Thoughts from MAST’s Corner Office - January 2019 Monthly Commentary

Instead of celebrating a Santa rally, investors were left with a heavy lump of coal for Christmas as the S&P 500 fell 9% in December.
January 2019
“The stock market has predicted nine of the past five recessions.” – Paul Samuelson

Financial Markets are Too Early in Predicting a Recession

  • December was brutal for equity markets, but we think stocks sold-off too excessively on unjustified fears of recession. While U.S. growth is slowing to more sustainable levels, we don’t see a recession in the near-term as consumer spending is well supported by tax cuts and a solid job market.
  • Negative news abounded last month, but remarks from Fed Chair Powell regarding the balance-sheet runoff being on auto-pilot spooked markets and fueled fears of a Fed policy mistake, but he walked it back earlier this month.
  • Valuation and earnings growth continue to justify an overweight to equities, in particular in the U.S. a less hawkish Fed without threats of inflation should also support equities.
  • Canadian stocks should also benefit from renewed U.S. stock momentum, but its economic performance is expected to continue lagging the U.S. and maintain downward pressure on the loonie


That Escalated Quickly – Ron Burgundy

Instead of celebrating a Santa rally, investors were left with a heavy lump of coal for Christmas as the S&P 500 fell 9% in December. The intra-month drawdown even neared a brutal 15% on Christmas Eve as recession chatters intensified and scaremongers clamored echoes of 2008. Volatility was high, but not to unusual levels relative to historical norms (Chart 1). For Canadian stocks, the bloodbath was less brutal, though still painful, as the S&P/TSX registered a 5.4% loss for the month, similar to European stocks. Things were not as bad for emerging markets, with the MSCI EM index falling only 2.9%, whereas Japan’s Nikkei fell 10.3%. Fears of a global economic slowdown also crushed oil prices to $45 per barrel, a 42% collapse from their October peak, which pushed the loonie lower by 2.5% in December. Safe-haven government bonds had a great month as Canada’s 10-year federal bond yields fell 30bps to end the month below 2%.

Chart 1: S&P 500 Trading Days +/- 2% Per Quarter

Chart 1: S&P 500 Trading Days +/- 2% Per Quarter

Source: Bloomberg, BMO Global Asset Management

From a factor perspective, equity investors had nowhere to hide last month as the main equity style factors registered fairly even losses, all hovering between -8.5%, for Quality, to -9.8%, for Value. When volatility spikes and correlations approach 100%, effective diversification is not easy to achieve within an equity portfolio.


December: A Cold Shower of Negative News

Between President Trump’s “I am a Tariff Man” tweet, a U.S. government shutdown, the arrest of a Huawei senior executive in Canada, and a fumbling Brexit process, investors had ample worrisome material to deal with last month. However, the most negative driver was comments from U.S. Federal Reserve (Fed) Chair Powell, who spooked markets by saying that the balancesheet runoff program was on autopilot while delivering the ninth rate hike since 2015. His rosy economic assessment even had market commentators suggesting he sounded like Bernanke’s “contained” moment in 2007. Investor’s fear of a Fed policy mistake rose. Even the dovish remarks that followed from New York Fed President Williams were not enough to cheer investors. Although Williams sought to deliver a more pragmatic message, suggesting the Fed was not a preset course, he doubledowned on the autopilot remarks. What a month.


Is a Recession Near?

We have been expecting a slowdown for 2019, but we don’t see a U.S. recession before 2020. While some indicators have recently softened– notably manufacturing and housing activity– consumers have been resilient going into year end, with spending supported by tax cuts and an unemployment rate sitting below 4%, a record low for the U.S. We expect Q4 consumer expenditure grow at an annualized rate above 3%, a pretty solid pace. Given that U.S. consumers account for 70% of economic activity, it’s hard to see a recession at this point. It’s equally hard to envision firms switching from an environment of labour shortages to laying-off workers without much of a transition. The economic situation in Canada is similar with a cooling of growth but no recession on the radar. In Q4, Canada added 115k jobs, whereas non-farm payrolls in the U.S. jumped by solid 762k jobs.

As much as investors feared higher interest rates back in October, the collapse in government bond yields in Canada and U.S. has effectively removed a key headwind to economic growth and stock markets. Capital markets are a great discounting mechanism, but they don’t always get it right. As the quote from Nobel Laureate Paul Samuelsson says about equity markets predicting nine of the past five recessions, investors tend to overreact to uncertainty and fear, and thus tend to over predict recessions.


…But the Yield Curve is So Flat

Investors are obsessed with the yield-curve flattening, especially the 2- and 10-year points of the curve, which ended the year at less than 20bp away from inversion, it’s flattest since 2008 (Chart 2). While we recognize the forward-looking aspect of bond yield curves, we also think the U.S. curve is flatter than it should be at this point of the cycle because of a few factors. First, the Fed is hiking and yield curves flatten when a central bank hikes. Second, the Fed has deliberately made the curve flatter with Operation Twist in 2011, when it sold short-term Treasuries and bought long-term ones, which pressured long-term bond yields downward. Third, the U.S. Government is running a behemoth fiscal deficit but relies mostly (85%) on short-term paper (less than 5 years) for its funding. The flooding of bonds in the front end of the yield curve thereby exacerbates the flattening. Finally, add to it that it’s been a great trade since 2014 with 250bp of flattening, it’s no wonder investors have piled into that steady wagon.

Chart 2: 10Y - 2Y US Treasury Yield Curve

Chart 2: 10Y - 2Y US Treasury Yield Curve

Source: Bloomberg, BMO Global Asset Management

Is the Fed Done?

For the same reason we don’t see a U.S. recession in the next 12 months, we don’t think the Fed is done with rate hikes just yet, even though the rates market recently went as far as fully pricing a rate cut next year. Although we don’t think rate cuts are coming soon, there is now a greater scope for an extended pause by the Fed. If U.S. growth remains above 2% this year, as we expect, it’s hard to envision the Fed not hiking at least once.

As for the Bank of Canada (BoC), the interest-rates market is now predicting that the BoC stays on the sidelines through 2019. This is also in sharp contrast to euphoric market expectations last October, when Governor Poloz dropped his “gradual” language and emphasized on the need for monetary policy reaching neutral (at least 2.5%). For the BoC, hiking rates independent of the U.S. seems unlikely given that Canada is a small, open economy and highly dependent upon U.S. activity. What is now clear is that the threat of inflation has largely disappeared with lower oil prices. With job creation still robust in the U.S., wage growth and the impact of tariffs are the key threats to the inflation outlook.


Outlook and Positioning: Are Equities Attractive?

Despite slowing economic growth and lower market expectations for earnings growth, improved valuations mean that equities remain attractive, especially U.S. stocks. We expect healthy economic growth, mid to high, single-digit earnings growth for 2019, which, when coupled with what we feel is an overly bearish market sentiment, warrants maintaining an overweight to stocks versus bonds (Chart 3).

Chart 3: MSCI World EPS Growth Forecasts

Chart 3: MSCI World EPS Growth Forecasts

Source: Datastream, BMO Global Asset Management

The January 4th speech by Powell probably represents a key pivotal point for markets. Powell finally fine-tuned his messaging and re-assured investors the Fed would not hesitate to change its view, notably on the balance-sheet runoff, if needed. In our view, this clear statement regarding the Fed not being on a preset course should limit the scope for a Fed policy mistake and support equities while sending bond yields higher.

In December, the key changes we made to our geographic positioning tilts was to upgrade EM stocks from negative to neutral, while downgrading the U.K. For the U.K., the lingering Brexit process should limit upside potential for U.K. shares. The upgrade of EM was driven from a few factors which recently turned favourable. First, we have been increasingly optimistic on a trade deal between the U.S. and China. Second, a more dovish Fed removes a critical headwind to EM equities and should limit further appreciation of the USD versus EM currencies, especially for the CNY. EM valuations are attractive after experiencing a 16.6% decline in 2018. Finally, we think government bonds with duration above 7-years are unattractive and yields have retraced too excessively, so we maintain our short-duration call on fixed income.

For the Canadian dollar, its recent weakness below $0.75 makes it better aligned to its fundamentals and our views on Canadian and U.S. interest rates. Because we continue to expect Canada’s economy to underperform the U.S., we remain bearish on the loonie, although the Fed stance could drive more the upcoming moves for the loonie. We are probably near the cyclical peak for the broad USD.

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