An Economy at a Crossroads

Sadiq S. Adatia, CFA, FSA, FCIA

Chief Investment Officer (CIO)

CIO STRATEGY NOTE

As we emerge from a period of seasonality in which markets pulled back and investor nervousness shone through as expected, the focus now shifts to the gradual deterioration of the economy. So far, this is playing out as we anticipated—a slow, gradual decline with some potential upside surprises along the way. With interest rates remaining elevated, we’re also seeing another leg lower in the housing market; in fact, given the stubbornness of inflation, rate hikes remain a real possibility. “Higher for longer” is the slogan of the day, and the implied message is clear: don’t go overweight equities. But that doesn’t necessarily mean that you should be underweight equities, either.

“Higher for longer” is the slogan of the day, and the implied message is clear: don’t go overweight equities.

Cracks are emerging in the economy—that much is apparent. However, the transition we’ve experienced so far has been from a very strong economy to merely a good one. It feels like a decline, but that doesn’t mean that investors should be completely de-risking their portfolios; in fact, we believe that the impulse to go underweight equities is premature. We have, however, added defensive elements to our portfolios to protect in the short term in case we do get a much faster deteriorating economy or more rate hikes. It’s been a strong year for markets, and there’s nothing wrong with locking in gains and being more cautious in the near-term.

The next three months are make-or-break for the economy—an inflection point that will tell us whether a recession is around the corner or if it’s relatively smooth sailing ahead. If the decline of the economy is going to pick up speed, we’re likely to know soon.

Brittany Baumann

Vice President, Investment Strategist

ECONOMIC OUTLOOK

Markets (Mis)Price in a No-Landing Scenario

Implied expectations for U.S. rate cuts in 2024 are muted, indicating investors believe growth will stay solid or even re-accelerate next year. Our view is that a soft landing or even recession are more likely scenarios.

U.S. Outlook

Soaring bond yields are being driven by macro resilience and the U.S. Federal Reserve’s (Fed) higher-for-longer stance. Market-implied expectations have pared back to only a 50-basis point cut through all of 2024—which is effectively pricing in a no-landing scenario for the economy, where growth either continues at a solid pace or even re-accelerates. We’re more of the view that the economy is going to slow from here in the face of high interest rates. The U.S. as well as other global economies are not immune to high rates. Labour markets are slowing and, in our view, will continue to show greater signs of cooling, allowing inflation to fall further. In turn, that will allow central banks to normalize monetary policy next year. So, while we still see scope for another hike from the Fed—which has been priced in for a while, and especially on the back of the strong September jobs report—we still think the fixed income market is mispricing what will happen in 2024. A soft landing or even recession is more likely than a no-landing scenario.

Canada Outlook

The outlook for Canada is similar to the United States, but we think the fixed income market here is even more mispriced. We are already seeing growth momentum slow dramatically in the third quarter in the face of restrictive rates. The current backdrop will allow the Bank of Canada (BoC) to ultimately stop hiking. Canada is also much more sensitive to high rates compared to the U.S., with more indebted consumers as well as mortgages that are more short-term and variable. Resale activity in the housing market has taken a hit amid the recent backup in yields while listings are steadily rising—which makes us doubt whether BoC can maintain its policy rates near 5% through much of 2024. We see cuts coming as soon as the first half of next year.

International Outlook

The growth outlook for China remains grim amid the fallout of the Real Estate sector’s troubles, including now several Chinese real estate giants missing debt payments. There’s also been a lack of significant fiscal stimulus from Beijing. In relative terms, however, monetary policy remains looser than other regions while there are rising hopes for more fiscal stimulus to come, with the Chinese government considering raising its budget deficit forecasts and therefore signaling its preparing to unleash another round of stimulus to prop up growth. In short, the immediate Emerging Markets (EM) outlook is soft, but more medium term we will likely see rate cuts in those countries begin before other regions, propping up those economies.

In Europe and the U.K., recession risk make remains elevated. That’s where leading indicators are weakest and are pointing to a potentially significant slowdown. Their central banks are very restrictive and are potentially prone to hiking into a hard landing.

Key Risks	BMO GAM House View
Inflation	• Pockets of inflation persist, but it’s no longer broad • There is still a risk of a second wave of inflation, in large part due to energy, but it is more manageable now than it was last year
Interest rates	• We may see another rate hike from the Fed, but the end of the cycle is near
Recession	• In Canada, it’s likely approaching and may already have arrived, though it should be mild • The U.S. will have to wait a while longer
Consumer	• The U.S. consumer is resilient • The Canadian consumer is starting to struggle
Housing	• The market has survived the rate hiking cycle • Now, the risk is layoffs, but that should be manageable
Geopolitics	• The greatest risk is escalation of the Israel-Gaza conflict into broader Middle East war that disrupts oil markets
Energy	• Upside for oil is peaking as the demand side grows more negative. • Risks are balancing, though, amid jump in geopolitical tensions

Steven Shepherd, CFA

Director, Portfolio Manager

PORTFOLIO POSITIONING

Asset Classes

Long bond yields are stretching to levels we have not seen in quite some time. That doesn’t automatically mean equity valuations have to suffer, but we are still aware of short-term volatility and maintain defensive hedges within our overall positioning.

Everybody’s been watching the U.S. 10-year Treasury yield, which has been pushed up to levels that are testing the magical 5% threshold, supported by a wave of incoming data that suggests the Fed’s work on stamping out inflation perhaps isn’t done yet. That has raised the spectre of long bonds yields pushing to levels that we haven’t seen in quite some time, opening up the question of whether valuation multiples can withstand historically elevated bond yields. We have seen this situation before, and equities were still able to do quite well over the long term. The sentiment in terms of our equity weight at the moment remains neutral (0)—the outbreak of another conflict initially fired off the market’s collective amygdala, as investors attempted to understand what a second active war is going to mean. We saw primarily a flight to Quality initially, as one would expect, as well as Energy and Defense industry stocks. Overall, we aren’t overtly defensive, but we are being cautious. Seasonality-related market weakness is may not be completely behind us, despite the fact that October is typically the beginning of an upswing. We’re not entirely sure that investors’ collective angst is gone, so we’re still underweight equities in our more conservative portfolios by a percent or two. Overall, we remain neutral (0) on bonds versus cash, as well.

EQUITIES

FIXED INCOME

CASH

Marchello Holditch, CFA, CAIA

Head of Multi-Asset Solutions

PORTFOLIO POSITIONING

Equity

We have gone from a Goldilocks market, where the data flow was just good enough to maintain rising valuations, to one where too much good news has the market fearful of a prolonged bout of elevated rates—and the impact that could have on stocks.

The current weakness and volatility we’ve seen is, in our view, the result of higher rates, which ironically stem from economic data that’s too good—it shows an economy that is still demonstrating a lot of resilience. That’s fed through to higher interest rates, which is subsequently hurting sentiment in the equity market as investors worry about creeping interest expenses and crimped profit margins. We’re seeing one of those ‘good news is bad news’ kind of corrections, as opposed what we would like to see: a Goldilocks scenario like the one we experienced earlier this year, where the data was good but left more room for the Fed to pause its hiking cycle. Now, we’re getting employment data and other indicators that leave central banks with fewer options. In terms of developing geopolitical risks, first and foremost we do not want to overlook the human impact of the Israel-Gaza conflict, which is tragic. Economically, that region doesn’t play a major role in the global economy. The risk, however, is that this becomes a wider conflict, akin to what was feared at the start of the Ukraine-Russian crisis. There are key oil channels in that area, and an escalation would spike the price of oil and hurt key import economies, like Europe.

In Canada, we’ve downgraded equities to slightly bearish (-1) because we are starting to see cracks emerge in the economy, in contrast to U.S. data. We experienced an outright gross domestic product (GDP) contraction in the most recent quarter. A caveat is that we still do selectively like certain sectors within the Canadian economy, in particular the banks. But overall, economic momentum is fading, so we’ve taken some money off the table.

CANADA

U.S.A.

EAFE

EM

Marchello Holditch, CFA, CAIA

Head of Multi-Asset Solutions

PORTFOLIO POSITIONING

Fixed Income

A ceaseless run of strong U.S. data has put increasing pressure on the global bond market, while investors are driving yields higher by requiring more term premium. That said, our view is that an inflection point is on the approach for the Fed and other central banks.

Similar to equities, the bond market has been under pressure because of strong economic data, in particular in the U.S. Whether that be employment, inflation, GDP growth—everything’s pointing to a very resilient economy. With U.S. rates going up, there has been a spillover effect in the global bond market, which is why we’ve seen rates in Canada rise. There’s also uncertainty around whether or not the Fed’s policy is restrictive enough— is it just going to take time for current rates to have their intended effect, or should the market continue to price in ongoing hikes? It is a debate that even Fed officials are having internally. There is camp within the U.S. central bank that believes more needs to be done. Others think we just have to wait. It’s been term premiums driving yields up more than rate hike expectations—investors are driving long-term yields up, not necessarily the fact that more hikes are priced in. There are other considerations for why bonds are under pressure, include fiscal concerns, but a lot of the term premium has been driven by uncertainty around longer-term growth and inflation dynamics.

In terms of our ratings for the month, we downgraded Investment Grade credit and have gone neutral (0) across all three spread categories. We are in a highly uncertain time. We think we are nearing an inflection point where we’ll see central banks move from a tightening to a neutral bias, at minimum. We do not want to be placing big bets in any direction right now.

IG CREDIT

HIGH YIELD

EM DEBT

DURATION

Steven Shepherd, CFA

Director, Portfolio Manager

PORTFOLIO POSITIONING

Style & Factor

Similar to our current view on bonds, we are not making any major bets on any Factor lens. There are some Value trades we still favour, including Japanese equities and Canadian banks. We also continue to employ option overlays on our Energy position.

Last month, we were slightly bullish (+1) on Value but with a neutral 0 on Growth; we don’t like decimals on our scorecard, so that is to say our Value tilt was modest at best. We’ve neutralized that pairing this month and are now dead flat (0) on Value versus Growth. Meanwhile, we’re maintaining our slight Quality tilt (+1); some of the air has come out of the extreme valuations we saw from the ‘Magnificent Seven’ stocks (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla), but they are still driving the market on many days.

There is some Value-oriented positions we favour—one trade would be Japanese equities, and another would be Canadian Banks. In some portfolios, we’ve made an allocation to equal-weight S&P 500, which dials down the exposure to growth-oriented Technology stocks. Overall, we’re being defensive at the margin but we’re firmly within a neutral (0) range. We have made one sector change: Energy went from slightly bearish (-1) to neutral (0). It is important to note, however, that this shift occurred before the onset of the current Israel-Gaza conflict. We continue to sell options around our current holdings and there is no reason we can see to think energy demand is going to drop on an absolute basis in the short term. Many investors are adjusting for a recession sometime next year. However, we are still seeing prints of 336,000 jobs per month in the U.S. and 60,000 in Canada, which would suggest an immediate drop in oil demand isn’t in our outlook.

VALUE

GROWTH

QUALITY

VOLATILITY

Steven Shepherd, CFA

Director, Portfolio Manager

PORTFOLIO POSITIONING

Implementation

All eyes are on the U.S. dollar (USD) and the level of support the higher-for-longer interest rate scenario will provide. Renewed geopolitical risks also represent a tailwind for the greenback.

We remain neutral (0) on the Canadian dollar (CAD). It is really a USD story right now—everyone is watching what the Fed is going to do relative to other central banks. That’s really what’s driving the view on DXY—the U.S. Dollar Index. The USD has received another tailwind given current events in the Middle East; any time there is volatility in global markets, the USD benefits. We are still holding a small Gold position across the portfolios. It makes a great tail risk hedge in the worst of times, and especially with bonds and equity correlations rising over the past month. With correlations between bond and equity returns turning positive again, Gold helps act as an offset to this reduction in diversification.

CAD

GOLD

Disclosures

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An Economy at a Crossroads

BMO GAM’s Monthly House View

Sadiq S. Adatia, CFA, FSA, FCIA