BMO ETF Portfolio December commentary: Wrapping up 2023 with a rally

Portfolio activity

• We completed our move to overweight equities early in the month, which helped the BMO ETF Portfolios’ relative performance. We are holding this overweight position heading into year end and a strong consumer and continued U.S. economic strength should lend themselves to a Santa rally.

• Our tactical overweight of Canadian Banks gained some ground, as third quarter earnings reports were mixed, with some misses on higher expenses, some upside beats on revenue, and a couple of dividend increases. There were additional provisions made for increased loan losses, but not as high as expected in some cases. Canada’s banking regulator decided not to boost capital requirements on the country’s largest lenders, suggesting banks’ balance sheets are strong enough to withstand economic turbulence. The Office of the Superintendent of Financial Institutions left the domestic stability buffer at 3.5%, following increases in both June and last December.

• Our Overweight duration position in the BMO ETF Portfolios has worked exceptionally well, with a half year overweight benefitting from the sharp drop in yields. While we are cognizant that the market may be getting a bit ahead of itself relative to consensus U.S. Federal Reserve cut pricing, we are maintaining the position headed into year end.

Wrapping up 2023 with a rally

Last month set a number of records. The 5th best November S&P500 Index return since 1930: 8.9%. The second best return for 60/40 portfolios (ie, 60% Bloomberg U.S. Aggregate Bond Index, 40% S&P500 Index): 7.3%. The day after month end, gold set an all-time closing high of $2072.22 USD/oz, a 2023 year to date return of 13.6%. The largest driver of the positive trends were falling rates, pushed downward by accelerated expectations of U.S. Federal Reserve (“Fed”) cuts in 2024, due to softer inflation data. All told, a welcome respite from September and October’s downdraft.

Here in Canada, we hit the “technical recession” target, with third quarter GDP registering -1.1%. However, revisions to the prior quarter were dramatic, rewriting the prior -0.2% print to 1.4%, keeping us out of the recession categorization, although the overall weakness of the economy remains clear. The Bank of Canada held rates at 5% as broadly expected, although the timing of market-implied 2024 cuts is now a month earlier than the U.S. (April versus May), with five cuts by the end of 2024. Since it’s peak in early October, the Government of Canada 10-year yield has fallen over 96 basis points (bps), pushing the FTSE Canada Universe Bond Index 4.3% higher in the month of November. (Bloomberg, 2023).

US JOLTS (Job openings and labour turnover survey) and ADP Employment Report came in light, fueling a bit of an equity bounce, but the more broadly followed Non-farm Payrolls data showed 199,000 versus the expected 189,000, and follows the 150,000 print of October. The impact on bonds has been significant, with the U.S. 10 year falling as low as 4.14% over the past month before easing back up modestly, with Fed Futures moving to price in up to five 25 basis point rate cuts from the Fed in 2024. This seems to be pricing a perfect landing, not a soft landing for the U.S. economy. Meanwhile, factory and durable Goods orders have continued to contract, with the ISM Manufacturing Index moving lower to 46.7, confirming contraction. Services have kept things afloat, but also remain the primary driver of inflation for wages. However, surging productivity resulted in lower unit labour costs in the third quarter, so even low wages were higher, there was more output per dollar, boosting both the economy and presumably, corporate profitability. This is in stark contrast to Canada’s six quarters of consecutive productivity declines, leading to unit labour costs of over 6% year-over-year.

The European Central Bank (ECB) joined the reindeer games as well, with increasingly dovish commentary on the progress shown in fighting inflation, with futures markets pricing in six cuts, or 146 bps. Keep in mind that the ECB policy rate is already a full 100 bps lower, so this larger absolute cut pricing is proportionately more aggressive. Considering the U.S. and European Monetary Union core inflation rates are near dead equal at 3.46% and 3.60%, this seems odd. However, a comparison of headline inflation (at 2.4% vs 3.4%) along with weaker Manufacturing Purchasing Managers’ Index (PMI) readings would suggest that the more aggressive ECB cut projections are justified. It certainly does reflect the weakness in manufacturing PMIs in the region however, as policy makers focus more on stoking growth versus sticky inflation (situations where prices do not adjust as quickly to supply and demand changes).

Given the pace of the equity rally, concerns of it being stretched are admittedly fair. From a technical aspect, while a surge in the net number of names trading setting new 20-day highs is promising for December’s returns, the percentage of names breaking above their 50-day moving average remains shy of 90%, a level more typical of the early stages of a more durable rally. However, futures positioning is still remarkably bearish, indicating that investors are not “all in”, and the massive balances in U.S. money market funds indicates that there is more dry powder to be deployed ($5.9 trillion, according to the Federal Reserve Bank of St. Louis as of end of the second quarter). December is also historically a strong month for equity returns, particularly when there has been established momentum through November.