CIO STRATEGY NOTE
Only fools rush in (or out): Caution calls for a rotation, not exit
If there is one thing I’ve learned about the psychology of the investor, it’s this: people don’t like to miss out on a run-up. If you sat on the sidelines in 2022 and 2023—perhaps opting for a guaranteed 5% return on a GIC—then you ended up missing out on significant gains.
That creates an emotional pull to make a change and jump back into Equity markets when the perfect opportunity arises. But here’s the catch: the perfect opportunity doesn’t exist, because precisely timing the market is virtually impossible.
What we do instead is stay invested, taking profits and rotating to areas with more potential upside when prudent. That’s exactly how we’ve adjusted our positioning recently. Markets are continuing to show strength, but there are reasons to exercise some caution: U.S. election-related uncertainty is rising, earnings expectations are running high, the job market is softening and consumers are continuing to shift their purchasing preferences as their financial health weakens. To echo my comments last month: we don’t believe it’s the right time to take on additional risk, but we also don’t think it’s the right time to take significant money off the table either. There is nothing wrong with some profit taking in winning positions. This bullish-but-cautious approach has worked well for us recently, and it is our intention to stay the course and keep some protection in our portfolios for the remainder of the year.
Markets are continuing to show strength, but there are reasons to exercise some caution.
What kind of protection are we employing? For one, we’ve reduced our allocation to cash and increased our weight to Fixed Income; if stock markets were to gyrate downward, that could speed up the U.S. Federal Reserve’s (Fed) rate cut schedule and fuel the bond market. We’ve also increased our Duration1 on the expectation of rate easing. In Equities, we’ve increased our factor exposure to Value, and we’re taking off our large cap bias, in part due to potential rate cuts (which could support a broadening-out of the market) and in part because large caps have more room to fall than small caps. Finally, our knowledge of the options market allows us to buy protection through puts or put spreads without reducing our Equity position. We have to pay a small premium, but it’s an efficient way to secure protection while staying invested for the long term and participating in potential upside. We can also employ selling calls when volatility picks up to help add incremental returns.
Director, Multi-Asset Solutions
ECONOMIC OUTLOOK
Wheels down: the long-awaited soft landing is here
Both U.S. inflation and the economy have cooled to levels that should bring monetary policy relief, despite consumers that, on the surface, are doing just fine. As the Fed likely gets going with a double-shot rate cut in September, Canada is also likely to accelerate interest rate cuts.
U.S. Outlook
The U.S. continues to surprise—Q2 gross domestic product (GDP) has come in a bit stronger than expected, confirming once again that there might be things we don’t like within the U.S. economy but the big picture is still a story of decent growth and resilience. In the first half, growth averaged 2.1%, which, yes, is a step down from the 4%-plus witnessed in the second half of last year—but that is certainly not to be confused for a weak economy. Although we have been expecting continued cooling of labour demand, the July payrolls report disappointed investors and slightly raised the odds of a recession over the next twelve months. However, we expect labour demand will remain robust enough to avoid wide-spread job losses, which is typically what triggers a recession. The cooling of the labour market should reinforce the view that inflation is in the rearview mirror, which should allow the Fed to proceed with rate cuts at its September Federal Open Market Committee meeting, perhaps with a 50-basis-point cut.
Digging below the surface, we continue to see a bifurcation across segments and households; housing and car sales are looking a bit weaker as high interest rates drag. But overall, we expect households to continue to benefit from improving real (i.e., inflation-adjusted) wage growth and purchasing power. Another big boost of late has been wealth effects. Home prices in many areas have stabilized and rising Equity markets are boosting confidence. Given that the Fed has its overnight policy rates, it leaves plenty of room for rate cuts and this should represent more good news in terms of realizing an economic soft landing.
Longer term, the fiscal deficit is a sizable, structural risk, which will remain so for the foreseeable future. Neither Vice President Kamala Harris nor Donald Trump is talking about cleaning up fiscal policy. They both want to spend in different ways—yet that too can be viewed as bullish in the short term, even though it’s far from ideal from a macroeconomic perspective.
Canada Outlook
Unemployment rate rising without job pain (yet)
Source: Bloomberg, BMO GAM, as of June 2024.
The key word is sluggish, with 1–1.5% year-over-year GDP growth expected at best. We may take a victory lap insofar as a recession has yet to be triggered, but it is still a bruised economy that is in need of more rate cuts. The picture has darkened as the year has progressed—in April, the market was debating whether we needed interest rate cuts. The Bank of Canada (BoC) has now delivered back-to-back cuts with the market pricing in another at the next decision in September. We would argue the BoC’s overnight rate should be no higher than 3%, with an economy moving firmly into excess supply, an unemployment rate going up (but encouragingly with limited job losses, see chart) and a housing market that remains frozen. Part of the remedy is looser financial conditions. The consensus is leaning toward an overnight rate of 4% by year-end. Our view is, there is a greater likelihood the BoC gets more aggressive to quicken the pace. Economic performance has been sluggish enough to justify getting policy rates to at least neutral, which is 2.5–3%, or 150 basis points (bps) of cuts that will need to occur sooner rather than later.
Domestically, that justifies a negative view on the Canadian dollar (CAD), which is what our current position reflects. The upside risk to CAD is if the Fed begins to move more aggressively, and likewise commences 50 bps cuts. The base case however is for a weaker loonie.
International Outlook
The international data flow has turned disappointing from a macroeconomic perspective, with important high-frequency indicators out of Europe unexpectedly softening. We know it has been a choppy period for industrial production out of Germany, but we were hoping to see improvement through the summer. Instead, it looks like a plateauing. The Eurozone remains in a modest rebound, but we are now seeing some speed bumps already, which is a concern.
Japan is a similar story: an emergent weaker-than-expected growth outlook. If you listen to the narrative around the Bank of Japan, and economic potential, the data has surprised to the downside; the economy is struggling despite global demand for manufactured goods and very strong exports. Even with that, Japan is unable to pick up growth momentum, and it is now an open question of whether growth is merely paused, or there is a risk of a new wave of sustained weakness. The Japanese yen has finally broken out against the U.S. dollar (USD), which will be negative on the export side for Japan.
On Emerging Markets (EM), specifically China, the last month has been one more disappointment in a long series of them. Revival hopes are pinned on stimulus but as we’ve been saying, the trickling of stimulus has been a band aid rather than booster shot. They still have a long way to go to achieve a sustainable economic outperformance. The drying up of foreign direct investment (FDI) is a structural headwind that is not likely to dissipate—there is now FDI outflows out of China, which can be considered a game changer versus where they’ve been for the past two decades. Domestically, real estate remains a painful mess, with recent central bank rate cuts mostly putting a floor on the economy.
Key Risks | BMO GAM house view |
|---|---|
Recession |
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Inflation |
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Interest rates |
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Consumer |
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Housing |
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Geopolitics |
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Energy |
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Director, Portfolio Manager
PORTFOLIO POSITIONING
Asset Classes
U.S. Equities continue to benefit from a constructive macro environment, but are increasingly subject to bouts of near-term volatility. With the Fed’s rate path coming into better view, we are getting bullish on bonds.
Our Equity score remains neutral this month—but only by a whisker. There’s probably a heightened uneasiness around tail risk2 and shorter-term issues, but the macro picture still looks good in terms of the directional strength of the global economy, continued earnings growth and importantly, a broadening of that growth. That’s all positive for Equities over the longer term. To be sure, it is hard to argue with the market’s sensitivity toward overvaluation, resulting in some near-term sell-offs in the Mag 7 stocks (Microsoft, Apple, Alphabet, Amazon, Nvidia, Meta Platforms, Tesla), Technology as a whole, as well as the index (NASDAQ). Emotions are also running pretty high in the U.S. surrounding the election. So, while we are sticking with neutral based on macro fundamentals, those things taken together means we are cognizant of shorter-term volatility. That said, an encouraging indicator of durability has been the broadening of the market, which entered another level this month with the rotation into non-Technology sectors such as Financials and Energy as well as mid and small caps.
On Fixed Income, we have switched cash positions back to bonds, where we think there is growing visibility on the Fed’s policy rate path. What we’ve seen recently with economic data—the softening of core inflation, a little bit softer job numbers (not aggregate, but at the lower end)—is leading the market to more aggressively price in Fed cuts at the margin. It is why we have moved to +1 on bonds, and -1 on cash.
EQUITIES
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
FIXED INCOME
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
CASH
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
Head of Multi-Asset Solutions
PORTFOLIO POSITIONING
Equity
We are neutral overall on stocks, but are positioning for potentially sustained rotation given the alignment we are seeing around economic data, policy rates and earnings growth.
The question we find ourselves asking is, will the trade out of Technology be sustained? There are three requisites needed for a durable rotation. First, we need the economy and employment not to crack—we do not need to see elevated strength, but we do not want sharp contractions. The second requirement is rate relief from the Fed on the back of easing inflation. The final item is broad-based earnings growth; prior to this quarter, headline S&P 500 earnings have been fine, though digging beneath the surface excluding the Mag 7, profits have been flat to negative. The market simply will not get a sustainable rally or rotation on flat to negative earnings—and the third driver is what investors are most on the fence about. As of this writing, we are well into Q2 earnings season, and the good news is, we have seen earnings growth broaden. We are likely to see the first two requirements hold. We need that third piece to continue. The comparable example is the rally witnessed in late 2023, where the market was beginning to price in all three drivers—rate relief, cooling-not-crashing economic conditions and steady earnings growth. That rally fell short, because we did not see rate relief or steady earnings growth.
On Canada, the domestic economy continues to falter, which is keeping us from getting more aggressive on even historically reliable sectors, such as the banks (though we do like Financials globally). Similar to the three drivers for U.S. Equities, we are seeing rate relief, but cracks are forming in employment and the economy, while the TSX had a lackluster earnings season. Just one of those three requisites is being met.
In Europe, we have seen a pullback, with composite Purchasing Managers’ Index readings unexpectedly declining. Germany was particularly soft. With respect to EM, valuations are looking more attractive in Chinese Equities, but a weak economic backdrop doesn’t give us the necessary conviction to upgrade our view.
CANADA
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
U.S.A.
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
EAFE
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
EM
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
Head of Multi-Asset Solutions
PORTFOLIO POSITIONING
Fixed Income
Odds are climbing of deeper cuts in the U.S.—benefitting Duration—but with policymakers keenly averse to rattling market confidence, we expect a more reserved path for rates, commencing next month.
We have upgraded Duration this month given the likelihood the Fed will commence cutting—it is a high bar not to cut in September with the inflation data where it is and several months of trend or sub-trend prints now in the rearview mirror. That’s given us the confidence to upgrade longer bonds to +1. The market is starting to price in an emergency cut before September as a possibility. We are not in that camp—we think a cut would in fact be very negative for markets. The Fed is very cognizant of not sending any kind of “panic signal” that might suggest they made a mistake they need to rush to fix. They will likely avoid that. A quarter to 50-basis point cut in September will most likely be the kickoff to a new cycle, warranting an upgraded view on Duration. More broadly, economic growth is holding up very well which gives us confidence that Investment Grade (IG) spreads won’t widen materially. We are happy to pick up that additional yield from corporates. In this environment, IG spreads should stay tight but still provide a bit of yield pick-up.
We should lastly make a comment or two regarding the BoC and Canadian Fixed Income. Quite simply, a relatively weak economy requires sub-3% rates in order to affect stimulative policy. That cannot come soon enough, in our view. We think the overnight rate will be there by the end of 2025 but anticipate faster and deeper cuts from the BoC compared to the Fed.
IG CREDIT
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
HIGH YIELD
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
DURATION
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
EM DEBT
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
Director, Portfolio Manager
PORTFOLIO POSITIONING
Style & Factor
There are risk sensitivities building, making us partial toward low-vol strategies across the portfolios. Value stocks have been primary beneficiaries at the expense of certain corners within Technology—a trend that could well continue.
We have discussed at length in recent reports the lack of a clear-cut catalyst to spark a rotation trade toward Value, and despite flows now moving in that direction, Value is still trading below its long run average relative to Growth. There is an argument to be made for some stealth catalysts at work, by virtue of the fact that there has been a clear rotation over the past month (seemingly into anything but Technology). Recent market volatility has amplified Value’s relative gain, which only turned upward as recently as July 10, leaving Growth still firmly in the lead on a year-to-date basis. Further confirmation from economic data between here and the September Fed meeting will be key to see if this firms into a longer-term trend.
We remain partial to low-volatility strategies, hence our score of -1 for the Volatility3 factor. Low-vol is simply a way of getting defensive, whether we are lowering beta4 in the portfolios or rotating into Value exposures, it all reflects some heightened risk sensitivity—not aversion, because we are still neutral Equities. But all portfolios at the moment are looking for one or two levers to pull in order to play some defense. To be sure, we do not want to pull them all at once—we still favour the U.S. market over the long term expressly because of its Growth tilt—but there is an alpha-generating shift into Value opportunities, with many stocks within that lens potentially poised to benefit from upward revisions in terms of their earnings. When you look at profit growth and fundamentals, Industrials and Healthcare in particular appear very much undervalued.
VALUE
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
QUALITY
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
VOLATILITY
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
SIZE
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
Director, Portfolio Manager
PORTFOLIO POSITIONING
Implementation
There is little hope for a higher CAD, while the opposite is true for Gold. We are looking to add at current levels, with expectations the precious metal’s rise will go on.
On the CAD, we’ll refer you to the economic outlook for Canada at the beginning of this report but in short, a strengthening and likely aggressive rate-cutting cycle coupled with a darkening economic picture leaves little room for any CAD appreciation scenario in the near future. There has been a shorter-term rally in CAD/USD on increased cut pricing in the U.S., but we see that as more an opportunity for the BoC to proceed with deeper cuts of their own rather than a narrowing of the current rate differentials.
On Gold, it is another asset class taken up by the near-term “Trump trade” market movements. Should the Republican nominee win the U.S. presidency in November, expect bullion’s ascent to continue (recent flirtations with cryptocurrencies notwithstanding). When you think about what Gold hedges against, it provides protection against a falling USD—a decline that Trump favours, and thus will do everything he can to pressure the Fed to lower rates. Gold hedges against Equity market volatility, as well. It also hedges against the polarization of global trade, and we’ve got central banks around the world buying it. So, we remain bullish, with a score of +2. Several of the portfolios are looking to add to positions, with the next point of resistance at around US$2,700 per ounce.
CAD
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
GOLD
- Very Bearish
- Bearish
- Slightly Bearish
- Neutral
- Slightly Bullish
- Bullish
- Very Bullish
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).↩
2 Tail risk: The possibility that a highly improbable event will occur.↩
3 Volatility: Measures how much the price of a security, derivative, or index fluctuates.↩
4 Beta: A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.↩
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.
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