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Shifting to Neutral: The Case for Optimistic Caution

BMO GAM’s Monthly House View

June 2024
CIO STRATEGY NOTE

Shifting to Neutral: The Case for Optimistic Caution

The winds of change are blowing. In early June, the Bank of Canada (BoC) became the first of the world’s major central banks to lower interest rates, cutting by 25 basis points a day before the European Central Bank (ECB) made the same move.

But in the United States, it is a different story. There, we’ve seen a great run-up in markets on the back of resilient consumers and strong earnings. Given the strength of the U.S. economy, a higher-for-longer interest rate trajectory seems nearly certain.
However, there are some signs of softness – consumers being a little more “value-focused,” rising defaults and a few more cautionary comments from retailers. With those factors in mind, we believe this is an environment where you don’t necessarily need to be overweight Equities anymore. That is why we’ve taken down our position from overweight (+1) to neutral (0) for the first time since last year. Overall, we still remain relatively optimistic about markets and the economy. A shift to neutral on Equities allows us to take some profits and reduce our risk while still getting the exposure we want.

We believe this is an environment where you don’t necessarily need to be overweight Equities.

Don’t take your eyes off of the consumer. The key question is: what will happen to inflation? Will it head lower like in Canada or stay relatively stubborn? In the U.S., we are seeing consumers slowly adjusting but not at a worrisome pace, which makes the Federal Reserve (Fed) rate decision even harder. Cut rates too fast, and we could see a surge in inflation. The markets remain resilient driven by earnings, which justify current valuations even without rate cuts. So, if the consumer remains fairly strong, we think markets can still go higher from here. That doesn’t necessarily mean the economy and market momentum won’t slow down somewhat; we’ve already seen a shift in consumer spending away from Discretionary and toward Staples. But crucially, the consumer is still spending—just on different things. That’s an encouraging sign for markets as we head into the summer.
ECONOMIC OUTLOOK

Canada’s Yawning Productivity Gap Taking a Toll

Signs that a humming U.S. economy is losing steam are emerging, notably among lower-income households. In contrast, the Canadian economy is grasping for growth amid a worsening split with the U.S.

U.S. Outlook

Overall, things are steady. We have a soft- to no-landing backdrop where we no longer are fearful about the economy overheating—which was a legitimate concern just a few months ago. Inflation remains a bit strong, but demand is moderating, which is important. Headline economic growth is running at about 3% annualized. The consumer remains strong but is similarly cooling into a more sustainable position, mirroring the labour market. One concern is, we’re seeing a two-speed economy where lower income households are definitely struggling. Credit delinquencies are going up—they’re not spiking—but they’re going up despite full employment because accumulated inflation has been biting into purchasing power. Those households are fully employed, but they are struggling.

Canada Outlook

A growing disparity between the U.S. and Canada goes on, with the former not quite on the cusp of rolling into recession but stuck with a backdrop of sub-1% gross domestic product growth—which is definitively soft enough for the central bank to continue with interest rate cuts. The U.S.-Canada productivity gap that opened up about a decade ago is again worsening (see chart). The job market overall is holding up, but that is underpinned by public administration and healthcare jobs. The private sector, especially the goods producing side, is exhibiting weakness. The Canadian economy is coping, but is bruised from rate hikes and the worst of the mortgage reset “storm” is still ahead of us. It is going to be challenging in the next 12 months.

GDP Per Capita in U.S. Dollars

GDP Per Capita in U.S. Dollars
Source: Bloomberg, BMO GAM, 2023 Q4 data.

International Outlook

EAFE is improving, though still at a modest pace. Emerging Markets (EM), led by China, is still challenged. The trickling of stimulus is helping but there are issues—especially domestically in the latter, with real estate headwinds lingering. China manufacturing is also struggling to ramp up production because it is already producing so much. Chinese manufacturing Chinese manufacturing Purchasing Managers Index readings (PMIs) are struggling to remain above 50—a key gauge that if below that mark, indicates contraction; China is flooding the world with cheap manufacturing goods but it is still in the context of massive excess supply.

Key Risks
BMO GAM house view
U.S. Recession
  • Risks have been diminishing over the past 12 months
  • Likelihood is now low risk – consensus for U.S. contraction is 30% odds
Inflation
  • Peak anxiety around sticky inflation has likely passed
  • Weakening demand environment supports a lower inflation outlook
Interest rates
  • With U.S. inflation concerns cooling, so too are rate worries
  • A rate hike is likely ruled out, but further delays may still be in cards
Consumer
  • The Canadian consumer remains bruised
  • The U.S. consumer is finally moderating from strong to ‘less strong’
Housing
  • Both U.S. and Canadian markets are feeling rate effects; activity is dampened.
  • Rate cuts in Canada may affect demand side dynamics
Geopolitics
  • Escalation risk is lowering in the Middle East
  • The U.S. is working to keep conflict localized and markets undisturbed
Energy
  • Dampening geopolitical risks are suppressing oil prices
  • OPEC+ agreement to unwind production cuts is a countervailing force—though moving slowly
PORTFOLIO POSITIONING

Asset Classes

Divergence abounds across stocks and bonds, with a shift in monetary policy from Canadian and European central banks creating opportunities in Fixed Income, while inflation is causing headwinds for some Equities—and tailwinds for others.
We are back to a neutral rating across the board. Despite the positives in the U.S. economy, the market is squarely focused on where rates are going. In that regard, higher-for-longer is now edging over the line into higher forever. We are still seeing sticky inflation in areas such as wages and housing prices, and the Fed just keeps pushing back on the idea of cutting rates. The market has a single 25 basis point cut priced in for the year, for November, after the U.S. election.
On equity markets, Nvidia has done its part, delivering on promises and expectations. But when you look under the hood, the breadth of stock participation has been narrowing. Inflation is an issue for many parts of the market. That said, other parts, such as commodity producers, are getting a tailwind. It is not just gold but base metals now reacting, namely copper. Part of this is the long-term theme of AI and an ‘electrified everything.’ But be mindful—when you start seeing commodities pop, there’s a fear that we’re going to keep seeing inflation. We are also starting to see some weakness in the economy, which is when talk usually turns to stagflation. For the moment, cyclicals are still outperforming defensives, with one notable exception: utilities, which are being caught up in the Artificial Intelligence (AI) mania.
On Fixed Income, we are currently trading range bound on Treasury yields. The question is, if we do see a slowdown in growth and commodity prices ticking up, that’s when you get a “bear steepener”—the market starting to price in long-term inflation, but not enough rate cuts to counteract it. By contrast, for Europe and Canada, there is markedly more opportunity for Fixed Income upside. With one cut already under its belt, the markets expects the BoC will likely cut 50 basis points or more this year. The ECB outlook is similar. There is some opportunity to pick up potential gains in those bonds on the realization of lower rates in those markets.

EQUITIES

FIXED INCOME

CASH

PORTFOLIO POSITIONING

Equity

The U.S. stock market rolls on despite valuations becoming a concern, particularly among Technology names. We remain overweight to that market, though some rotation into EAFE may not be far off.
The U.S. market continues to be in a relatively unique position. When soft data comes through, it can be market positive because it gives the Fed more room to cut interest rates. Whereas with strong data, which supports revenues and earnings, it is a negative for interest rate policy. For the second half of 2024, we expect to that trend continue, with ongoing volatility. Yet we still remain overweight to U.S. equity because those companies—and the broader economy—are still in the best relative position. The caveat is valuations, specifically with Technology. While we are maintaining our overweight to the U.S., we have downgraded that sector to underweight. More broadly, the U.S. stock market is handling setbacks—whether it is soft data or stronger data, no matter. It has resumed its uptrend.
With respect to Canada, we remain slightly bearish (-1). We are seeing slower growth, a rise in unemployment and the gap in our relative competitiveness widening, particularly with our neighbours to the south (see Economic Outlook chart). As that persists, we are maintaining an underweight to Canada. Bank earnings were telling, the sector overall remains healthy despite elevated interest rates that have started to squeeze the consumer. That is a worry. Yet when we look at valuations, they are attractive in light of the fact that banks should be big beneficiaries of rate cuts.
Internationally, the ECB is embarking on a rate cut cycle even as growth has been heading in the right direction. We have not seen enough evidence yet for us to rotate from the U.S., but it is a relative waiting game. We are seeing green shoots. We remain neutral on EM as well. China is taking more measures to stabilize the real estate sector. While small in terms of the relative size of the market, it should positively impact investor psychology.

CANADA

U.S.A.

EAFE

EM

PORTFOLIO POSITIONING

Fixed Income

The Fed is standing pat until inflation settles into a 2–3% range for a prolonged stretch, therefore we remain patient, too. In Canada, the market is perhaps underestimating the extent to which the BoC may diverge from U.S. policy rates.
The resilient uptrend in U.S. inflation that was witnessed in the first quarter has reversed but there is still work to be done. The Fed will likely want to see several months of consistent inflation in the 2-3% range before they cut. Inflation may be cooling again but it will take a quarter of weaker prints before the Fed responds. The market sees policy rates staying put until at least the fall. We are still in the camp that sees the risk of the Fed doing less rather than overreacting. For them to rush, we really need to see some significant deterioration in the labor market. We are not seeing that. From a positioning perspective, as the Fed stays patient, we are likewise staying so on Duration,1 we are not making any leap to go overweight. At the same time, we know the overall direction the market is readying for, so we are not underweight either.

In terms of credit spreads on High Yield, they are tight in the U.S. and we expect them to remain so, with growth cooling and not crashing. In Canada, they are less tight and there is scope for improvement as interest rate cuts price in. There is going to be more divergence in bond market pricing between the U.S. and Canada, based in part on the fact that there will likely be more cuts in Canada than what the market is pricing in. A significant driver of why the market isn’t pricing more BoC cuts in, is the perceived limits of that divergence with the Fed. There are definite limits to that divergence, but our view is there is more scope for respective monetary policies to widen over the next couple of years than the market currently appreciates. There is significant mortgage refinancing that is coming in 2025 and 2026. Putting aside timing, the narrative has yet to catch up to the amount of loosening the BoC may undertake.

IG CREDIT

HIGH YIELD

EM DEBT

DURATION

PORTFOLIO POSITIONING

Style & Factor

Factors are blurring as Growth names further collide into other categories, while dividends now flow from Technology stocks. Value remains underappreciated, lacking a catalyst that we don’t see arriving anytime soon.

Factors are bleeding into each other in this market. Value is not necessarily synonymous with Quality and Yield at this point. Microsoft falls into the Growth bucket but it is also one of the best Quality names by virtue of its cash flow generation. Even Nvidia is making money on the cash that it is sitting on right now, and it is very much in growth mode. We’re seeing dividends come out of a number of the key market leaders in the Technology area.

Has Growth peaked? Yes—until the next time. Slowing does not necessarily mean stopping and Growth could reaccelerate if we see another blowout quarter for Technology and semiconductors. All the indications on AI spending are there, and that is fuel that could keep Growth outperforming Value for some time. Value stocks are missing a catalyst to unlock that trade, which is typically along the lines of a recession or a credit crisis, and we don’t see either of those quite yet.
On a sector basis, Utilities have gone parabolic following the observation that they are really an AI trade in disguise. Traditionally, Utilities have been a very defensive sector by virtue of their high yield and the fact they raise prices along with inflation, similar to infrastructure stocks. With AI, everybody’s going to need more electricity, which will need to be built and holds implications for materials and even industrials. If AI takes a breather, we might see a cascade effect. Volatility2 is still abnormally low, which has made using options to buy portfolio insurance relatively cheap. And we’ve continued to do that.

VALUE

GROWTH

QUALITY

YIELD

PORTFOLIO POSITIONING

Implementation

Central bank buying underpins a bull market for Gold, which may be in place for some time to come. The outlook for the Canadian dollar (CAD), meanwhile, is challenged. Options are providing downside protection across portfolios.
There is not a great deal to be optimistic about for the CAD. The good news is, we haven’t seen the BoC come out and say, ‘Surprise, we are cutting 50 basis points.’ The CAD would probably head down to 70 cents (U.S.), or further in such a scenario. The other not-so-good scenario to monitor is how wide the spread gets between the Fed and the BoC. If it reaches a full 100 basis points—and it has in the past—you are likely to see a relatively weak CAD.
For Gold, which we have moved to bullish on (+2), we were waiting for a more pronounced correction that never materialized. The next stop on the line now appears to be US$2,500 per ounce, which certainly seems possible given the performance over the past 12 months. Central bank buying is the driving force behind it. The other tailwind has been retail buying, particularly within China as investors have been looking for other opportunities outside of real estate.
We’ve also stepped up the use of options on both equity (S&P 500 put spread) and Fixed Income portfolios, keeping that downside protection in place. As we’ve been in this range-bound yields market for bonds, volatility has come down and made options relatively more attractive. Which is to say, we haven’t overweighted Duration, but we have bought some options on longer duration bonds.
gold bars in the stock exchange graph

CAD

GOLD

Footnotes

1 Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).

 

2Volatility: Measures how much the price of a security, derivative, or index fluctuates.

Disclosures

The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.

 

Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated. For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination. BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.

 

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.

 

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.

 

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