Strategy

Recession or Market Rebound? How to Position a Portfolio Using ETFs.

Alfred Lee
CFA, CMT, DMS, Director, BMO ETFs, Portfolio Manager & Investment Strategist, BMO Asset Management Inc.
May 24, 2022

Details:

BMO Money Market Fund ETF Series (Ticker: ZMMK)
BMO Ultra Short-Term Bond ETF (Ticker: ZST)
BMO Ultra-Short-Term U.S. Bond ETF (Ticker: ZUS.U)
BMO Equal Weight Banks Index ETF (Ticker: ZEB)
BMO MSCI USA Value Index ETF (Ticker: ZVU)
BMO Low Volatility U.S. Equity ETF (Ticker: ZLU)
BMO Low Volatility Canada Equity ETF (Ticker: ZLB)
BMO Global Infrastructure Index ETF (Ticker: ZGI)
BMO Covered Call Utilities ETF (Ticker: ZWU)
BMO Short-Term Bond Index ETF (Ticker: ZSB)
BMO Short Corporate Bond Index ETF (Ticker: ZCS)
BMO Canadian Bank Income Index ETF (Ticker: ZBI)

It has been a challenging year so far for assets from equities to bonds. The S&P 500 Composite is down 17.2% on a total-return basis, while the FTSE/TMX Canada Universe is down 10.9%. Canadian equities have fared much better relative to their peers due to their heavy exposure to financials and commodities; however, the S&P/TSX Composite is still down 4.4% over the same period. While geopolitical concerns between Russia and Ukraine have dominated headlines, the main headwind for assets has been inflation and central bank efforts to tame its effects through the unwinding of many COVID-19-response policies. This has included tightening monetary policy through raising rates and quantitative tightening (QT).

Many indicators have shown ominous signs of an economic slowdown, including the recent inversion of the U.S. yield curve (102 yield spreads). Although this lasted only a number of days, we can certainly experience a relapse as the spread between the two terms is currently only 20bps. In addition, the most recent quarterly gross domestic product (GDP) numbers out of the U.S. came in at -1.4%, demonstrating an economic contraction. While the negative growth was chalked up to a bunch of one-time events, it certainly should be viewed with caution. On a technical level, equity markets have established a clear downtrend since the end of January, with even the S&P/TSX Composite eventually turning over. Given the aggressive rate-cutting and implementation of quantitative easing (QE) inflated all assets, it should come as no surprise that reversing these policies would only have the opposite effect. The big question now is whether we are headed into a recession and thus if markets will see more downside, or if the sell-off is overdone, with current levels presenting a buying opportunity. 

Both equities and bonds are down YTD

Both equities and bonds are down YTD
Source: Bloomberg, December 31, 2021 to May 182022.

Unless we see a significant slowdown in economic growth, the current equity sell-off should represent something very different than what we’ve experienced in the past. While central banks like the U.S. Federal Reserve (Fed) have resorted to zero interest rate policies (“ZIRP”) and QE in the past, these measures are no longer available as they would only further stoke inflation. Therefore, the key measures investors should keep an eye on this time around are whether the momentum in the run-up on inflation has started to slow, and hence if inflation has peaked. Some encouraging signs from the most recent consumer price index (CPI) numbers in both Canada and the U.S. suggest that while inflation remains elevated, the readings are essentially unchanged from the month prior. Should we continue to see this trend and eventually a deceleration of inflation, that would mean future central bank rate hikes currently anticipated by the market would be too hawkish. If this happens, it would be a catalyst for a rally in both equities and fixed income since central banks would not require as many rate hikes to stifle inflation. It should be noted that since interest rate hikes currently priced into market are already so aggressive, we don’t need central banks to become dovish for markets to turn around, we just need them to be less hawkish. 

Aggressive assumptions of Fed rate hikes

Aggressive assumptions of Fed rate hikes
Source: Bloomberg (World Interest Rate Probability – Overnight Interest Rate Swaps -U.S. as of May 182022).

With the current market turbulence, it may be tempting for some investors to move to cash. However, academic studies have repeatedly shown that over the long term, staying invested is the best course of action. Investors should stick to their long-term asset allocation mixes as that has proven to be the main determinant of long-term performance. However, there are instances where investors do need to hold cash, such as to pay for upcoming major purchases like a house, car, vacation or tuition. 

For those investors looking for cash or cash-like instruments to park money

BMO Money Market Fund ETF Series (Ticker: ZMMK): Invests in high-quality money market instruments issued by Canadian governments and corporations, such as T-Bills, banker’s acceptances, and commercial paper. This ETF allows investors to have a stable net asset value (NAV) while also having on-exchange liquidity, which may be a better option for some investors than a guaranteed investment certificate. 

BMO Ultra Short-Term Bond ETF (Ticker: ZST): Invests in Canadian investment-grade bonds that mature in less than one year. While the NAV of this ETF may not be as stable as ZMMK, it is a cash-plus” vehicle that can earn additional yield above GIC and money market products. 

BMO Ultra-Short-Term U.S. Bond ETF (Ticker: ZUS.U): Invests in U.S. investment-grade bonds that mature in less than one year. This ETF is suitable for investors looking for a cash-plus” vehicle that can earn additional yield above GIC and money market products. 

Fine-tuning a portfolio to tilt towards certain exposures may be warranted in the current environment. Below, we discuss some positioning ideas within the equity and fixed income portions of a portfolio, which are relevant if the sell-off intensifies or if markets rebound and move higher. 

Equity positioning ideas 

On the equity side of a portfolio, investors can either take advantage of the sell-off by targeting assets that are trading at attractive valuations or those that provide defensive characteristics. 

Valuation trades:

BMO Equal Weight Banks Index ETF (Ticker: ZEB): Provides exposure to the Big-Six” Canadian banks using an equal-weighted approach. Canadian banks have an average current price-to-earnings (P/E) ratio of 10.5x, compared to 15.6x for the broader S&P/TSX Composite. In addition, some Canadian banks are in a position to potentially see mid-year dividend increases. 

BMO MSCI USA Value Index ETF (Ticker: ZVU): Provides exposure to a diversified portfolio of U.S. stocks that exhibit value-style characteristics. These are defined using three variables: Price-to-Book (P/B), Price-to-Forward Earnings (P/E), and Enterprise Value-to-Cash flow from Operations (EV/CFO). This ETF has a current P/E ratio of 10.6x, compared to 19.6x for the S&P 500 Composite. 

Defensive tilts:

BMO Low Volatility U.S. Equity ETF (Ticker: ZLU): Provides exposure to a diversified portfolio of U.S. stocks that have a lower beta than the broader market. This ETF allows investors to maintain equity exposure while being more defensive relative to the broad market index, such as the S&P 500 Composite. 

BMO Low Volatility Canada Equity ETF (Ticker: ZLB): Provides exposure to a diversified portfolio of Canadian stocks that have a lower beta than the broader market. This ETF allows investors to maintain equity exposure while being more defensive relative to the broad market index, such as the S&P/TSX Composite. 

BMO Global Infrastructure Index ETF (Ticker: ZGI): Provides exposure to a portfolio of infrastructure-related stocks. Infrastructure stocks tend to be defensive as they are underpinned by stable cash flows that are inflation-linked. 

BMO Covered Call Utilities ETF (Ticker: ZWU): Provides exposure to a portfolio of Canadian and U.S. utilities, telecom, and pipeline stocks with the addition of a covered call overlay. This ETF provides defensive exposure with enhanced yield through its underlying dividends and the call-writing strategy, resulting in a distribution yield of 7.2%.1

Fixed income positioning ideas: 

On the fixed income portion of a portfolio, investors may want to minimize interest rate risk by shortening up duration. Should stagflation talks grow louder, it is likely long duration would outperform; however, if economic growth picks up, the yield curve could steepen and negatively impact the long end of the curve. As a result, from a risk-reward perspective, it may be more practical for investors to shorten duration and minimize interest rate risk.

Short duration ETFs:

BMO Short-Term Bond Index ETF (Ticker: ZSB): Provides exposure to a portfolio of investment-grade Canadian bonds that have a term to maturity of between 1-5 years. This ETF has a duration of 2.6 and a yield to maturity (YTM) of 3.2%.2

BMO Short Corporate Bond Index ETF (Ticker: ZCS): Invests in Canadian investment-grade corporate bonds with a term to maturity of between 1-5 years. This ETF has a duration of 2.8 and a YTM of 4.0%.3

BMO Canadian Bank Income Index ETF (Ticker: ZBI): Invests in instruments issued by Canadian banks with 60% of the portfolio in bonds and the remaining 40% in preferred shares, institutional preferred shares, and limited recourse capital notes (LRCN). This ETF allows investors to focus on the quality of the Canadian banks while generating higher yield by going lower in the capital structure. In addition, many of the preferred shares in the fund are anticipated to be called by issuing banks in the coming years.

While the current volatility in both the equity and bond markets has made it challenging for investors, it’s important to remember that timing the market has historically been very difficult to do. Staying invested has proven to be the prudent move for investors over the long term; however, these trade ideas can enable investors to better navigate today’s market environment.

Note: All content is as of May 182022.

1 BMO Global Asset Management, as of May 18, 2022. Distribution yield is not an indicator of overall performance yields will change from month to month based on market conditions and is not guaranteed. See below for the full disclaimer.

2 Ibid.

3 Ibid.


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