The Fed in the Driver’s Seat

Higher rates continue to be the primary concern for the market, as measures, such as the Consumer Price Index (CPI), seemingly indicate that inflation is persistent. The terminal rates for the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) for 2023 are currently 4.2% and 4.6%, respectively. That would imply approximately another 100bps and 150bps of rate hikes from the BoC and Fed before the end of next year. Depending on how inflation prints come in over the next several months, we believe this can potentially change by 50bps each.

Although CPI numbers, particularly out of the U.S., have been stubborn, we believe they are a lagging indicator that may not provide an accurate indication of the inflation trend. As an example, housing, which makes up the largest component of the CPI basket in the U.S. at more than 40%, will not be immediately impacted by higher rates. Mortgage demand in the U.S. just hit a 22-year low, which would eventually mean lower housing prices. Lower housing prices would also eventually translate to lower rents, as home ownership would become more affordable.

A large cause of inflation has been supply-side-driven, resulting from the lockdowns and the unpredictability of the supply chain. Manufacturing and supply chains halted, and inventory management moved to ​“Just-in-Time” delivery, where the stock was kept extremely lean. At the last Federal Open Market Committee (FOMC) meeting, chairman Jerome Powell commented that supply-side healing was modest, but we point to data that suggests the contrary. Container shipping rates of 15 routes from Shanghai are trending down near pre-COVID-19 levels, while companies like Nike are actually reporting an oversupply.

Shanghai Shipping Exchange (Export) Containerized Freight Index

Typically, it takes 18-24 months on average for rate hikes to work their way into the financial system, so it can be argued that the full brunt of the initial rate hikes this year by the BoC and the Fed have not even been absorbed by the economy. While the central banks likely have a few more rate hikes in their chambers, there’s a high likelihood they will end up overshooting. We expect a pause in interest rates at some point early in the new year in order for the economy to digest the impacts of tighter monetary policy. Furthermore, the Bank of England (BoE) recently had to bail out its pensions via long-bond purchases, which may indicate a limit to how much rates can rise in other jurisdictions.

The recent revision of the Fed’s dot plot¹ several weeks ago to a terminal value of 4.6% in 2023 created a massive tailwind for its currency, given its current wider expected interest rate differential. As a result, the Fed is exporting its inflation, as foreign countries now need to pay more for U.S. exports, in addition to goods priced in U.S. dollars. While the BoC is expected to reach its terminal value before the Fed, it will be interesting to see if the Canadian central bank will choose to hike rates more than what’s necessary to fend off the surging greenback. The Fed is clearly in the driver’s seat now, as other central banks will have to be, at least, a bit reactionary to what Mr. Powell does over the next several months.

Things to Keep an Eye on

The last two recessions of 2008 and 2020 were event-driven, making them unlike the present one, which is more structural in nature. The current economic slowdown is also different, as inflation has been the primary concern. The required remedy, as a result, has been higher rather than lower rates. The last time we saw a similar recession was the ​“Great Inflation” era of the 1970s-1980s, where the Paul Volcker-led Fed finally tamed inflation by raising the overnight rate to 20%. Given the similarities to that period in the current economic climate, it’s important to take a visit down memory lane.

Recommendation: During that time, the S&P 500 Composite (SPX) experienced two major declines. Once, in February of 1980 where the SPX fell by -24.5%. Equities bounced back quickly, recovering its full value from its peak in only 140 days. This was due to the Fed believing that inflation had peaked and thus quickly easing its interest rates. The Fed then raised rates back to 20%, causing a second equity market sell-off, and was much more cautious in relaxing monetary policy. The second sell-off in the SPX was -35.0%, which took 705 days to recover. Fast forward to today, and the SPX is already down -25.3%² from its earlier high in 2020. While investors may want to move to cash, it’s very difficult to time the market. Staying invested through an ETF, such as the BMO S&P 500 Index ETF (ZSP) or the BMO S&P 500 Index ETF (Hedged to CAD) (ZUE), tends to be the correct decision over the long haul.

Currencies have been a very important consideration, with the massive moves in the U.S. dollar over the last several months. Up until September, the Canadian dollar was one of the few currencies that was able to keep pace with the greenback, as the BoC was one of the central banks that was ahead of the Fed in tightening monetary policy. When the FOMC recently revised its ​“dot plots,” which showed a revision in its anticipated terminal rates for next year, the U.S. dollar skyrocketed against its Canadian equivalent, as a wider interest rate differential was repriced into the market.

Recommendation: In contrast to the ​“pre-COVID-19” world, in which countries wanted a lower currency to bolster exports, under current conditions, economies are looking for higher currencies to offset higher import costs — and thus bring down inflation. While we believe the BoC to be closer to taking a potential pause in rate hikes, compared to the Fed, it will be interesting to see whether it will be forced to move rates to defend its currency and put pressure on the economy, as household debt in Canada remains at record highs. The upper bound of the CAD/USD rate tends to be $1.40, with the lone exception of the ​“dot-com” bust, where it hit $1.60. Statistically speaking, however, investors may want to start considering hedging some of their U.S. dollar exposure. Investors can take advantage of equity losses this year by selling unhedged positions, moving into currency-hedged ETFs and simultaneously harvesting tax losses.

As mentioned, how the CPI basket is constructed will have a lagged effect on expressing true inflationary conditions. While there are encouraging signs of supply-side healing and decreased demand, we acknowledge that inflation will be sticky in certain areas. The ongoing conflict between Russia and Ukraine will constrain supply on energy and grain prices. In addition, a stronger labour market with a retiring boomer demographic will keep wages high. The Producer Price Index (PPI), when broken down between goods and services, shows a decline in the former while the latter continues to increase.

Recommendation: While we see encouraging signs of inflation abating, it will not be uniform. Also, there will be elements that will be structural and will take longer to cool. Consequently, monthly readings of the CPI will likely not come down in a straight manner, which will create market volatility, when smart investors should instead focus on the longer trend. In order to offset volatility in the fixed income portion of a portfolio caused by inflation, the BMO Short-Term US TIPS Index ETF (ZTIP) can be used to mitigate duration risk. 

Asset Allocation:

• With the slight increase in our equities weighting last quarter, we don’t see a pressing need to change our asset allocation strategy. While balanced portfolios have favoured equities over the last decades, with the prototypical 60/40 portfolio leaning towards stocks, it will be interesting to see whether traditional asset mixes will shift to overweight bonds in the future. Once bond yields hit a neutral rate, bond coupons will be increasingly more attractive. Higher rates could mean more moderate economic growth, potentially eroding corporate earnings and causing equity risk premia to contract. Aging demographics would also place further demand for bonds: another reason why fixed income may play a more critical role in asset mixes in the future. However, in the current environment where inflation persists, we still favour equities, particularly with the earnings yield on the S&P 500 Composite higher than the 10-Year U.S. Treasury yield.

Fixed Income:

• For the first time in a very long time, fixed income looks attractive as an asset class. Before the current tightening cycle of central banks, the lack of yield from fixed income forced investors to find ways to generate yield from equities and other parts of the portfolio. The rise in yields certainly has more investors taking a closer look at the asset class, which shows we have gone from a market, that investors described as TINA (There Are No Alternative ​“to stocks”) to TARA (There Are Reasonable Alternatives ​“to stocks”).
• We continue to favour the short end of the curve, especially given the current ​“flattish” term structure.³ As investors are not currently rewarded with additional yield for taking on term risk, we continue to overweight the short end of the curve with credit, such as the BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF (ZSU) and the BMO Canadian Bank Income Index ETF (ZBI). We continue to pare our short-term credit positions with exposure to the BMO Long-Term US Treasury Bond Index ETF (ZTL) as a hedge should recessionary concerns continue to grow. We are not making any changes to our fixed income positioning this quarter.

Equities:

• Equities will face a critical test in the coming weeks, with the S&P 500 Composite (SPX) closing in on 3,386, its pre-COVID-19 high and prior to when pandemic relief via monetary and fiscal stimulus was announced. This also represents a key technical level, as it coincidentally denotes the approximate 30% drop from its peak, the average equity market decline in a recession. The overall risk to the equity market from a fundamental perspective is that, while valuations are low, with the forward P/E ratio of the SPX to be 16.4x, continued downward revisions of company earnings would mean that prices would be forced to reprice lower. Earnings season, which just started, has been promising so far, with several early positive earnings surprises. Despite the uncertainty, we believe opportunities are already looking attractive in certain pockets of the equity market for long-term investors. We will not be making changes to our equity mix, as we believe we are already well-positioned between defensive exposures, such as low volatility, strategic growth positions, such as quality stocks, and select sectors that we view as bargains.
  
• Canadian bank stocks are a prime example of an industry group where valuations look extremely attractive. Higher interest rates can certainly put pressure on borrowers, particularly with Canadian household debt at record highs. The recent underperformance of Canadian banks, relative to the S&P/TSX Composite, was largely due to banks writing up their loan loss provisions. However, non-performing loans on the Canadian banks remain between 30 to 70bps of total loans, suggesting that some bad news is already priced into bank shares. In addition, Canadian banks remain well capitalized, with Tier 1 capital ratios well above the Basel 3 requirements and the more conservative Office of the Superintendent of Financial Institutions (OSFI) minimums. The average P/E ratio of 9.3x on the ​“Big-Six” banks also represents a -26% discount to the broader S&P/TSX Composite and is well below its historical average. The BMO Equal Weight Banks Index ETF (ZEB) allows investors to easily target Canadian banks, which we view as a buying opportunity for longer-term investors, particularly with the average 4.8% dividend yield on the group.
• We also view high-quality, blue-chip stocks as currently undervalued. The ​“quality” factor has been one of the worst-performing factors in U.S. equities year-to-date. While some may find this surprising, given the focus on companies with stronger and better earnings profiles and low financial leverage, the underperformance has been more attributable to the higher technology weight in the BMO MSCI USA High Quality Index ETF (ZUQ). It should be noted that the technology holdings in this ETF are composed of ​“cash-rich” companies with low debt loads, which should better withstand higher interest rates. The recent underperformance of this factor signifies an opportunity for longer-term investors to pick up cornerstone, blue-chip holdings for their portfolio at a more reasonable valuation

Non-Traditional/Hybrids:

• Preferred shares suffered a blow in recent weeks, with TD Bank electing to extend a preferred share rather than redeem it and replace it with a newer funding vehicle. This came as a surprise to many, as the OSFI has previously suggested it prefers the traditional $25 par preferred shares to be taken out of circulation. While we suspect this was more to keep its risk-weighted assets high to retain the ability to issue more Limited Recourse Capital Notes (LRCNs), we don’t necessarily view this as a negative. The higher reset spread on the recently extended preferred shares keeps the universe better represented by banks and helps keep the yield on the universe attractive. This should be a positive for both the BMO Laddered Preferred Share Index ETF (ZPR) and the BMO Canadian Bank Income Index ETF (ZBI).

Stats and Portfolio Holdings

Portfolio holdings

Portfolio Characteristics

Fixed income sector breakdown

The Good, the Bad and the Ugly

Conclusion: Central banks remain focused on taming inflation, with recent CPI readings still remaining resilient, especially in the U.S. We believe relying solely on CPI measures will provide a lagged measure of inflation, with many of its components slow to react to changes in monetary policy. Given interest rate changes take on average 18-24 months to be fully digested into the economy, and early evidence of supply chain is healing, it would be prudent for central banks to pause on interest rate hikes in the new year. Longer-term investors should not be trying to pick a bottom, but instead, should be taking advantage of the pockets of value already within the market. Investors should also take solace that risk assets can and will rally ahead of the turn of the economy and will bottom well before we move out of a recession.

Quarterly Fixed Income Strategy – Q4 2022 >

¹ ​“Dot Plot,” Investopedia.
² As of October 14, 2022.
³ ​“Terms Structure of Interest Rates Explained,” Investopedia.

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