When elections and bond yields collide.

Market recap

• Equity markets pulled back modestly this week with little U.S. economic data or policy announcements to move the needle on the growth outlook.

• The S&P 500 dipped 1.0% with a wide mix of sectors posting declines. The earnings season is also getting underway, and expectations are for a solid quarter with double-digit growth pencilled in for the S&P 500 in Q3.

• The TSX gave back 1.4% with consumer staples and telecom services weighing along with declines across most sectors.

U.S. Election

The U.S. presidential election is a week away and polls continue to show a tight race between former President Donald Trump and Vice President Kamala Harris.¹ In our view, that uncertainty is contributing to the market volatility we’ve seen recently. The odds remain in favour of a split Congress, which would make big policy changes unlikely to occur, something that the markets are hoping for. Given the strength of the U.S. economy and markets, a continuation of the status quo wouldn’t be a bad thing, in our opinion. That said, there appears to be a rising possibility of a Republican sweep, which would give Trump maximum leverage to enact sweeping change. In that scenario, we could see some market declines as investors take a wait-and-see approach. For that reason, we think adding some defensive plugs to portfolios in the form of options makes sense. The election also has potentially significant ramifications globally. China has already been in the news for its economic woes, and uncertainty about the election could be why it hasn’t yet announced the exact details of its stimulus plan. Under a Trump administration, the U.S. is likely to enact significant tariffs on Chinese exports, which Beijing might feel a need to offset with a larger stimulus package in addition to retaliatory tariffs. Conversely, trade relations under a Harris administration are likely to be closer to the status quo, meaning that less stimulus may be required.

Bottom Line: We think the overall trend for U.S. markets is bullish, but there’s no denying the political uncertainty.

Bonds

Recently, yields on 10-year U.S. Treasury bonds have risen—a curious development given that the U.S. Federal Reserve (Fed) appears likely to remain on an interest rate-cutting path. In our view, this is a symptom of volatility and uncertainty. In addition to the toss-up election, there are also some questions about the rate trajectory. The Fed’s 50-basis-point cut in September was an important first step, but it all comes down to the next two meetings—if we get two 25-bps decreases, we’d expect bond yields to gradually come down a bit. Potential post-election investor nervousness could cause the Fed to accelerate its rate-cutting schedule, which could also cause bond yields to decline. Looking ahead, we’ll continue to closely monitor investor sentiment and how it may impact the pace of rate cuts. Broadly speaking, we think the outlook over the next three-to-six months is comparable for bonds versus equities, especially in comparison to the bull market for stocks that we’ve seen so far this year. As money continues to come out of Guaranteed Investment Certificates (GICs) and high-interest savings accounts (HISAs), its first step is likely to be into fixed income or conservative balanced portfolios rather than pure equities. With the end of the year approaching, portfolio rebalancing will also occur, which means that many investors will likely sell out of areas that have run up—like equities—and buy into areas that haven’t, including bonds.

Bottom Line: Equities are likely to rally through the end of the year, after which we expect bonds to have their day in the sun.

Rotation to Value

Previously in this space, I’ve discussed the rotation to Value—a potentially-accelerating shift from higher-priced names to comparatively undervalued areas of the market. But what’s the best way to play this rotation? If you break down the income cohorts in terms of spending, the higher brackets have been responsible for the bulk of expenditures. This means that the lower income brackets—the bottom 60%, say—have been decreasing their spending. Higher-income earners will still do some Discretionary spending, but for everyone else, the focus is largely on the essentials. That’s why, from a sector standpoint, we’ve tilted toward Consumer Staples. There could be some interesting individual names in Consumer Discretionary, but we don’t view it as a sector play. By contrast, Financials have been under a dark cloud for some time, dating at least as far back as the Silicon Valley Bank collapse. Recently, however, U.S. bank earnings have come out strongly—perhaps helped by relatively low expectations—and there was some positive price movement as a result. Previously, those gains had proven unsustainable, but they’ve stayed up so far this time. Health Care offers a similar opportunity as a defensive-type sector that hasn’t participated as strongly in the recent market run-up. (For more on opportunities in U.S. markets, including Financials, see my recent piece in the Globe and Mail.)

Bottom Line: As the rotation to Value continues, we expect investors to seek out less volatile, more dividend-oriented areas of the market, including U.S and Canadian Financials.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Surprise, surprise: A U.S. job market that simply won’t quit.