Russian Roulette

In what was already a complex macroeconomic backdrop, Russia’s invasion of Ukraine has now added an additional wrinkle for investors. While the North Atlantic Treaty Organization (NATO) has so far focused exclusively on economic sanctions rather that providing military support, there is concern that the ongoing conflict has the potential to escalate. While the main concerns regarding Russia’s act of aggression have been mainly geopolitical, it has also had global economic ramifications as investors have pared back risk and flattened the yield curve through the buying of bonds in a flight to safety move. Though market concerns have somewhat alleviated, it his has seemingly added another ball in the air for central banks and policy makers to juggle.

With Russia being one of the world’s largest exporters of oil and natural gas, sanctions both self-imposed and by NATO have taken further supply off the grid, which has further exacerbated commodity prices. Though peace talks have continued, a ceasefire agreement has yet to be reached, which has been detrimental to the NATO nations themselves. Ongoing conflict would further fan the inflationary fires, thus potentially forcing the hand of central banks in North America and Europe to become even more hawkish.

Both the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) have initiated their move towards higher overnight rates by making their first-rate hikes at their March meetings since the start of the pandemic. The BoC recently made a further 50bp rate hike at their April meeting, showing to the market it can be hawkish if needed. The Overnight Interest Rate Swap (OIS) market is currently pricing in very aggressive moves by both central banks for the remainder of the calendar year. Low unemployment rates and improving gross domestic product (GDP) north and south of the border suggest that much of the economic slack has been absorbed, which warrants tighter monetary policy. However, it should be noted that with a good part of inflation caused by supply chain disruptions, an overshoot by the central banks can send us into stagflation without solving for higher prices.

The recent temporary inversion of the yield curve (the difference between the 10- and 2-year U.S. treasury yields) signals the potential for an economic recession and thus an equity market turnover on the horizon. While the Canadian yield curve has yet to become inverted, it came to being just a mere 10bps away from doing so (Chart B). This may limit how aggressive central banks can act in taming inflation, unless they adopt a ​“Volkeresque” type mandate by putting economic growth on the backburner. As noted, with supply chain disruptions likely to continue in spite of ​“Just-In-Time” inventory management systems, its likely tighter monetary policy will have a more limited impact on inflation after a certain point.

Since Pfizer and BioNTech announced the success of their vaccine in early November, cyclical stocks have outperformed defensive-oriented stocks. Cyclical stocks, which tend to be more sensitive to economic growth, experienced a more significant repricing, as investors became more optimistic for an eventual economic reopening. In the second quarter, however, that outperformance became less evident, as the appetite for risk has waned and investors have become less willing to overpay (Chart B). We anticipate equities will continue to outperform fixed income for the remainder of the year, but investors should keep risk in check and have the core of their equity exposures in factors such as quality and low volatility. More cyclical-oriented exposures can be used around the peripheral.

Given that any change in monetary policy takes months before its impact is felt throughout the economy, we expect both the BoC and Fed to pause with its rate hikes in late summer or early fall. At that point, both central banks will have a number of successive rate moves under their collective belts, which should restore credibility and thus allow them to utilize forward guidance. We believe this would be a more impactful tool as it would not only provide time for the economy to digest the changes related to the key overnight rate, but it would also allow the central banks to tame inflation without further inverting the yield curve or slowing economic growth.

Things to Keep an Eye on

Two indicators investors often use to highlight market risk are U.S. High Yield Bond credit spreads and the CBOE Volatility Index (“VIX”). Typically, the two are highly correlated given they indicate levels of risk aversion in the market. Due to the Russian invasion of Ukraine, both indicators notably increased to illustrate concerns related to the escalating conflict and the potential for other NATO members to become involved. More recently however, the VIX has returned to more normal levels while high yield credit spreads remain wide. At first glance, this appears to suggest that bond and equity investors are perceiving risk very differently.

Recommendation: Part of this divergence is due to yield chasers de-risking their portfolios as sub-investment grade bonds have been one of the main benefactors of lower interest rates, as bond investors had to search for yield. With treasury yields on the rise, some have moved back into investment grade assets, which are now offering yields to maturity not seen in years. For those bond investors that have a longer time horizon and can stomach some volatility, you should consider the BMO High Yield US Corporate Bond Index ETF (ZJK) or the BMO High Yield US Corporate Bond Hedged to CAD Index ETF (ZHY). With current credit spreads in the high yield market well above historical rates, most issuers in the space are well insulated from the geopolitics outside of North America.

Of the S&P 500 Composite sectors, information technology has been one of the main laggards year-to-date. Rising rates have been a headwind for the sector since some of the less mature companies tend to rely on debt, with higher interest rates potentially meaning higher costs for debt servicing. While this may be true for the smaller cap companies in the space, the larger more mature technology stocks tend to be cash rich, but unfortunately have been indiscriminately sold-off within the sector. With interest rates expected to rise further, the sector could be faced with continued volatility.

Recommendation: Investors looking for technology exposure may want to consider the BMO Covered Call Technology ETF (ZWT). This fund invests in only the larger cap, more mature companies in the sector. In addition, the covered call overlay of the portfolio allows investors to harvest the uncertainty and earn higher option premiums as volatility remains elevated in the sector. When looking at the companies in the portfolio, they carry a lower debt-to-total assets ratio than both the S&P 500 Composite and the S&P 500 Information Technology sector. Furthermore, when considering net debt, which factors in cash and liquid assets, many of these companies in the sector exhibit lower debt burdens than the broader sector and market.

The Japanese economy has long been shunned by equity investors given its aging demographics, low economic growth and deflationary environment. As the global economy currently struggles with high inflation, Japan is now being explored by some as a potential safe haven. With many central banks in other economies becoming more hawkish, and thus raising rates and tightening quantitative measures, Japan’s year-over-year CPI remains at 0.9%, suggesting its equity market won’t be met with the same headwinds as its peers in other developed markets.

Recommendation: The low valuations of Japan’s equity market make it attractive now as its price-to-earnings (P/E) ratio is below other developed markets. Some investors have been looking to move away from Europe given its exposure to the war between Russia and the Ukraine. As a result, weightings in Japan have increased with some institutional investors. Many of Japan’s companies also have globally derived revenues while its local labour market has not experienced wage inflation, suggesting the potential for higher profit margins. The BMO Japan Index ETF (ZJPN) and BMO Japan Index ETF (Hedged Units) (ZJPN.F) provide investors with efficient access to the Japanese equity market. 

Changes to Portfolio Strategy

Asset Allocation:

• Currently, all the various asset classes have their respective concerns. Higher inflation and rising rates will weigh on fixed income, while rising prices will erode the real value of cash. Equities may face additional challenges given the recent inversion of the yield curve. Despite the many challenges that asset markets currently face, as they often say ​“There Is No Alternative (TINA)” to stocks right now, particularly given equities have historically outperformed even commodities in times of inflation. Despite our preference for equities, it should be noted that diversification is still important. The rally in bonds on the days following the Russian invasion is a good example of how fixed income can help mitigate equity market volatility.
  
• Our portfolio strategy is already well overweight equities with its current allocation at 66.0%. As such, we believe we are well positioned from an asset allocation perspective for an inflationary environment. Our core equity exposures remain more defensively positioned in low volatility and high-quality factors. We are not making any adjustments to our asset allocation strategy this quarter, nor to our positioning within the various assets.

Fixed Income:

• While there’s been some short-term pain for fixed income investors particularly in the last year, we believe over the long-term the rise in yields is a much-needed calibration for the bond market. With bonds trading at a premium in recent years, yield to maturity on bonds has fallen short of coupon rates, making them tax inefficient. However, the recent increase in bond yields has allowed plain vanilla fixed income ETFs to be as tax efficient as their discount bond counterparts. Nevertheless, as a general rule of thumb, investors should always default to products like the BMO Discount Bond Index ETF (ZDB) for fixed income exposure in non-registered accounts as tax implications are one less issue that investors need to worry about in this case, particularly if rates reverse course and bonds go back being at a premium.
  
• Outside of default, the main risks that fixed income investors face are inflation and rising rates. Currently, both of these concerns are front and centre in the bond market. Though we prefer equities in the current environment, we would strongly dissuade investors from abandoning fixed income. Despite inflationary pressures, catalysts such as the Russia-Ukraine war could lead the equity market to potentially turnover, depending on how events unfold. As a result, duration exposure in a portfolio still helps mitigate potential equity market volatility. Positions such as the BMO Short-Term US TIPS Index ETF (Hedged Units) (ZTIP.F) can help offset some of the negative impacts of inflation on duration risk.

Equities:

• The quality factor has underperformed year-to-date, particularly in the U.S. equity market. One of the reasons has been due the exposure to the technology sector. Many of the stocks in the technology sector tend to be interest rate sensitive, as some are early-stage companies that rely on debt financing. Earlier this year, investors appeared to be indiscriminately selling technology stocks, including the mature, cash-rich companies that make up the BMO MSCI USA High Quality Index ETF (ZUQ). In recent weeks, these established tech companies like Microsoft Inc. and Apple Inc. have started to rally back, thus providing a lift for the quality factor. The quality factor remains a core position in our portfolio strategy for U.S. equities; we view it as an efficient way to get exposure to large-cap, blue chip companies with competitive advantages in their respective fields. We view their underperformance relative to other factors year-to-date as an accumulation opportunity for investors looking to build a long-term core position in their portfolios.
  
• Energy stocks have had a significant run over the last two years. While recent gains in the West Texas Intermediate (WTI) benchmark have been largely driven by concerns over Russia, longer term capacity issues remain, which means supply and demand imbalances will persist even if a ceasefire is reached. With the aggressive government push towards renewable energy, capital expenditure on fossil fuels has been low, thus likely keeping crude supplies low. The strategy we’ve been recommending for our BMO Equal Weight Oil & Gas Index ETF (ZEO) has been called ​“taking the house’s money,” where profits on ZEO are periodically rebalanced to core positions of a strategy such as ZUQ.

Non-Traditional/Hybrids:

• Both the BMO Laddered Preferred Share Index ETF (ZPR) and the BMO US Preferred Share Index ETF (Hedged Units) (ZHP) were trading at premiums to start the year. However, the recent credit spread widening in corporates provide an opportunity for both Canadian and U.S preferred shares. Issuers in both markets tend to be pretty well insulated by the geopolitics outside of North America, which may indicate credit spreads have overreacted. Should risk normalize, the opportunity particularly with ZPR may be attractive given the recent rise in the five-year Government of Canada yield.

Stats and Portfolio Holdings

Portfolio Characteristics

The Good, the Bad and the Ugly

Conclusion: For the first time in years, COVID-related headlines have taken a backseat to geopolitical risk coming out of Russia and Ukraine. Countries learning to live with the virus marks a shift in policy that should re-open much of the global economy and allow supply chains to eventually normalize. First and foremost, our thoughts go out to the people of Ukraine for a quick path towards peace. The unfortunate crisis has also made it even more difficult for policy-makers to navigate, given rising inflation, growing political division and signs of a potential recession. Any mishaps in policy can lead to an undesirable outcome, making it a game of economic Russian roulette. In terms of portfolio construction, diversification must resolve positioning for various outcomes including inflation, stagflation, recession and a tail-risk event.

Visit bmo.com/etfs or contact Client Services at 1−800−361−1392.
To listen to our Views From the Desk BMO ETF Podcasts, please visit bmoetfs.ca.

BMO ETF Podcasts are also available on