Canadian CPI underscores steady rate outlook for Canada

Canadian investors breathed a small sigh of relief following January inflation data that showed a continued cooling in consumer prices. In today’s episode, portfolio managers Chris Heakes, Matt Montemurro and your host, Mckenzie Box discuss the divergence of inflation trends occurring between Canada and the U.S., where price gains continue to run hotter than expected, increasing the likelihood interest rates will need to go higher for longer there. They also discuss the relative performance of real-estate income trusts as well as technology stocks to start the year, and where those sectors go from here. 

Mckenzie Box is Director of Product and Strategy at BMO Global Asset Management. She is joined on the podcast by Matt Montemurro and Chris Heakes, Portfolio Managers and ETF Specialists at BMO Global Asset Management.

The episode was recorded live on February, 22, 2023. 

Episode Summary

REITs market in Canada

While ZRE - BMO Equal Weight REITs Index ETF underperformed the broad market in 2022 ZRE is up approximately 9% YTD. We believe 2023 will be more constructive with interest rates expected to normalize. In higher inflationary markets, when rates are rising, there is a bit of push and pull when it comes to performance in REITs. On the bright side, real estate has the benefit of being a real asset that tends to hold value in periods of inflation. Furthermore, lease resets give REITs the ability to pass on inflation through reset rent agreements. On the negative side, however, higher interest rates impact the REIT’s cost of capital and make the hurdle rate for new projects to be cash-flow accretive more difficult. The ​“bond-proxy” quality of REITs can be a negative. In any event, the condition of the economy does play a large role, so if rate increases occur during a state of economic prosperity, or an economic slowdown, impacts on valuations and markets will be different. For more on this trade idea please visit Constructive on REITs.

CPI Print

Last week we had a hotter CPI print in the US. We’ve seen the US terminal rate expectations soar as a result. It appears that the US will continue to raise rates until inflation is under control. All eyes were on the Canadian CPI print to see if we followed the same trend as the US however, January CPI year over year printed at 5.9%, versus consensus estimates of 6.1%. It is likely that we will see a pause on raising rates from the BoC in the next meeting. As of now it looks like the impact of an aggressive BoC is starting to make its way through the economy. We still have inflation above the BoCs target of 1-3 percent. Food prices are still trending higher, (we hope that higher rates will make its way through the supply chain) and Mortgage interest costs continues to see upward trajectory. As of now we still have to wait and see how the effects of higher rates play out. ZTIP - BMO Short-Term US TIPS Index ETF, TIPS - BMO Short-Term US TIPS Index ETF, ZRR - BMO Real Return Bond Index ETF

How to Play Technology

Overall, we are bullish on the Technology sector however, we believe that the ​“easy money” is done (when looking at the rebound from COVID). We expect this sector to continue to be profitable over the long term and we look to keep exposure to tech. When playing the tech sector we look at companies with high return on equity, low financial leverage and stable earnings growth using our Quality Factor ETF ZUQ - BMO MSCI USA High Quality Index ETF. A more conservative approach is the ZWT - BMO Covered Call Technology ETF where we use the covered call overlay on the portfolio, and given the uncertainty in the market around tech you can get paid an above avg yield while you wait out the volatility.

Terminal Rates

The market is expecting a peak terminal rate in Canada of about 4.72. In the US we expect 3 more rate increases of 25 bps to bring us to a terminal rate to approx. 5.4%. For the US we like short term credit ZUS.U - BMO Ultra Short-Term US Bond ETF (USD Units) and ZSU - BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF provide higher yield with low duration risk.