Nikkei, +8.3%) and Europe (MSCI Europe, +4.6%) led across regions, but Europe remains the weakest regions with a year-to-date performance of -12.9%, pulled by severe losses in France (CAC 40, -19.5%). Meanwhile, U.S. stocks (S&P 500, +4.8%) outperformed global stocks slightly, helped by a strong performance of small cap (Russell 2000, +6.5%). Canadian stocks (S&P TSX, +3.0%) underperformed, notably held back by financials and real-estate stocks. Finally, EM stocks were nearly flat in May (MSCI EM, +0.8%), as U.S. anti-China rhetoric and Hong Kong protests added to ongoing woes across EM countries.

Canada’s economic woes are keeping yields on government debt under downward pressure. The yield on Canada’s 10-yr was stable this month at 0.54% with very mild intra-month volatility. Oil prices (WTI, +88.4%) registered their best monthly gain ever, which, coupled with the overall positive risk tone that broadly weighed on the U.S. Dollar, helped lift the loonie by 1.2% in May. Gold prices rose 2.6% as investor’s added safe-haven hedges that would be expected to perform well if the monetary and fiscal stimulus fuels an inflation uptick in 2021 or if the COVID recovery proves weaker than expected and requires more money printing. The VIX fear index ended the month below 30, a first since February, in tandem with the stock-market rebound (Chart 1).

Chart 1: Investor Fear also Normalizing as VIX Falls Below 30

Chart 1: Investor Fear also Normalizing as VIX Falls Below 30

Source: Bloomberg, BMO GAM (June 2, 2020)

Equity Factors: Growth rules at the hunger games

The COVID-induced economic collapse will likely see global Gross Domestic Product (GDP) shrink by over 3% in 2020 (Source: International Monetary Fund). Many firms are in an intense hunger game to survive while others are trying to increase their market share as competitors go under. Global Growth (+5.9%), Momentum (+5.2%), and Quality (+5.2%) equities registered another solid month in May, while Small-Cap stocks (+5.4%) also outperformed to trim their year-to-date losses (-11.4%). The streak of underperformance continued for Value (+2.4%) and High-Dividend stocks (+2.1%) as many companies are facing lasting financial strain because of COVID and may axe their dividend or file for bankruptcy.

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, +1.9%)* lagged the broad market BMO S&P TSX Capped Composite Index (ticker: ZCN, 2.8%)** in May as the energy sectors, BMO Equal Weight Oil Gas Index ETF (ticker: ZEO, +5.1%)*** benefited from the nearly doubling surge in oil prices. 

BoC and Fed Policy Outlook: QE > NIRP

With major central banks at near-zero policy rates, discussion around relying on negative interest rate policy (NIRP) territory has gained traction. U.S. markets recently started pricing cuts to negative rates in 2021 (Chart 2). We think negative rates in the U.S. are unlikely in the next year, but cannot be ruled out, especially in other countries including Canada. First, evidence is mixed on whether the benefits of negative rates outweigh the costs. Countries with negative rates (Euro area, Denmark, Switzerland, Japan) show that they can stimulate growth by lowering long-term real yields, steepening the yield curve and weakening the currency. But evidence is less convincing on whether taxing saving can boost consumption and investment. Negative rates are difficult to pass on to customers, so they weigh on net interest margins (NIMs), hurting bank intermediation and profitability. The U.S. and Canadian banking systems are exposed to the costs given the sheer size of money market funds which would “break the buck” and shutter without regulatory changes.

Chart 2: U.S. Rates Markets Bleeding into Negative Territory

Chart 2: U.S. Rates Markets Bleeding into Negative Territory

Source: Bloomberg, BMO GAM (June 1, 2020)

Second, U.S. Federal Reserve (Fed) officials are unanimous in their opposition, with Fed Chair Powell highlighting that “all participants” believe negative rates are not “currently” an attractive tool. The Bank of Canada (BoC) likely sides with the Fed, emphasizing the drawbacks and affirming that its effective lower bound is 0.25%. Interestingly, countries already with negative rates have not cut rates further since the outbreak.

Finally, we think policymakers will prefer quantitative easing (QE) until there is more certainty over the virus. Until then, QE and fiscal stimulus will be used to provide liquidity and backstop incomes. Beyond the virus when weak demand is the main economic problem, the policy goals will be to stimulate spending and credit, and the preferred tools will be state-based (i.e., linked to the growth and inflation outlook) forward guidance and potentially the introduction of yield curve control—the latter which best complements ongoing fiscal stimulus and rising deficits by keeping short-term borrowing rates capped.

In any case, lower-for-longer interest rates are here to stay for a long time. The pile of debt will make it difficult to raise interest rates without damaging the economy. Overall, this asymmetry and dedication of policy makers to save the economy is bullish for risk assets, including gold. For investors concerned about negative rates, gold is a good hedge too.

Don’t be Afraid of Elevated Forward P/Es

Forward P/E estimates for the S&P 500 look elevated, but we think there are good fundamental reasons why this is the case. First, near zero interest rates means investors should pay a higher price for earnings when discounting future cash flows, all else equal. Second, because equity analysts mostly focus on predicting earnings on a 12-month forward basis and because the process of economic normalization will take place over the next couple years, equity investors are seeing through the 2020 weakness when buying stocks. Finally, the higher weighting of tech companies, which are experiencing strong growth as COVID is reshaping our lives, is contributing to a higher multiple.

Outlook and Positioning: There-is-no-alternative creates equity tailwind

Our stock-bond asset mix remained unchanged last month with a modest stock overweight. Fiscal and monetary policy remains highly supportive of risk assets. Negative or near zero interest rates on government debt is forcing investors to increase their long-term allocation to riskier assets—“TINA: there is no alternative”—to generate yields and returns.

We increased our U.S. equity overweight while reducing Canadian stocks another notch. Near-term prospects for global equities remain attractive, but we think Canada could lag the U.S. over the medium term. Over the next 12 to 18 months, we think Canada’s economy and stock market are in a weaker position compared to other major economies, particularly the U.S. We also remain overweight of EM equities while underweighting EAFE.

In fixed-income, we prefer investment grade (IG) corporate bonds to riskier high-yielding (HY) bonds as we think the wave of default has more room to run and will weigh on corporate funding spreads despite central-bank buying. Bond duration remains attractive in Canada where debt and the woes of the oil sector will weigh on growth for many quarters and the yields on the 30-year federal bond hovers around 1.15%.

Finally, the loonie has gained a bit more than we expected in recent weeks, but the broad U.S. Dollar selling is in line with the ongoing positive risk tone in markets. Over the medium term, we believe the loonie will face significant headwinds and we would expect the loonie to selloff if market gyrations resumed this year.

Disclosures

*The performance for (ZLB) for the period ended May 29, 2020 is (as follows: -4.71% (1 Year); 3.52% (3 year); 5.42% (5 year); and 11.39% since inception (on October 21st, 2011).

**The performance for (ZCN) for the period ended May 29, 2020 is (as follows: -2.02% (1 Year);
 2.82% (3 year); 3.36% (5 year); 5.19% (10 year); and 5.82% since inception (on May 29th, 2009).

***The performance for (ZEO) for the period ended May 29, 2020 is (as follows: -28.43% (1 Year);
 -15.56% (3 year); -13.00% (5 year); -7.76% (10 year); and -7.56% since inception (on October 20th, 2009)

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.

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.

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.

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