Performance Updates
Strategy Updates

ETF Mid-Year Market Review & Outlook Report

Jul. 28, 2022
Inflation: Are we there yet?
Alfred Lee, Director, Portfolio Manager, BMO ETFs

Inflation continues to be the key metric that investors are focused on as the consumer price index (CPI) in both Canada and the U.S. continues to tick up to levels not seen since the Great Inflation” of the 1980s. Both the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) have countered higher prices by tightening monetary policy through aggressive overnight interest rate hikes. The next six months will be critical as the market will look to see whether central banker’s hawkish stance will be enough to tame inflation.

With aggressive assumptions for further rate hikes already priced in, leveling inflation would be the catalyst to turn the markets around. Asset prices don’t need central bankers to become doves overnight, only less hawkish. With the move away from COVID-related lockdowns, it is likely that inflation will be persistent as supply will take longer to come back online. If China moves away from its zero-COVID policies, it could further alleviate many supply bottlenecks, but it’s unclear whether this will be the case. Therefore, the next 6 – 8 months should be very telling in whether we head back towards pre-COVID levels inflation or sustained inflation consistent with the pre-Volcker” years.

Gold has not proven to be an inflation hedge so far in 2022, as evidenced by SPDR Gold Shares ETF (GLD) returning –1.5% (in U.S. dollars). Gold rose quickly with the market stimulus back in the second quarter of 2020 but has been in decline since March of this year despite higher than expected inflation prints.

It may be tempting for investors to time the market by moving into cash. While moving small portions of a portfolio into short term fixed income ETFs such as the BMO Ultra Short-Term Bond ETF (ZST) will certainly allow investors to have dry powder on hand to take advantage of lower valuations, moving entirely into cash often proves to be detrimental on the long-term growth of a portfolio where staying invested generally proves to be the correct decision, regardless of immediate market conditions. Ultra short term bond ETFs picked up $819 million in net new assets over the first half of the year, as investors pulled back from markets and long term fixed income exposures.

Broad beta ETFs like the BMO S&P/TSX Capped Composite Index ETF (ZCN) and the BMO S&P 500 Index ETF (ZSP) provide investors with cost efficient ways to stay invested in the markets. Thematic ETFs such as the BMO Global Infrastructure Index ETF (ZGI) will provide stable revenue streams that are pegged to inflation and sector ETFs like the BMO Equal Weight Banks Index ETF (ZEB) are attractive from a valuation standpoint, regardless of the inflationary environment.

Sectors: Energy a clear winner
Chris McHaney, Director, Portfolio Manager

When looking at sector performance over the first half of 2022, there was one clear winner. Energy stocks rallied on the back of oil prices rising from $75 a barrel of West Texas Intermediate (WTI) Crude Oil at the beginning of the year, to a high of over $120 during the first half of 2022. The Russian invasion of Ukraine caused already rising oil prices to spike to levels not seen since before the 2008 Financial Crisis. With Europe under immense political pressure to reduce reliance on Russian oil and gas, concerns over supply have dominated the market during the first half of the year. This led U.S. President Joe Biden to authorize a historic release from the Strategic Petroleum Reserve (SPR) – one million barrels of oil per day for six months to ease prices until more supply comes online.

In Canada, the BMO Equal Weight Oil & Gas Index ETF (ZEO) returned 33.3% year to date. On the back of the climbing oil price, the sector saw inflows of $730 million from Canadian ETF investors.3 In the U.S., the sector also returned over 30% during the period. Exploration and production companies represent attractive investments if oil prices can stabilize in the $70 – 80 range. This provides the potential for the sector to continue its strong performance going forward, particularly over the next 6 – 12 months. With the sector exhibiting a bit of weakness to end the period, this may represent an opportunity for investors who missed the previous move to gain access to the sector.

The only other sector to show positive performance so far in 2022 is the defensive utilities sector, with BMO Equal Weight Utilities Index ETF (ZUT) returning 2.9% during the period.4 With some ties to the energy complex, and companies that generally have high levels of current cash flow, the sector displayed its defensive traits as most others sold off. ETF investors added $273 million to the Canadian sector so far in 2022.3

On the other end of the spectrum, growth-oriented sectors were hit the worst, as rapidly rising interest rates caused a repricing across markets, but particularly in those areas that entered the year with higher valuations. The technology sector, which includes companies like Apple and Microsoft in the U.S., and Shopify in Canada bore the brunt of resetting valuations, with the tech-heavy BMO NASDAQ 100 Equity Index ETF (ZNQ) selling off 28.3% during the period.4 With lower growth expectations for the sector going forward, investors may want to consider BMO Covered Call Technology ETF (ZWT) to gain exposure to this area. The covered call option overlay employed by the fund trades away a portion of potential future growth in return for consistent cash flow. This has an effect of reducing overall portfolio volatility, creating a more consistent return stream, while also providing the potential for outperformance in periods of slower equity market growth.

Low volatility and dividends offer some respite
Chris Heakes, Director, Portfolio Manager, BMO ETFs

From a factor perspective, most notable is the shift from growth factors to defensive factors in 2022. The shift has largely been driven by rising interest rates, and the risk-off tone in markets, where the selloff in February has largely continued through the end of the first half, resulting in low volatility and dividend factors strong relative outperformance.

Dividend strategies built around companies with sustainable payouts and strong current cash flows have benefitted. BMO’s dividend strategies, which focus on blue-chip quality dividend payers, have outperformed the broad indexes by 6 – 10% depending on region. As an example, BMO Canadian Dividend ETF (ZDV) has been a leading Canadian equity strategy, outperforming ZCN by 7.3% (-2.6% vs -9.9%), improving on total return versus broad equities, and significantly better than global equities, as the MSCI World Index was -19.1% (in Canadian dollars) for the first half of 2022.4 Dividend ETFs had over $1.3 billion in net inflows over the first six months of the year.3

Low volatility factor is also continuing to show relative benefits, as fears of a market slowdown increased towards the end of the period. The most defensively oriented of factors has shown its worth, with BMO Low Volatility Canadian Equity ETF (ZLB) outperforming ZCN by 5.8% (-4.1% return vs -9.9%), as well as BMO Low Volatility US Equity ETF (ZLU) outperforming ZSP by a staggering 18.2% (-0.5% vs -18.7%), with its overweight defensive sectors and companies adding significant benefits.4 Surprisingly, low volatility ETFs had close to $1 billion in net outflows over the first six months of the year.3

Value has outperformed this year, though it has weakened in recent weeks, as fears of recession have increased. We tend to continue to hold a positive outlook for value, though this may be in part conditional on the global economy not entering a recession, as value-oriented exposure hold more cyclical risks in general. The quality factor has underperformed so far in 2022 (largely due to the technology overweight), though it remains over the long-term a reliable factor exposure.

ESG: under a microscope
Erin Allen, VP, Online ETF Distribution, BMO ETFs

Despite uncertain markets, geopolitical events, and a pandemic ESG ETFs continue to attract investors, dominated by institutional flows. ESG adoption continues to be greatest in Europe with North America beginning to catch up as investors continue to recognize the benefits of the approach. Inflows into ESG ETFs and new ESG ETF launches have continued although at a slower pace year to date in 2022 after a record year in 2021 where ESG ETFs had inflows of over $4 billion. In 2022 we have seen flows into ESG ETFs of over $2 billion. Equity ESG ETFs continue to lead in flows, and we continue to see momentum in the clean energy space with $177 million in inflows.5

The impact of Russia’s invasion of Ukraine has been significant for climate change and ESG regulation, forcing companies, investors and governments to wrestle
with developments that are contradictory to their ESG commitments, for example countries in Europe turning to fossil fuels to reduce dependence on Russian gas. Whether it was Elon Musk and his comments over Tesla’s exclusion from the S&P 500 ESG Index, or the recent allegations of greenwashing at major providers, there is no shortage of news on the ESG front. Regulators are acting with the Canadian Securities Administrators issuing guidance for ESG funds earlier this year clarifying disclosure requirements.

The impact of Russia’s invasion of Ukraine has been significant for climate change and ESG regulation, forcing companies, investors and governments to wrestle with developments that are contradictory to their ESG commitments.

ESG ETFs relative performance has depended on region due to higher technology exposure and lower exposure to energy companies. ZSP has returned -18.7% versus the BMO MSCI USA ESG Leaders Index ETF (ESGY) return of -19.7%. In Canada, we see the impact of the lower exposure to fossil fuel intensive companies driving down performance for the ESG exposure; ZCN has returned -9.9% versus the BMO MSCI Canada ESG Leaders Index ETF (ESGA) return of -17.7%. Performance in Canada was impacted by the lack of exposure to fossil fuel intensive businesses which are thriving due to supply imbalances caused by the geopolitical environment and Russian oil sanctions. BMO’s suite of ESG Leaders ETFs targets a sector neutral exposure, including energy, which helps under normal circumstances to keep performance in line with the broad market. The ESG Leaders Indexes invest in companies that have higher ratings relative to their peers in each sector while avoiding the ESG laggards.

Innovation, Technology, and Crypto: under heavy pressure
Mark Raes, Managing Director, Head of Product, BMO ETFs

The rise of inflation has hit growth stocks hard, as companies valued on future cash flows now face a higher discount rate in cash flow models. As well, the aggressive action of central banks has led to fears of an economic slowdown and lower growth estimates. BMO MSCI Innovation Index ETF (ZINN) declined 31.2% over the period, and BMO NASDAQ 100 Equity Index ETF (ZNQ) declined 28.3%,4 showing that there was little opportunity to hide with growth ETFs. Perhaps the most well known growth innovation strategy, ARK Innovation ETF (ARKK), declined 57.1% (in Canadian dollars)6, testing innovation investors after an incredible run during the post-COVID market recovery. This ETF has positive inflows year to date, as investors position for the long term and buy on lower valuations. In Canada, thematic ETFs, which include these growth strategies, have had net inflows of close to $2 billion.3

The rise of inflation has hit growth stocks hard, as companies valued on future cash flows now face a higher discount rate in cash flow models.

For crypto assets, it’s been a very difficult six months, as pricing has undergone a hard correction. Purpose Bitcoin ETF (BTCC) has declined 60% over the period,6 as crypto is no longer being considered an inflation hedge, and as other coins and stable coins have been under extreme duress. For crypto believers, it’s been about taking the long view on returns, and despite significant outflows in June, crypto ETFs are close to flat on flows year to date.3

Fixed Income: under siege
Matt Montemurro, Director, Portfolio Manager, BMO ETFs

2022 has been a challenging year for fixed income investors. Inflation fears, fueled by the pandemic’s impact on the global economy, have come to fruition, exceeding central bank expectations, forcing them to act more aggressively with their interest rate policy. The pace at which the central banks have been forced to raise interest rates shows the severity of the problem; attempting to use aggressive interest rate policy to cool the impact of inflation. In a rarely used tactic, the Fed and BoC have both employed mega-hikes at recent meetings, increasing rates by 50bps and 75bps per meeting. This has been a main driver of fixed income underperformance, year to date. Yields have increased, across the curve, and there has been material flattening of the yield curve with shorter term rates rising at a faster pace than longer term rates.

Compounding the impact of rising interest rates, the Russian invasion of Ukraine caused credit securities to sell off. Credit spreads, both investment grade and high yield, have widened significantly, sitting well above historical norms, leading to underperformance of corporate bonds, relative to federal bonds. The combination of the negative drag on performance, due to interest rate sensitivity, and the widening of credit spreads, has left investors with very few places to hide.

Looking forward, central banks have identified that their near term priority is to get inflation under control, meaning that there is an increasing chance that they might overshoot with their interest rate policy causing an economic slowdown and possibly a recession. Even with these conditions, aggregate fixed income exposures pulled in over $3.1 billion in net inflows over the period.3 With an eye to safety, cash ETFs pulled in close to $1.7 billion in net inflows.3 Observing outflows of near $700 million in corporate bond ETFs,3 higher quality corporate bonds such as BMO High Quality Corporate Bond Index ETF (ZQB) provides investors with more defensive exposure to A rated corporate bonds and above.

ETFs continue to lead the way as access vehicles, with the launch this year of BMO Canadian Bank Income Index ETF (ZBI), investors gain access to bond and hybrid exposure to the Canadian banking sector. Pairing the stability of bank bonds with the attractive yields of bank issued preferred shares and limited recourse capital notes ZBI is well positioned to buffer the rising rate environment, offsetting some of the traditional interest rate sensitivity of fixed income.

Looking Ahead
Mark Raes, Managing Director, Head of Product, BMO ETFs

It’s been a bumpy ride with markets this year, ETFs continue to prove their worth both strategically and tactically, as they are cost effective to hold, and efficient to trade. As indexed ETFs provide market returns, they are critical portfolio construction tools to help investors pivot in volatile markets.

ETFs have gone mainstream, their use as access vehicles for satellite positions and as core building blocks in portfolios means that they appeal across investor types and portfolios. With the continued positive momentum in industry flows, we expect that the industry will continue to offer new innovations and existing products will become even more efficient with more trading interest.

1 BMO Global Asset Management & Morningstar, July 2022.

2 ETFGI Global Insights, July 2022.

3 NBF Research Report, June 30 2022.

4 BMO Global Asset Management, June 30 2022.

5 NBF Research report, July 2022.

6 Bloomberg, June 30 2022.

Forward-Looking Statement:

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. 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.

Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent prospectus.

The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.

S&P®, S&P/TSX Capped Composite®, S&P 500® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”) and TSX” is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with BMO ETFs. The ZCN and ZSP is not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such BMO ETF(s).

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Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated. For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/​or elimination.

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