Back to the Old Normal

Many economists have stated that the markets are headed to a ​“new normal” but in reality, markets are likely transitioning back to the ​“old normal.” Since 2009, the markets have been driven by Zero Interest Rate Policies (ZIRP), which fueled higher growth through the use of cheap margin, which rewarded risk-taking, especially as companies could access low cost of capital. We believe 2023 will bring new opportunities, though it will be met with some challenges. Here are some major investment themes we see headed into the new year – and some of the main risks. 

Inflation continues to trend in the right direction

The consumer price indexes (CPI) in both Canada and the U.S. remain well above their target rate of 2.0%. The good news, however, is that readings both north and south of the border have been trending in the right direction. Furthermore, we have continuously pointed out the challenges in using CPI as an inflation indicator. For example, an investor that purchased a $1 million dollar home would have been able to do so with a 5-year fixed rate around 2.25% in 2017. When renewing that mortgage now, the rate would be above 5.0%. That would mean some numbers in the CPI calculation would not only be sticky, but would move higher before moving lower. However, the Teranet-National Bank Home Price Index Composite shows a deceleration in home prices over the last five months.

Additionally, it takes on average 18-24 months for the effects of higher interest rates to be fully reflected in the market. This would mean that even the initial rate hikes by both the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) in March, have not been entirely digested by the market. In our last quarterly report, we anticipated that both central banks would likely pause their rate hikes in early 2023, and now commentary from both indicate that it is a possibility.

Investors should note that even without rate hikes, central banks have other tools at their disposal, such as forward guidance and also adjusting their pace of quantitative tightening (QT). The Fed’s recent adjustment of its ​“dot plots” is an example in which they raised forward expectations, even though they hinted that dialing down the pace of tightening is a possibility. The increase of the 2023 terminal value allows the Fed to eventually take a pause, but also bring back a few jumbo rate hikes, should data warrant.

Other leading indicators also suggest some disinflationary pressures have begun. Companies are already reporting a build up of inventory, while cargo shipping rates are back to pre-COVID-19 levels. Most raw material prices, such as lumber and base metals, are also down as of December 2022 year-to-date. At the start of last year, we suggested that the world would emerge from the pandemic and demand would comeback online before supply eventually catches up, which would cause a temporary pop in inflation. Though we believe inflation is trending in the right direction, we ended the year with CPI above the target rates of central banks. The reopening of China will also have an impact on inflation, which we will discuss later.

Golden era of bonds

Bonds have faced significant criticism over the last decade. Historically low yields and increasing correlation to equities have been a few of the reasons. However, with yields rising to levels we haven’t seen since pre-Great Financial Crisis, fixed income is again becoming relevant. The yield-to-maturity (YTM) on our BMO Mid-Term US IG Corporate Bond Index ETF (ZIC) reached as high as 6.2% in October of 2022. When the Fed reaches its terminal value, it potentially reaches higher, which would lead investors to allocate more from equities to bonds. The market would then demand more risk premia for investing in equities. 

Similar to the 1982 reset to the bond market, the current tightening cycle, though painful for bonds, could be setting the stage for a new bull market in bonds. However, we don’t believe (and definitely hope) that yields reach nowhere near the Volcker-era levels. The majority of rate hikes have likely already occurred. Fed Chairman Powell said interest rates would remain ​“restrictively high,” which makes bonds attractive for investors and financing expensive for issuers, which could create a headwind for growth-oriented, high-duration stocks. If and when real rates go positive, the bond market would be ripe for a sustained rally. 

Real rates becoming less negative 

A close watch on the technicals of the S&P 500 Composite

The S&P 500 Composite (SPX) has been in a descending channel since the start of 2022. A break above this technical pattern would be bullish and likely driven by continued positive news on the inflation front, which would further lay reason for the Fed to pause on raising rates. Should the SPX continue downward in this channel, the critical test would be 3380, which was the pre-COVID-19 high. We view a break above this resistance level would be a bullish signal to the market. Further language from the Fed indicating a pause in rate hikes and/​or cooling CPI data would be the catalyst. We remain constructive on equities, but view the following as the ongoing risks to the market. 

S&P 500 Composite registering lower highs

The major risks to the market

China Reopening

While inflation is still the main concern, as we have outlined, it is trending in the right direction. However, China moving away from its Zero-COVID policies is the major wildcard on the inflationary front. As we also outlined a year ago, with the rest of the world treating COVID-19 as endemic, demand will come back online before supply. While China is a supply hub for the rest of the world, its citizens have become major consumers, which could cause a temporary spike in inflation numbers. This may lead central banks around the world to panic, which could lead them to reinitiate aggressive monetary tightening.

Inversion of yield curve

The inversion of the yield curve has been prominent, especially in Canada. The spread between the 10- and 2-year yields have shown the steepest inversion since the early 1990s. Both the Fed and the BoC will have a delicate balance in taming inflation and not creating structural damage in the economy, particularly in Canada where household debt levels are at record highs. The inverted yield curve is another reason we believe the BoC and the Fed will likely pause on their rate hikes in early 2023. The sliver lining in the inverted yield curve is that investors buying the long end of the curve at lower yields indicates they believe inflation will eventually be resolved.

Lower yields at the long end of the curve may also allow pensions to side step potential systemic risks. A surge in long-term bond yields in the U.K. forced a number of pensions to face margin calls and eventually a ​“bail-out” through a policy that looked and felt like quantitative easing and the equivalent of throwing gasoline into a fire. It is possible that similar risks may be unearthed if long-bond yields rose in other jurisdictions. 

Geopolitical tensions

Its unlikely the tensions between Russia and Ukraine will resolve anytime soon, which means that energy and agriculture prices will remain volatile. This is why we believe that, though inflation will cool, the ongoing conflict between the two creates a structural persistence in inflation. A China invasion of Taiwan would likely escalate into a global conflict we haven’t seen since World War II, but the reopening of China may likely keep its governments hand tied in handling its own internal affairs.

We are constructive on risk assets in 2023, though we anticipate bouts of volatility. Higher interest rates are likely to create an environment where we no longer experience sustained rallies and caution is thrown to the wind. We continue to believe both the Fed and the BoC will pause rate hikes in early 2023 or at least slow their pace. However, yields will remain more restrictive, meaning the cost of leverage will be higher. The higher cost of margin would likely mean rallies will be more muted and result in greater variance in returns between different equity factors. We believe 2023 will be a better year for risk assets than the one outgoing, particularly for bonds. It is likely we are transitioning to a new regime, away from ZIRP, and ETFs will remain the most efficient tools for portfolio construction. 

Canadian yield curve most inverted since 1990 

Things to keep an eye on

Investors have been hugging the short end of the curve and rightfully so. Prior to the recent inversion, the yield curve has been relatively flat, which means there was no compensation for taking on duration risk. Additionally, whereas quantitative easing and low rates led to an inflation of both stocks and bonds, the reversal of these monetary measures has been deflationary for both. The inverse relationship between long treasury bonds and equities has thus broken down. As interest rates have moved to more normalized levels, we anticipate the recent positive correlation between the two will break down, as higher rates have resulted in less margin use, and thus less deleveraging when equities sell off. 

Recommendation: With the yield curve now inverting, we recommend implementing a barbell strategy in a bond portfolio. Investors can maximize credit by utilizing the BMO Short Corporate Bond Index ETF (ZCS) on the short end of the curve, and complement this with the BMO Long-Term US Treasury Bond Index ETF (ZTL). We’d overweight the short end by using this in a combination of 75%/25% ZCS and ZTL, respectively, as short-term bonds are much less sensitive to interest rate volatility. 

Correlation between equities and long bonds has been positive

With taming inflation seemingly headed in the right direction in North America, many investors have asked what can drive the market lower. While we are constructive on equities, the risk is that sustained higher rates will lead bonds to look relatively more attractive, and equities will have to compete for allocation in a portfolio. This means, unless equity risk premia is adjusted upwards, investors will increase their allocation to bonds. Moreover, if higher rates are sustained, the cost of financing will be more prohibitive, making it more difficult for companies to grow and thus lower earnings. 

Recommendation: The quality factor had a tough run in 2022, but this was largely a result of its heavy skew towards the technology sector. Quality screens for companies with high return on equity (ROE), low earnings variability and low financial leverage. This results in companies with strong balance sheets, defendable profit margins and its lower debt load will be less impacted by higher rates. The BMO MSCI USA High Quality Index ETF (ZUQ) remains a core position in our portfolio paired with our BMO Low Volatility US Equity ETF (ZLU).

Volcker years saw lower P/E ratios

Gold prices could be set to surge if the Fed looks to pause it rate hikes. While inflation is still well off its target, data suggests that it may have already peaked. Inflation in Europe and the U.K., however, is much higher and far from being tamed. It is likely that the pace of rate hikes with the European Central Bank (ECB) and the Bank of England (BoE) will be more hawkish than the Fed. As a result, the U.S. Dollar Index (DXY), will likely continue to lose momentum, which would be favourable for gold prices. Central banks around the world also continue to stockpile gold bullion, which would create a further tailwind for precious metals. 

Recommendation: ETFs remain an efficient vehicle to access gold. Gold bullion and gold companies may perform differently depending on the environment; however, should the tone on equities turn positive, gold equities may provide some additional beta to bullion prices. Investors may want to put the BMO Equal Weight Global Gold Index ETF (ZGD) or the BMO Junior Gold Index ETF (ZJG) on the radar. 

Gold picking up momentum as U.S. Fed expected to slow pace of hiking

Changes to portfolio strategy

Asset allocation:

• As noted earlier, the 60/40 portfolio has become less effective over the last decade. In our opinion, lower bond yields were one of the primary reasons why the prototypical balanced portfolio faced challenges, especially in recent months. As a result, we have relied primarily on the 50÷30÷20 model, which carved out an additional sleeve in a portfolio for hybrid/non-traditional assets. As yields have now been normalizing to levels not seen since pre-Great Financial Crisis, the 60/40 portfolio may eventually see a rebirth, as bonds and equities may become less correlated in the near future. Nevertheless, we believe the market has developed significantly in the last decade, where asset classes outside of equities and bonds may provide non-correlated returns and further insulation during various investment regimes. As mentioned, we believe rising rates will make bonds increasingly attractive for portfolio constructors, and are hence increasing our weight towards fixed income. With real rates still negative, we are likely early on this switch, but given the bond-to-equity ratio is at levels not seen since 2008, we believe bonds are becoming increasingly attractive.

Fixed income:

• As mentioned last quarter, ​“TINA” has reigned supreme for the last decade. This was an acronym given to investor belief that ​“There Is No Alternative” to stocks. With the yield-to-maturity on bond instruments, such as the BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF (Hedged Units) (ZSU) at 5.2%, we are clearly entering an environment where ​“There Are Reasonable Alternatives (TARA)” to stocks. With supply chain thawing leading CPI to steadily decline, it is likely both the Fed and the BoC will slow their pace in interest rate hikes. We are thus increasing our allocation to ZSU by 2.0% and the BMO Long-Term US Treasury Bond Index ETF (ZTL) by 1.0%. Given the inversion of the yield curve, we continue to recommend utilizing barbells by overweight credit on the short end of the curve and using a federal government exposure on the long end of the curve. It should be noted that though we are allocating to bonds, it doesn’t necessarily mean we are bearish on equities. We just view bonds as offering better relative value, compared to stocks.

Equities:

• We are constructive on equities and believe there are already areas within the market that offer significant opportunities. As we transition into another regime, higher sustained interest rates will likely mean greater headwinds for growth stocks. We continue to see value in areas such as Canadian banks. Despite concerns of rising rates on indebted Canadians, lenders in Canada have significant capital buffers, as indicated by their Tier 1 Capital Ratios. The current discounted value of the BMO Equal Weight Banks Index ETF (ZEB) potentially provides a good entry point, especially for those investors that are willing to look several years out. While Canadian banks represent an attractive opportunity, we believe U.S. banks are less well capitalized, and are therefore reducing our weight in the BMO Equal Weight US Banks Index ETF (ZBK) by 3.0% in order to fund our allocation to fixed income.

Non-traditional/hybrids:

• Preferred shares have faced challenges, despite rising rates in the last year. The benefits of rising rates were unfortunately muted by widening credit spreads. If central banks slow the pace of rate hikes, the economy would be able to stabilize and adjust, which would allow credit spreads to eventually tighten. As preferred shares reside below corporate bonds on the capital structure, we believe they are well positioned when rates stabilize. Furthermore, as a number of issues have recently been extended, it provides many of the issues in the BMO Laddered Preferred Share Index ETF (ZPR) to be reset to higher interest rate levels.

Stats and portfolio holdings

Portfolio holdings

Portfolio characteristics

Fixed income sector breakdown

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