A Walk Down Memory Lane

Over the last year, the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) have been raising rates at the fastest pace in recorded history. As the global economy has grown accustomed to zero-interest rate policies (ZIRP) over the last decade, it is no surprise that the rapid rate hikes have revealed some systemic risks. We saw the first signs last autumn, with the long bonds within some U.K. pension plans being exposed to rising rates and, more recently, when two U.S. regional banks went into receivership in March. 

Memory lane is paved with parallels
With the held-to-maturity (HTM) portfolios of Silicon Valley Bank (SVB) and Signature Bank (SBNY) valued at a notable discount if marked-to-market, the Fed and the U.S. Treasury created the Bank Term Funding Program (BTFP) and backstopped the Federal Deposit Insurance Program (FDIC) with the ability to guarantee even deposits exceeding $250,000. For my fellow market historians, some elements are eerily reminiscent of the Savings and Loan (S&L) crisis that took place during the 1980s and 1990s.

Pressing pause to play catch-up
In October, we started calling for a spring pause in rate hikes by the U.S. and Canadian central banks. We have so far only seen this from the BoC. The Fed pause is likely imminent, but we believe it is prudent, as it allows time for the economy to digest the impact of rate hikes properly. Inflation data continuing to trend in the right direction provides further reason to do so.

Many investors remain overly focused on Fed rate hikes, even though the BTFP has increased the central bank’s balance sheet. At one point, it essentially erased the Fed’s quantitative tightening (QT) efforts dating back to October. 

While this program isn’t exactly quantitative easing (QE) per se, it certainly looks and feels that way. The BTFP injects liquidity into the system while the Fed simultaneously tries to remove it through QT and higher rates. The BTFP’s introduction is part of the reason long bond yields have declined, with the U.S. 10-year treasury yield falling 75 basis points (bps) since early March. As a result, we believe long-duration assets (both stocks and bonds) should be added to a portfolio.

The Federal Reserve’s balance sheet

All eyes are on the Fed’s next move

While the U.S. regional banking crisis may linger, it may also lead the Fed to back down on its rate hike intensity, which could be positive for the broader equity markets. In fact, any further remedies to prevent potential contagion will be exactly the opposite policy to fight inflation. The Fed cannot be on the accelerator and the brakes concurrently, so to speak. The best-case scenario is that it has done enough to fight inflation, allowing it to pause rates and prevent further pressure on the banks or any other risks we don’t know about yet. The worst case is inflation is not on the mend, and the Fed has to continue hiking rates into a banking crisis, which would leave us in a stagflation environment. 

In our first quarter report, we pointed out that a breach above last year’s resistance level would lead to technical buying, which we have seen. Supply and demand of the market suggest equities are trying to mount a rally as a new support level is forming. Whether this continues, however, depends on inflationary data trending in the right direction. The good news is that inflationary data out of Canada and the U.S. continues to trend in the right direction, which should be supportive of equities. 

S&P 500 Composite forming a new support level

Things to keep an eye on

Clearly, low volatility and dividends were the winning factors in 2022. However, with the expectation that the end of the Fed’s hiking cycle is within sight, a factor leadership change looks to be developing. Similar to low volatility and dividends, quality also exhibits defensive growth characteristics but has more of a growth bias. Longer-term rates falling has benefited quality blue chip stocks and removed the headwinds that the technology stocks in the BMO MSCI USA High Quality Index ETF (ZUQ) faced last year. The technology stocks in ZUQ tend to be more cash-rich and mature companies like Apple Inc., Alphabet Inc. and Microsoft Corp., amongst others. 

Recommendation: Positions such as the BMO Low Volatility US Equity ETF (ZLU) and ZUQ remain the core positions in our portfolio strategy. As a long-term strategic combination, it allows investors to better manage downside risk while also providing growth. Additionally, low volatility has proven to fare well in rising rate environments, whereas quality will be better situated as rate hiking expectations ease. We believe this barbell strategy is well positioned both strategically and tactically. 

Source: Bloomberg, BMO Global Asset Management, as of March 31, 2023 (total return, net of fees, expressed in CAD).

The recent decision by the Organization of Petroleum Exporting Countries (OPEC) to cut oil production may put pressure on consumers at the gas pumps. As both Brent Crude and West Texas Intermediate (WTI) prices have fallen since last summer, OPEC’s move is to defend the cost of crude and attempt to establish a floor at approximately US$80/barrel.

This will have political consequences as the current U.S. administration began drawing on the Strategic Petroleum Reserve (SPR) ahead of the 2022 mid-terms to gain political traction. However, this strategy may backfire, as inventory levels have not been this low since the early 1980s and will need to be replenished shortly, which will ramp up demand. Biden’s approval rating remains low, and Republicans continue to gain momentum.

Recommendation: Energy stocks tend to be lower duration, as cash flows are earned in the near term. While yields are falling, longer duration sectors such as technology and utilities have been in favour. Over the long term, the push towards renewables has disincentivized traditional energy companies to invest in infrastructure, which will leave fossil fuels in short supply. Cash flows at energy companies continue to build up, and raising dividends may look to be the only option. Investors may want to consider either the BMO Equal Weight Oil & Gas Index ETF (ZEO) or the BMO Covered Call Energy ETF (ZWEN).

Drawing down the U.S. Strategic Petroleum Reserve

Long government bonds have historically been the ideal equity market hedge. When equity markets sell-off in anticipation of an economic slowdown, central banks typically respond by easing rates to stimulate economic growth. Lower rates tend to benefit longer duration bonds, and in turn, investors further benefit as the market flocks towards risk-free government bonds. The sell-off we experienced last year was unique in that long bonds were ineffective in mitigating equity market risk. This was due to the primary concern being inflation, which forced central banks to raise rates aggressively to slow growth, contrary to their typical end-of-cycle playbook. 

Recommendation: Central banks have relied heavily on ultra-lax monetary stimulus measures since the Great Financial Crisis of 2009. From Alan Greenspan, every Fed Chair successor has kept monetary conditions too low for too long, which has led to asset inflation. It should come as no surprise that removing liquidity will deflate assets and cause correlations between stocks and bonds to become increasingly positive. However, with the Fed easing up on the pace of its rate hikes, that positive correlation has started to break down and market dynamics are normalizing. This potentially means that the BMO Long Federal Bond Index ETF (ZFL) and the BMO Long-Term US Treasury Bond Index ETF (ZTL) may be effective equity market hedges again. 

Correlation between the S&P 500 Composite and Long U.S. Treasury Bonds

Changes to portfolio strategy

Asset allocation:

• After increasing our allocation to fixed income last quarter, we are leaving our asset mix unchanged. While we are still overweight equities, our exposure tends to be more defensive compared to traditional market capitalization-weighted indices. On the one hand, the Fed’s move to increase its balance sheet will inject liquidity into the system, which likely benefits risk assets. However, the Fed is ultimately further encouraging bailout culture and moral hazards in the long term. Additionally, the higher rates have unearthed some systemic risks. We remain cautiously optimistic and are still overweight equities; however, as already noted, our positioning remains biased towards defensive growth. Our focus this quarter will be to fine-tune our allocations within each of the sleeves.

Fixed income:

• We are adding 2% to the BMO Long-Term US Treasury Bond Index ETF (ZTL) to add further duration exposure to our portfolio. We will fund this by selling 1.0% in each of the BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF (ZSU) and the BMO Short-Term US TIPS Index ETF (Hedged Units) (ZTIP.F). The yield curve may see little additional inversion on the long end. However, as aforementioned, we believe the breakdown of the positive correlation between long bonds and equities indicates that the efficiency of long bonds as an equity market hedge is returning.

Equities:

• Last quarter, we halved our weight to the BMO Equal Weight US Bank Index ETF (ZBK), which allowed us to partially skate past the damage the SVB and SBNY insolvencies caused. A recent rebalance of ZBK in late March allowed it to improve its quality as several smaller problematic regionals no longer met the minimum market capitalization thresholds and have since exited the ETF. For investors who believe the industry has addressed contagion and companies are undervalued, ZBK provides a pure play to the area. Investors may want to consider the BMO Covered Call US Banks ETF (ZWK), to monetize volatility in the sector. The BTFP and FDIC, having been granted full guarantees on accounts, will probably help calm depositors. However, from our perspective, we see better risk-to-reward opportunities elsewhere. As a result, we are removing the remaining 3.0% in ZBK.
• We believe larger-cap technology stocks will continue to see some reprieve as interest rates look to level off. There has been a distinction between the larger cap, more mature technology names and their smaller cap counterpart. This is evident through the outperformance of the Nasdaq-100 Index compared to the broader Nasdaq Composite Index. We are thus reallocating the 3.0% from ZBK to the BMO Covered Call Technology ETF (ZWT). This ETF includes 30 of the largest U.S. technology names and writes call options against these positions to generate yield. 

Non-traditional/hybrids:

• Preferred shares have not been able to catch a break in the recent past. However, with monetary policy easing, we hope the secondary effect will be tightening credit spreads. Corporate spreads widened last year when higher rates placed additional pressure on the balance sheet of issuers as the cost of debt servicing and refinancing increased. Lower rate volatility will eliminate some uncertainty with preferred shares. While the market is pricing in rate cuts by the BoC in the very near future, we believe that it is unlikely in 2023 unless there is a crisis event. Rates remaining stable and at these levels, while credit spreads tighten, is the ideal scenario for the BMO Laddered Preferred Share Index ETF (ZPR). In the meantime, ZPR is an effective portfolio construction tool, as it is non-correlated to traditional assets and generates a tax-efficient yield.

Stats and portfolio holdings

Portfolio holdings

Portfolio characteristics

Fixed income sector breakdown

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