Multi-Asset

MAST Asset Allocation Outlook - Central-Bank Easing and Trade Détente Help Reboot Cycle

Seasonal scarecrows played differently this year and global stocks registered another gain in October with new highs made in several markets.
November 2019
  • Trade détente and Fed easing are helping reboot the cycle. We might not have seen the bottom for growth yet, but the case for a mid-2020 re-acceleration is more compelling. It’s now up to Presidents Trump and Xi and to deliver a phase-one deal.
  • The reflation trade took some shine off Canadian equities. The more defensive nature of the S&P/TSX Composite Index left Canadian stocks down in October. Even Canadian Low-Volatility stocks registered a loss after nine consecutive monthly gains.
  • Although investors have a tendency to over-react to the ebb of the news flow, removing trade uncertainty will re-spark risk appetite. However, investor concerns are likely to switch to phase-two discussions next year should a phase-one deal be signed by December.
  • Trade deals will likely cause central banks to feel less inclined to ease from here and confirm the “mid-cycle adjustments” thesis as recession fears come down. It will also probably comfort the BoC about the downside risks and limit the chance of the BoC easing while the Fed remains on hold.
Our favourite holding period is forever.

– Warren Buffett

Central-Bank Easing and Trade Détente Help Reboot Cycle

Seasonal scarecrows played differently this year and global stocks registered another gain in October with new highs made in several markets. Canadian stocks were a notable exception, however. The news flow turned quite positive, from talks between the U.S. and China to reach a phase-one trade deal, Brexit, a third consecutive 25 basis points (bps) interest rate cut  by the Federal Reserve (Fed), and better-than-expected earnings. On the macro front, U.S. third-quarter Gross Domestic Product GDP growth came in a little better than expected at 1.9%, comforting investors about the resilience of the U.S. consumer while manufacturing activity is contracting. Labour markets in Canada and the U.S. remain solid and defy the broad negative market sentiment where recession fears have remained elevated. For long-term investors, the stock-market performance this year is a good reminder that while growth has slowed, it’s been better than feared. Once again, you can expect economists to push out their recession forecast by a year to 2021.

From Resilience to Euphoria

Global stocks rallied (MSCI ACWI, +2.6%) on trade optimism, led by relief rallies in Japan (Nikkei, +5.4%) and emerging markets (MSCI EM, +4.1%) where performance has lagged significantly this year. U.S. stocks slightly lagged global stocks (S&P 500, +2.2%) but broke new highs as the tech sector (Nasdaq 100) added to its strong year-to-date performance with a 4.4% gain in October. In Europe, performance was mixed. The U.K.’s FTSE 100, which depends heavily on foreign earnings, fell 1.9% as the British pound gained 5.3% on Brexit optimism, whereas German stocks rose (DAX, +3.5%) on hope for growth stabilization for the heavy industrial country. Canadian stocks, however, retreated (S&P TSX, -0.9%) as its safe-haven status receded and energy stocks took a dive.

Yields on government bonds in Canada and the U.S. were little changed last month, but experienced a rollercoaster ride in October. The yield on Canada’s 10-year Federal debt touched an intra-month low of 1.23% and a 1.62% high on a wild ride for risk sentiment. Trade optimism and some stabilization across global PMIs helped re-steepen the U.S. 2-10 yield curve back to its July level (Figure 1). The positive news flow also helped take some wind out of the U.S. dollar, which fell 2% whereas the loonie gained another 0.6%. However, recent data still leaves the growth outlook at a sub-trend pace in most regions, including Canada. This leaves bond yields to remain driven by hope for a U.S.-China trade deal.

Figure 1: Good news and Fed easing help re-steepen yield curves

Equity Factors: Can’t win them all

The tide of optimism helped narrow the dispersion of returns across global equity factors, but the Growth (+3.2%) vs Value (+2.2%) leadership flipped again while the monthly horse race was won by Quality (+3.8%). Unsurprisingly, Low-Vol (+0.9%) lagged as cyclicals made a comeback.

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, -2.1%) registered a negative month after 9 months of gains and also lagged the broad market BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN, -1.0%). Trade-optimism does not alter our overweight conviction on Low-Vol stocks in Canada. Although we remain steadily bullish on stocks, the road ahead is likely to remain bumpy as economic indicators remain soft. 

Trade Hope: Celebrating mini deals

Evidence is mounting that the U.S. economy is not immune to the drag from trade uncertainty caused by trade wars. With elections a year away, President Trump will lean into his economic track record with stocks breaking news highs and unemployment rate breaking new lows. Although we turned more skeptical of seeing a comprehensive trade deal this year following the August escalation, there is now a good chance that we see a de-escalation of tensions over the coming months with a phase-one mini deal. Lastly, Canada also recently saw some relief in its relations with China given the end of the ban on Canadian meat imports.

Brexit: “When you arrive at the fork, take it” – Yogi Berra

In a refreshing turnaround, Brexit finally took a positive spin after PM Boris Johnson negotiated a new Brexit deal with the E.U. The mounting economic pain caused by lingering uncertainty has probably been acute enough for both parties to try and come to an agreement. Odds of a no-deal Brexit have receded, though hurdles remain for a full deal.

Canadian Equities: Too much good news makes them lose their shine

Canadian equity outperformance this year partly reflects a safe haven bid relating to trade-war uncertainty. For one, gold-mining stocks, which account for roughly 6% of the broad index, have benefited from the performance of gold prices (Figure 2). But more fundamentally, Canadian economic activity is relatively less exposed to trade uncertainty and more closely tied U.S. growth. Finally, Canadian equities are tilted toward Low-Vol stocks, which has also outperformed this year but lagged in October.

Declines in October were broad-based across Canadian equities, with energy, consumer and healthcare stocks driving the downside. This has left Canadian equities trading at a heavy discount to U.S. stocks whereas other international equities have benefited from the value rotation. Looking ahead, October is a good reminder of the scope of outperformance for Canadian stocks should trade tensions return to a simmer. That is, Canada’s stellar performance must be put in perspective as stocks have significantly underperformed the U.S. in recent years.

Figure 2: Gold remains an important cyclical driver of Canadian stock market

Fed Policy: June dots 0, October reality -3

Recent Fed cuts are a good example of how little information content forward-looking statements by policy makers have. As much as the FOMC sounded like they were done this year following their October communique, the fact is that renewed trade optimism and a solid job report for October probably saved the Fed from a fourth consecutive 25bp cut in December (Figure 3). Although Q4 growth could show growth hitting air-pockets with a low 1-handle, U.S. growth is likely to re-accelerate to an above-trend pace in mid-2020 if trade uncertainty disappears.

Figure 3: Trade war de-escalation dampening need for Fed easing

Source:  Bloomberg, BMO GAM, Bank of Canada: Another Halloween spook by Governor Poloz

Instead of wearing a mask for Halloween, Governor Poloz spooked investors at its October rate decision by sounding the alarm over the negative impact of global trade tensions. Interestingly, a couple hours later Chair Powell spoke positively about recent trade developments. With housing and labour markets heating up, the case for BoC easing remains weak unless Governor Poloz thinks he can spur export demand by weakening the currency. The last time the BoC eased to stimulate growth by weakening the currency, non-energy exports flat lined even as global demand accelerated (Figure 4). What responded strongly to rate cuts was debt-financed household spending, which led to a historical debt load. We doubt the BoC is eager to see households reload on debt. Lastly, although the BoC has left rates unchanged this year, Canadians have de facto benefited from Fed easing, which helped send mortgage rates lower.

Figure 4: Would a weaker currency Canadian help non-energy exports this time?

Source: Haver, BMO GAM

Outlook and Positioning: Caution is never bad, but mind the optimism surge

With a volatile news flow, our core asset-allocation positioning is little changed. We remain modestly overweight to equities versus bonds. Our overweight to U.S. and Canadian stocks while underweighting EAFE is unchanged, but recent economic and earnings data reinforced our long standing preference for U.S. stocks.

We expect the renewed trade optimism to face some headwinds from softening macro data and keep yields on government bonds range bound until we get confirmation of growth stabilization in the U.S. and globally. Credit spreads remain tight for a late-cycle dynamic, but the reach-for-yield is persistent.

Finally, the loonie is a bit more exposed to Poloz’s fears and while Canadian economic growth is likely to remain underwhelming in into year-end, it’s hard to find evidence of contagion from the global slowdown. Extending the global reflation trade should bring a weaker greenback and benefit the loonie, though it may lag the weakest currencies this year, such as the Euro or other commodity currencies like the Australian dollar.

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.

This commentary has been prepared by BMO Asset Management Inc. the portfolio manager. This update represents their assessment of the markets at the time of publication. Those views are subject to change without notice as markets change over time.

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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