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2024 BMO ETF Desk Investment Outlook: Sticking the Landing

Our last new year outlook outlined how tighter monetary policy and supply-side healing would lead to disinflationary pressures. We expect these forces to continue as we head into 2024, and while central banks have significantly reined in inflation, they still need to stick the landing. The latest Consumer Price Index (CPI) readings are at 3.1%¹ and 3.1%² in Canada and the U.S., respectively. Real rates,³ which we measure as the 12-month T-bill, net of year-over-year CPI, are at their highest levels since 2009 on both sides of the border. Some central bankers expect this to be a drag on the economy, which may be why the market is pricing in aggressive rate cuts in 2024.

Comparing Canada and U.S. Real Rates

When Could We See Rate Cuts?

Overnight Index Swaps (OIS) are currently pricing in at least five rate cuts by the U.S. Federal Reserve (Fed) in 2024. With the most recent CPI reading still well above its target range, the Federal Open Market Committee (FOMC) will likely need to see the CPI in the low 2.0% range or lower for a sustained period before feeling comfortable in cutting rates. Additionally, with the U.S. Presidential Elections at the end of the year, the runway for rate cuts may not be as long as the market expects.

In Canada, inflation (when stripping the impact of shelter) is getting closer to the Bank of Canada’s (BoC) target rate. Moreover, household debt remains at record highs, which is why we anticipate rate cuts to be more likely and much sooner than those of its U.S. counterpart. It will be interesting to see whether lower rates will fuel housing prices, making homeownership a further stretch, as Canadians have not seen a meaningful correction in property prices. The path of rate cuts will depend on the economic scenario we find ourselves in and the geopolitical landscape. Below, we also include BMO Global Asset Management (BMO GAM)’s ​“House View” supplied by the Multi-Asset Solutions Team (MAST).

Current Implied Interest Rate⁴ Changes (Fed and BoC)

Source: Bloomberg (calculated using the World Interest Rate Probabilities (WIRP) <Go> function on December 18, 2023).

BMO GAM House View – 2024 Macro-Economic Scenarios:
A More Convincing Case for Soft Landing

Here are the four possible scenarios in the order in which we believe are most likely to least likely.

Time to Dial Back Expectations 

Currently, the S&P 500 Composite is pricing in an earnings growth rate of 11.8%.⁵ Combined with the ​“soft-landing” scenario becoming the market consensus, this seems inconsistent with the aggressive rate cuts on the table. Not long ago, the Fed outlined how higher long-term rates would reduce the need for further rate hikes, only for the long end of the curve to fall significantly in the last quarter. We remain constructive on risk assets in 2024; however, with the significant rally we saw from the reaction to the Fed’s ​“dot-plot” announcement in December, investors need to dial back expectations.

With rate cuts likely more moderate than the market’s current expectations (in a soft-landing scenario), we anticipate this will encourage investors to venture further out on the risk curve. Lower risk-free rates⁶ mean equity risk premiums will expand, which will see some asset flows migrate from cash or ​“cash-like” products, which experienced sizable inflows the previous year. As we highlighted in last year’s outlook report, we are now in an era that will not move back to zero interest rate policies (ZIRP) and quantitative easing, and as a result, rates will be higher this decade than last. This also means portfolio construction needs to be adjusted accordingly from both an asset allocation and selection perspective.

Continued disinflationary pressures should pave the way for central banks to ease monetary conditions. Should central banks stick the landing by taming inflation while keeping economic conditions relatively strong, risk assets should be well-positioned in 2024. The main risks remain geopolitical, with conflicts arising around the globe and a growing political divide in the U.S.

Things to Keep an Eye On

During the era of low interest rates, traditional balanced portfolios were challenged, as the allocation to fixed income provided few benefits. Lower rates meant less income coming from bonds. It also provided investors with inexpensive funding to leverage. Episodes of market volatility would then lead to margin calls, intensifying the correlations between asset classes. With interest rates returning to more normalized levels over the last 18 months, we have seen a revival of the prototypical 60/40 portfolio.

Recommendation: One positive of the low-interest rates era was using alternative assets to complement traditional portfolios. While traditional balanced portfolios have become more effective with higher rates, alternatives can still improve a portfolio’s overall efficiency. Complementing a portfolio with long-short equity strategies, such as the BMO Long Short Canadian Equity ETF (Ticker: ZLSC) or the BMO Long Short US Equity ETF (Ticker: ZLSU),can help to improve a portfolio’s overall risk/​return profile. Gold bullion, which we had on last year’s watch list, can also be a diversifier. 

Increasing Need for Alternatives

U.S. regional bank stocks experienced some substantial hardships last year. The significant tightening of monetary conditions led to a deterioration of duration-sensitive held-to-maturity (HTM) portfolios. The default of several regional banks led to the creation of the Bank Term Funding Program (BTFP), which allowed troubled banks to exchange high-quality bonds for par value. This program, one of the key tools in calming markets after the collapse of Silicon Valley Bank (SVB), is set to expire in March. 

Recommendation: The U.S. banks — particularly the regionals — will be an area to watch, as the industry will be highly leveraged to interest rates. Multiple rate cuts would likely benefit the regional banks, as it would remove significant pressure from their HTM portfolios. However, if interest rates remain resilient (or even rise, if inflation were to return), the termination of the BTFP may expose them to risk as it eliminates the backstop. Last year, we switched from our BMO Equal Weight US Banks Index ETF (Ticker: ZBK) to the BMO Covered Call Technology ETF (Ticker: ZWT). We believe the technology sector provides investors with upside if rates move lower, without the same degree of risks if rates remain elevated or even reverse course.

U.S Banks Are Leveraged to Interest Rates

High-yield bonds have been a forgotten asset class in recent years. Elevated interest rates have made the yields on investment grade bonds more attractive without extending reach into junk bonds. Moreover, lower credit quality issuers face more uncertainty when refinancing is more costly. While we still believe the sweet spot in fixed income to be investment grade bonds, high-yield issuers would benefit significantly from lower yields, provided economic conditions remain robust. 

Recommendation: Credit spreads tightened significantly in the last quarter of 2023, as measured by the CDX High Yield Spread Index, with a drop in yields on the long end of the curve. The revealing of the Fed’s dot plots in December also provided further credit spread tightening. This illustrates how spreads in the last year were a second derivative of interest rates, which led to concerns over refinancing rather than a weak economic backdrop. The BMO High Yield US Corporate Bond Index ETF (Ticker: ZJK) will be an interesting exposure to watch in 2024 and see whether flows will return to the asset class.

High Yield Bonds Spreads Have Tightened

Changes to Portfolio Strategy^*

*The portfolio holdings are subject to change without notice and only represent a small percentage of portfolio holdings. They are not recommendations to buy or sell any particular security.

Asset Allocation:

• We remain positive on risk assets for the new year, though we believe the market’s expectations (depending on the economic scenario) for rate cuts could be optimistic. The year could likely begin with strong returns as markets anticipate a dovish Fed. As the year progresses, we may see some rate cuts priced out of the market if economic conditions remain resilient and a soft landing is achieved. Without an economic fallout, it is hard to see how we get to six rate cuts unless disinflation quickly turns into deflation. We favour equities over fixed income and believe there will be a dash from cash in the coming year, as even a rate cut or two would force investors out the risk curve. Given we are already overweight in equities, we will not adjust our asset allocation; however, with intra-market correlation moving lower, there will be opportunities in the coming months to move to more targeted exposure, such as sector ETFs. 

Equities:

• The last two years showed how market leadership in factors can quickly change. Low Volatility was the factor that outperformed in 2022, with Quality being the laggard. Last year, we saw the opposite occur, with Quality making a significant comeback. While both factors tend to be more defensive growth in nature, they pair well, being complementary from a sector exposure perspective and in combination as a barbell strategy. The two factors combined have been shown to provide insulation in various rate environments. Our core consists of exposures such as the BMO MSCI USA High Quality Index ETF (Ticker: ZUQ) and the BMO Low Volatility US Equity ETF (Ticker: ZLU). Higher beta factors such as value may outperform in the first quarter, so we won’t be surprised to see the BMO MSCI USA Value Index ETF (Ticker: ZVU) be the first to get out of the gates. Over the long haul, however, we still favour defensive growth factors that provide exposure to mature companies and durable balance sheets. 

• This quarter, we look to eliminate our position in the BMO Equal Weight US Health Care Hedged to CAD Index ETF (Ticker: ZUH). This ETF has been a long-standing position within our strategy; however, we are looking to focus our bets on more interest-rate-sensitive sectors, such as Technology. We will redistribute the 4.0% allocation in ZUH evenly across the ZWT and ZUQ.

• We still view Canadian banks to be extremely attractive. We have allocated 8.0% to the BMO Equal Weight Banks Index ETF (Ticker: ZEB), the maximum for a sector ETF. As we believe the BoC to be more likely than the Fed to cut rates multiple times this year, that should be a catalyst for the banks as it would potentially reduce the amount of non-performing loans.

Fixed Income:

• As we have likely already seen peak rates in this hiking cycle, investors have gravitated towards long-duration exposure in the last quarter. With the long end of the curve moving lower at the end of last year, exposure to ETFs like the BMO Long-Term US Treasury Bond Index ETF (Ticker: ZTL) have delivered sizable returns. We believe the yield curve will eventually normalize through a combination of lower short-term rates and longer rates potentially moving up. Our barbell strategy of combining the BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF (Ticker: ZSU) with ZTL is well-suited for the current environment, particularly when paired with core exposures, such as the BMO Discount Bond Index ETF (Ticker: ZDB).

Non-Traditional/Hybrids:

• We are eliminating our position in the BMO Canadian Bank Income Index ETF (Ticker: ZBI) in favour of ZLSU. We believe this change will provide greater diversification, as the preferred shares and bonds held in ZBI can be attained from other positions in the strategy. Similar to hedge funds, ZLSU can provide diversification to traditional assets without the exorbitant management and performance fees. Furthermore, it can provide some protection as its exposure to short securities can potentially benefit when markets sell off. 

Stats and Portfolio Holdings

BMO Global Asset Management, as of November 30, 2023.

Portfolio Holdings^†

Portfolio Characteristics

Fixed Income Sector Breakdown

Weighted Average Term: The average interest received by a bond investor, expressed on a nominal annual basis.

Weighted Average Current Yield: The market value-weighted average coupon divided by the weighted average market price of bonds. 

Weighted Average Yield to Maturity: The market value-weighted average yield to maturity includes coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity. 

Weighted Average Duration: The market value-weighted average duration of underlying bonds divided by the weighted average market price of the underlying bonds. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. 

Weighted Average Coupon: The average time it takes for bonds to mature in a fixed income portfolio.

The portfolio holdings are subject to change without notice and only represent a small percentage of portfolio holdings. They are not recommendations to buy or sell any particular security.

Source: Bloomberg, BMO Global Asset Management, as of December 18, 2023.

Q1 2024 BMO ETF Fixed Income Strategy Report >

Other Interesting Reads and Upcoming Webinars:

• 10 Big Investment Trends for 2023
• 2024 Outlook: On Wednesday, January 24, we’ll be releasing a special report and video featuring our outlook for 2024. It will include a recap of where markets are heading, risks and opportunities, as well as our team’s bullish or bearish ratings on bonds, dividends, and four specific sectors: Financials, Real Estate, Health Care, and Technology. Stay tuned to this space for more details on how you can access it.

¹ Consumer Price Index. Statistics Canada, December 19, 2023.

² Consumer Price Index. U.S. Bureau of Labor Statistics, December 12, 2023.

³ The real rate is the observed market interest rate adjusted for the actual or anticipated rate of inflation. 

⁴ The implied interest rate is the difference between the central banks’ overnight rate and what the swaps markets are pricing in. 

⁵ FactSet, December 11, 2023.

⁶ The risk-free rate is the theoretical return an investor can get without assuming any risk.