Politics and profits: Finding wins in an election year

CIO STRATEGY NOTE

Politics and profits: Finding wins in an election year

The bad news is that the economic environment is worse than it was one year ago. The good news is that it is still in a pretty strong position and we’re not seeing any signs in the marketplace worrisome enough to warrant taking significant risk off the table. We remain fairly confident that markets can still go higher.

Last month, we did take some profits; we were overweight Equities and had a very positive run-up, so it just made sense. We also took some risk off our High Yield bond position and have moved to slightly underweight (-1) that sleeve of our Fixed Income portfolio. But those are the extent of our positioning changes. We haven’t taken more risk off because again, we remain cautiously optimistic (or optimistically cautious, as we put it last month) about the trajectory of markets.

We remain fairly confident that there is still room for markets to go higher

Looking ahead, there are three key indicators we’ll be watching:

1. The health of the consumer.

   We’ve already seen a shift in consumer spending toward Staples from Discretionary. Earnings data will tell us if this trend is accelerating—or if consumers go beyond a mere shift in spending patterns and begin to really tighten their belts.

2. Inflation and interest rates.

   Our expectation is that we will see a couple more rate cuts by the Bank of Canada (BoC) in 2024, and at least one from the U.S. Federal Reserve (Fed). If anything defers those cuts (like an inflation flare-up), that would be a negative for markets. If, on the other hand rate cuts come a bit faster than expected, that would be a positive (unless it was accompanied by very poor economic data).

3. The political climate

   Uncertainty could cause some material noise, but we’re skeptical that it would have major long-term ramifications for world markets. The U.S. presidential election is particularly noteworthy given reactions to the first Trump-Biden debate. U.S. election developments are certainly something we are keeping an eye on.

Overall, we don’t see any immediate cause for alarm. The issues outlined above merit careful scrutiny, and we don’t believe it’s the right time to take on additional risk. But we also don’t believe that taking significant risk off is necessary at this time.

ECONOMIC OUTLOOK

Strong but not screaming

U.S. economic data remains relatively resilient, but not unambiguously so, as more mixed signals emerge. Meanwhile, Canadian growth stays sluggish and political uncertainty rises in Europe.

U.S. Outlook

The U.S. economy remains relatively strong, but the numbers are no longer screaming—housing has weakened, manufacturing activity remains on the slow side, and gross domestic product (GDP) growth has eased from around 4% in the second half of 2023 to 2% in the first half of this year. High interest-rate fatigue is a concern, and comments from Fed chairman Jerome Powell seem to indicate that they’ve set a fairly low bar for the commencement of rate cuts. Inflation is also still a concern, with some speed bumps evident in the Q1 data. That said, the demand outlook appears to be stabilizing to a sustainable pace. Bifurcation within the U.S. economy continues, with some areas, including manufacturing, housing, and small business operations, struggling in the current environment. So are lower-income households despite a state of near-full employment. Even with the top-line economic numbers looking fairly good, the rising interest rate burden—not a tsunami, but rising nonetheless—is making it riskier for the Fed to keep policy as tight as it is.

Betting odds percentage of winning 2024 U.S. Presidential election: Trump vs. Biden

Source: Predictit, Bloomberg, BMO GAM, as of July 8, 2024.

Canada Outlook

In Canada, the trend of sluggish growth continues. The economy isn’t contracting, but it does seem to be mired in the 1–1.5% GDP growth range at present. There’s no question that policy tightening by the BoC has succeeded in slowing the economy. There was an inflation speed bump in May, but we think it was just that—a temporary concern rather than a sign of widespread inflationary pressure. Wages are easing, and labour market indicators are mixed: some recent numbers were on the strong side, but unemployment data has been trending upward, which we expect to continue. A loosening labour is likely to help keep inflation on the lower side. The overall economic outlook, in our view, is for positive but modest growth, which would fuel the case for further rate cuts. As many as four rate cuts this year is a possibility, with the first already in place, the second possibly coming this month (July), and potentially two more coming in the latter part of the year.

International Outlook

In Europe, concerns around political uncertainty, and particularly the recent election in France, have been the major story. While the situation will continue to evolve, our belief is that it is more signal than noise from a markets perspective. For one, it appears to be largely a domestic or European issue rather than a cause for global concern. With the Labour Party winning the UK elections and the surprise gains of the leftist alliance in France, it appears investors will have to expect a more left-leaning policy agenda from these two large economies, with scope for higher taxes in the mix, which would be another headwind for European Equities.

Emerging Markets (EM) are holding relatively steady. In China, Real Estate headwinds remain and excitement around stimulus has passed, which is keeping sentiment regarding the outlook on the low side. Trade anxiety is also on the rise as Donald Trump’s odds of reclaiming the Oval Office have risen following the first debate with incumbent President Joe Biden. That’s putting some negative pressure on both sentiment and the currency. Overall, the near-term outlook for China is challenging, but that’s nothing new and likely less damaging to the economy and markets than the initial round of tariffs instituted under the Trump administration.

PORTFOLIO POSITIONING

Asset Classes

Bonds are beginning to feel U.S. election tremors, while Equities revel in sustained U.S. economic resilience, led by—what else—Technology stocks. With tail risks growing, a neutral posture across asset classes is warranted.

The Magnificent Seven pulled away in the last quarter after the gap between the group and the rest of the market had narrowed, with names such as Tesla, Amazon and more recently Nvidia suffering pullbacks. Those could be harbingers of further weakness to come from Technology, but in general those mega-caps remain well ahead of the pack as we finish the first half of 2024. Yet it isn’t quite “Mag 7” versus Everything Else. When you look at the entire S&P 500 Index, the number of names trading above their 200-day moving average peaked at about 86% at the end of March. It is presently about 70%. The breadth reading of the index ex-Technology—so everything that isn’t a semiconductor or software—is actually 68%, not that different. It is a broadly healthy market, albeit with mega-cap names in a league of their own. There has been ample commentary asking if we back in a tech bubble. We would disagree, as this looks nothing like the early 2000s by any measure, including valuations.

On Fixed Income, yield curve normalization is a theme we’re watching closely for the second half of the year. The curve has been inverted for longer than any stretch in history without the onset of recession, but we may just achieve normalization without one if the Fed successfully engineers a soft landing. Typically, bonds benefit during yield curve reversioner-steepening, as short rates come down. We’re not seeing that materialize yet because rate cuts (or in the case of the U.S. Federal Reserve, the prospects for cuts) are coming very begrudgingly. There is no economic crisis that needs to be fought off and the economy is still relatively strong. However, while there is not an urgent need for cutting 50 or 100 basis points, real rates do remain restrictive by historical standards, suggesting some room to ease as the job market and associated inflation pressures ease. With that said, we may well see a flat yield curve by the end of the year, or first quarter. What could impact it the most is geopolitics, as the bond market is reacting to recent elections (i.e., UK, France, increasing odds of a Biden withdrawal) more than economic data at present. A neutral outlook is warranted across the board, with multiple tail risks currently in the market.

PORTFOLIO POSITIONING

Equity

A rotation trade has begun, if only just, as we hedge portfolios for a U.S. economic soft landing. Canadian Equities remain under cloudy skies, while Europe shows further signs of a strengthening backdrop for stocks.

The economy is in the driver’s seat for the equity market, and presently the U.S. is toggling between no-landing scenario, where growth and inflation stay too strong to cut interest rates, and soft-landing scenario, where growth and inflation slowly cool. The market came into the year with forecasts for interest rate cuts to commence in March, which were quickly moved to June and now September. When we get to September, will expectations be moved to after the U.S. election? We are presently still in a no-landing situation, and whether we stay here or not will have a significant impact on markets. If U.S. economic data continue to come in strong, momentum stocks (i.e., Technology) will continue to lead. If we move towards a soft landing, then a rotation trade could take hold and momentum will reverse as the rest of the market catches up. We received a preview last fall and we could again see that unfold this fall if the Fed actually pulls the trigger on rates.

Our current view is to maintain momentum exposure. We are still overweight the U.S., and still of the mind that what has done well will continue to do well. Yet under the hood, we’re starting to rotate. We are still partial to Quality Equities but are starting to look more toward Value areas, and moving away from Technology. A slow portfolio rotation is underway as we move into a soft-landing scenario—but haven’t made a full rotation yet.

On Canada, we remain underweight. We have not seen evidence of growth bottoming out yet and we are watching for further cracks in areas like the labour market. Even though jobs are being created, the unemployment rate continues to rise amid strong population growth. Inflation is cooling but not crashing. Overall, there is more downward momentum ahead before any kind of turn toward a more constructive view. Europe, on the other hand, is seeing some signs of acceleration. We have the addition of recent volatility¹ around elections, but that hasn’t changed our view. Those episodes usually do not last. On Emerging Markets, there remains a prevailing negative sentiment surrounding China; however, we may see pro-market reforms emerge from government meetings this month.

PORTFOLIO POSITIONING

Fixed Income

U.S. long bond yields are reflecting higher odds of a Trump win in November, potentially curtailing any rally stemming from Fed rate cuts. We have also downgraded High Yield, which is facing a lose-lose situation.

Softening inflation generally means less downside risk for bonds but we are still being patient when it comes to overweighting duration.² Economic growth in the U.S. remains resilient, even though it is slowing. There is a clear case for more interest rate cuts in Canada, but the BoC can only go so far—and can only sway yields on the short end of the curve. Ten-year and longer dated Canadian bonds are still driven by the U.S. market. It means our overall view on duration is still based on U.S. policy, which is still being driven by a no-landing, ‘higher for longer’ scenario for the moment. Again, patience is required. We favour Canadian duration over U.S., but are cognizant that it is U.S. policy that drives that trade. In addition, at this stage the U.S. election seems to be influencing Fixed Income even more than equity markets. There is a building concern that an already unsustainable fiscal deficit may spiral further out of control under a new Trump administration, causing 30-year yields in particular to drift higher. It is a development that could limit any bond rally on the back of interest rate cuts.

We have downgraded High Yield from neutral to underweight (-1)–our only score change for July. Spreads are historically tight as the economy slows back to trend. If interest rates remain elevated, that too will weigh most on highly levered companies—meaning if the economy doesn’t slow, that is not necessarily good for High Yield either.

PORTFOLIO POSITIONING

Style & Factor

Value continues to search for a catalyst, but the factor is growing more and more compelling. Entering an increasingly uncertain environment, we are more biased toward low-vol strategies.

From a factor perspective, we are constructive on Value relative to high-priced Growth with the understanding that it remains in search of a catalyst. To see one, we would need something akin to a tremendous change in interest rate expectations, where the market expects an aggressive decline. An all-clear signal for the economy in the stock market could also be the trigger, whereby we see broad rally participation among Equities back over 90%. Value-oriented sectors look interesting viewed through the prism of a few key dimensions; a) relative value, b) upward earnings revisions, and c) price momentum. The sectors that check most of those boxes (none check all) are Energy, Healthcare and Financials. Utilities have sold off and the market for the moment has taken a step back from the sector—though longer term, it is hard to argue against them given rising secular electricity demand trends. For the moment, we are seeing the most opportunity in Financials (with the steepening of the yield curve), Energy and Healthcare, based on expected upward revisions of growth and earnings for the next few quarters.

As we enter the second half of the year, our broad factor approach is tied the idea that we are biased towards lower-beta³ stocks. We think lower-volatility Equities will outperform the first half’s high fliers. Value, Quality and Yield also walk and talk in approximately the same direction, and our view is that low-vol strategies are certainly of interest when you’re entering a nervous environment.

PORTFOLIO POSITIONING

Implementation

One warmer inflation print doesn’t alter the twined trajectories of BoC rate policy and the Canadian dollar (CAD). Both are headed lower. Central banks, meanwhile, continue to bid up gold.

We remain slightly bearish on the CAD (-1) and supportive of gold (+2). We did see an inflation print surprise, which has suppressed the notion of quick successive cuts from the BoC and provided mild support for the CAD, but not enough to alter our view. Making that first cut in June means the BoC is committed to making multiple, and for them to change course, we would need a much more dramatic change in economic momentum. On gold, central banks are continuing their purchases based on the long-view trend of diversification from the U.S. dollar, which has meant bullion prices are holding up quite well, a trend that should persist.

With respect to options use, some of the portfolios have rolled their protection levels higher with the market, which reflects our neutral view from an asset class perspective. Volatility is modestly higher but not to the point that it makes protection too costly.