Sirens on the Horizon

Both as an epic poem and as a summer blockbuster hit film, ​‘The Odyssey’ offers many lessons. For those of us in the investment profession, the most important one is to appreciate the evolving risks and what they could mean for our base case scenarios – lest we end up lost like our hero Odysseus. And to be frank, there are a lot of similarities between the beginning of Odysseus’s journey and where we are in the market cycle right now.

Chart 1 – Long-Term Drivers for U.S. Long-End Yields

Currently, we remain entrenched in the ​‘reflation’ part of the macroeconomic cycle. That is when most leading indicators imply that economic growth remains firm while price pressures remain sticky. Recent data backs this view – with composite PMIs across the world’s largest economies still above levels that mark expanding economic growth (the notable exception being China). The recent estimate for the September PMI reading in the U.S. indicates that businesses haven’t been this optimistic about future sales growth in years. That is also aligned to the strong U.S. data of late – including recent nonfarms and retail sales reports – which suggests that the economy is expanding above its estimated potential growth rate.

This is the backdrop that we’ve operated in for several quarters, and it should continue to support broad risk appetite. However, we must also be mindful of the rising risks that are making this backdrop more precarious to those from prior quarters.

For instance, the conflict in the Middle East continues to complicate matters. It’s now been over seven months of below normal traffic through the Strait of Hormuz – with global shortages leading to a pronounced increase in the prices of both energy and refined products. That is directly feeding into producer and consumer prices such that central banks can no longer look past the second-round effects. Indeed, three of the ​‘big four’ central banks have hiked policy rates over the past month (the Federal Reserve, or the Fed, the European Central Bank, the Bank of Japan). There is also a very good chance that the Bank of Canada will end up hiking rates at one of its two remaining meetings this year. These are the main reasons why front-end yields have been rising across several markets.

Equally important are the moves in the long end, which are being driven by a multitude of factors. For one, there is increased competition amongst issuers, with U.S. corporations (hyperscalers mainly) looking to term out borrowing. That is ​‘crowding out’ sovereign bonds in the long end. Second, the artificial intelligence (AI) boom is compounding the narrative of robust U.S. economic growth, which is raising market estimates of the long-run neutral interest rate – pushing up long-end yields in the process. Finally, credibility risk is rising as few countries are seriously considering fiscal discipline at this point. All these factors are weighing on buyers in the long end, who are now far more price sensitive than they have been in years past.

And remember that given its composition, the S&P 500 is effectively a long duration asset. Sectors that are mostly made up of firms whose valuation depends heavily on distant future cash flows (like technology, communication services, consumer discretionary, etc.) make up around 60% of the index. That leaves them vulnerable to higher long-end yields.

Chart 2 – The Majority of S&P 500 Sectors are Negatively Correlated to U.S. 10-Year Yield Shifts

Another risk for markets is no longer a nascent one – the public backlash against AI. At the very least, this has been compounded by recent news that some frontier models had gone rogue, leading to a push within the industry for increased self-regulation or ​“pacing.” That compounds the lack of favourability of AI among the voting public that politicians are finding harder to ignore. For us, increased ​‘pacing’ or regulation will matter given the heavy degree of capital investment we’ve seen go into the space. Any signs of waning demand or excess data center capacity imply a capex slowdown – a serious risk for both economic growth and for risk appetite.

The combination of higher-for-longer energy prices, bond yields and increased risk of AI regulation makes us a bit more nervous about the current reflation-like backdrop than we have been in the past. The easy gains are no longer there as we’re moving from participating in the reflation backdrop to navigating it.

For our fixed income sleeve, remaining underweight is relatively straightforward. True, there is the temptation to look at higher yields as an opportunity, but the factors driving yields higher are too strong to fade at the current moment. At the very least, we’ll need to see evidence of slowing equity market and economic momentum before we become interested in the U.S. rates space. For our alternatives sleeve, we’re remaining overweight given our unease with the current inflation picture.

Additionally, we are growing more cautious with our equity outlook. While we’re maintaining an overweight position in our equity sleeve, we’re reducing the amount of downside risk embedded in that position through a greater allocation to lower volatility strategies. That allows us to participate in the upside, while paying greater tribute to the rising downside risks. As a result, our risk-weight for equities is substantially less than it has been in prior quarters.

To conclude, the journey is far from over. Like Odysseus, we remain committed to reaching our destination – but with the waters becoming more treacherous, we believe the next leg of the voyage calls for greater caution, not retreat.

For our fixed income sleeve, remaining underweight is relatively straightforward. True, there is the temptation to look at higher yields as an opportunity, but the factors driving yields higher are too strong to fade at the current moment. At the very least, we’ll need to see evidence of slowing equity market and economic momentum before we become interested in the U.S. rates space. For our alternatives sleeve, we’re remaining overweight given our unease with the current inflation picture.

Additionally, we are growing more cautious with our equity outlook. While we’re maintaining an overweight position in our equity sleeve, we’re reducing the amount of downside risk embedded in that position through a greater allocation to lower volatility strategies. That allows us to participate in the upside, while paying greater tribute to the rising downside risks. As a result, our risk-weight for equities is substantially less than it has been in prior quarters.

To conclude, the journey is far from over. Like Odysseus, we remain committed to reaching our destination – but with the waters becoming more treacherous, we believe the next leg of the voyage calls for greater caution, not retreat.

Table 3 – Asset Allocation Splits Relative to Benchmark

Source: BMO Global Asset Management, as of September 30, 2026.

Asset Allocation

• Our Macro Regime model output still suggests that we’re in the ​‘reflation’ phase of the cycle – which generally favours cyclicals and commodities. However, we’re now entering a different part of the monetary cycle (towards tightening), which means we need to exercise more caution when it comes to allocation and security selection. 
• We’re sticking with an underweight position for duration/​income (at 22% for this quarter). That reflects our concern on the current inflation trend as well as the supply/​demand factors that are playing out in the long end of the curve. For now, we favour Canadian dollar (CAD) duration over the U.S., though we may look to add to the latter if we see signs of slowing growth in upcoming data.
• Relative to Q2, we’ve pared some of the risk in our growth sleeve in two ways. For one, we’ve reduced our equity weight from 65% in Q3 to 63% in Q4. Second, we’re allocating more weight to products that are lower volatility in nature to reduce the risk weight of the equity sleeve. Of course, we’re still overweight equities as we feel the backdrop is constructive, but the shifts pay tribute to the fact that there’s less room for error from here. 
• Within the alternatives sleeve, we’ve increased our allocation slightly to 15% and will continue to maintain an overweight position. Again, this reflects our concern with the sticky nature of the inflation and the need for adequate hedges in the portfolio.
• In terms of currency implementation, we’re electing to keep our U.S. equity and alternatives exposure unhedged while maintaining a hedged position on our U.S. fixed income exposure. This reflects our view that U.S. dollar (USD) risk mitigates the overall volatility of the equities/​alternatives sleeves more effectively.
• USD/CAD has moved higher by over 2% in September. This is likely due to general strength in the USD against most developed currencies – which itself is partly due to a reassessment of Fed tightening expectations. Nevertheless, we are due for some consolidation in USD/CAD, albeit above the 1.40 mark.

Chart 3 – Macro Regime Model Output for Q4 2026

Fixed Income

• We’re curbing our core position in U.S. duration (ZUAG/F – BMO US Aggregate Bond Index ETF Hedged) and in our tactical position for Canadian bank credit (ZBI – BMO Canadian Bank Income Index ETF). We’re using both to fund a position in U.S. AAA CLOs (via ZAAA/F – BMO AAA CLO ETF Hedged).
• We covered our rationale on U.S. duration in the lead article. For Canadian bank credit, we felt it was prudent to trim our allocation given current positioning. For ZAAA, we like the floating rate exposure in this environment and generally feel that private sector balance sheets are in decent shape for now.

Equities

• We’ve shifted the weights for our core positions in ZUQ (BMO MSCI USA High Quality Index ETF) and ZEA (BMO MSCI EAFE Index ETF). Indeed, we’ve cut the allocation to the former and added to the latter to reduce the volatility contribution from the equity sleeve while also diversifying geographically.
• Within the tactical positions, we’re halving our allocation to ZEM (BMO MSCI Emerging Markets Index ETF) and removing our positions in ZLU (BMO Low Volatility US Equity ETF) and ZWB (BMO Covered Call Canadian Banks).
• In line with our goal of lowering the overall risk weight of our equity allocations, we are introducing two new tactical positions: ZOCT (BMO US Equity Buffer ETF – October) and ZPAY (BMO Premium Yield ETF). Both of these exposures are in sympatico with our view that equity markets should consolidate while also paying tribute to rising risks.

Alts/Non-Traditional Hybrids

• Again, the ​‘sticky’ nature of inflation concerns us right now, which is why we’re opting to maintain our overweight for the alternatives sleeve. 
• We’re upping our allocation to gold – but swapping out of ZWGD (BMO Covered Call Spread Gold Bullion) and into ZGLD (BMO Gold Bullion ETF). We’re maintaining a position for the former in our other portfolios.

Table 4 – Fixed Income Sleeve Breakdown

Source: BMO Global Asset Management, as of September 30, 2026. Model portfolio for illustrative purposes only. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. These are not recommendations to buy or sell any particular security. Particular investments and/​or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

Q4 2026 BMO ETFs Fixed Income Model Strategy Report >

Q4 2026 BMO ETFs Tax Efficient Model Portfolio Report >

Q4 2026 BMO ETFs Macro CDR Model Portfolio Report > 

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