Three Market Questions to Answer

It’s a quiet start to the week – with most markets consolidating in recent ranges ahead of the US/​China trade talks in London (later today) and US CPI (Wednesday).

That being said - there is still plenty of ground for us to cover. We figured we’d kick this week off by addressing three questions that we are routinely asked these days before delving into our Canada (point 2) and US (point 3) sections. From there, we make some minor adjustments to our portfolio strategy going forward (point 4).

1.) Three Market Questions to Answer

a.) How concerned should we be with duration?

Over the past several weeks, there’s been a fair bit of hand wringing when it comes to the long end for several sovereign curves across most of the developed markets.

• In the US, this is being led by concerns over the trajectory of the US fiscal deficit, with the House GOP rendition of the ​“One, Big, Beautiful Bill Act” (OBBA) alongside some spotty Treasury auctions leading to a rise in 10-30y UST yields since the beginning of May. 
• We still expect some tempering of the House bill in the Senate, but that won’t change the fact that little is being done to curb excess US budget deficits over the next several years. 
• For other DM countries (Germany, Italy, Canada, UK, Japan etc), the concern on long-end yields arises from the changing nature of trade. 
• For instance, the change in the configuration of global trade points to a reassessment of the internal drivers for growth for many countries. Indeed, most are now looking towards increasing deficits via expenditures on defense and infrastructure which points to an increase in coupon supply. 

What complicates the path for the non-US countries is that it is understood that most of them are getting to the end of their monetary policy easing cycles (barring a larger growth shock than expected). That points to a weaker demand backdrop amidst an increase in supply potentially that has bond investors a bit nervous. 

To answer the above question – yes, we ought to still be a bit wary of duration risks in the near-term. Having said that, we do envisage potential opportunities to get involved in UST longs here – not least as we suspect that US data should continue to slow which will necessitate deeper/​quicker Fed cuts than perhaps the market is expecting.

b.) Should we trust the rally in US large caps?

To answer this question, it’s important to note that the recent uptick in the S&P 500 has been accompanied with a shift in market expectations for the Federal Reserve. 

Indeed, the proxy for the Fed terminal rate (which we define as the lowest 1m forward OIS over the next 2 years) has shifted to 337bps from 316bps at the end of May. That means the market has removed close to one rate from the easing cycle for the Fed. 

The way we interpret this is that the market is reassessing the damage to the US growth profile from tariffs + trade (a more ​‘resilient’ US economy). Also, we cannot dismiss the possibility that the market sees OBBA as being net stimulative for the US economy.

However, we still have reservations on US large caps for the following reasons:

• Much of the ​‘stimulus’ for OBBA will be focused on extending the TCJA tax cuts. For instance, most estimates have the primary deficit expanding by $592bln by the end of 2026 with over 60% of that coming from an extension of TCJA. That’s not ​‘new’ stimulus – just a measure to prevent the largest tax increase in history.
• The expected long-term return on equities over TIPS (or the equity risk premium) is still close to its lowest level in decades (Chart 1).

To summarize, we’re still only cautiously optimistic on US large caps from here. It’s still one of the core positions in the equity sleeve of our balanced portfolio, but we’re not ready to increase our allocated weight here just yet.

Chart 1 – The S&P 500 Equity Risk Premium is Still at its Lowest Level in Decades

*Equity risk premium is calculated as the cyclically adjusted earnings yield (inverse of CAPE) minus the 10-year UST real yield

Source: BMO GAM

c.) Is the EAFE story done?

Not necessarily. The key ingredients for the outperformance of EAFE this year (trade policy uncertainty) still remains elevated. Also, there’s a palpable amount of concern on the rise of capital-related barriers (Section 899). 

The other thing to remember is that despite the relative outperformance of US large caps this quarter, small and mid caps continue to underperform relative to other markets.

Take the Euro-area equity market for instance. Despite the quarter-to-date underperformance of European large caps, small and mid caps from the region have still outperformed those of the US. This makes sense to us when you look at the fundamentals – higher tariffs in the US mean a rise in input costs for smaller firms while increased European fiscal spending is aimed on stabilizing the domestic economy.

Chart 2 – European vs US Markets by Size (Quarter-to-Date)

Source: MSCI

2.) Canada

a.) On the BoC from here…

Forward CAD OIS points to a BoC terminal rate that is around 246bps – which implies that the market is expecting the Bank to ease just one more time for this cycle. 

We do share the view that the Bank is close to the end of its easing cycle. That’s not least as incoming data has revealed a more benign backdrop than most would have expected heading into this quarter. 

Real activity in Q1 was firmer than expected and left us with a stronger hand-off to Q2. At the same time, the May edition of the ​“Labour Force Survey” surprised us in its strength as hiring increased in trade-related sectors while the main drag came from a drop in part-time public admin work (due to the end of the federal election).

Of course, we’re not out of the woods. The unemployment rate is still rising, while the most recent trade data does suggest that US demand for CAD imports is very much elastic. These are the sorts of things that the BoC will be weighing against still sticky core inflation.

b.) If the market is correct in its assessment of the BoC, then the most immediate implication is that the CAD rates market should underperform relative to the US. 

Remember, we’re still expecting a considerable degree of CAD supply for the coming year. What’s different now (relative to last year) is that the Bank is close to the end of its easing cycle. That suggests that demand conditions for additional CAD supply will likely be worse.

At the moment, the CAD-US 10yr spread is around -115bps. It’s probably too much to expect it to shift towards the -60bps area (which was the average between late 2022 and early 2023), but a move above -100bps is not at all out of the question.

3.) US News and Notes

a.) The May edition of Nonfarms was unremarkable for the most part. Bears could look at the two-month revision to payrolls (-95k) and note that it was the largest downward revision since last October – when most of the market was still fixated on rate cuts.

But that’s still mostly nitpicking. Despite the softish undertones to claims and ADP, the picture is that the US labor market is in balance. 

b.) Of course, we can’t not comment on the April trade report that was released last week. If you recall, that report showed the US trade deficit narrowed by the most on record as goods imports declined substantially. 

By now, there’s been enough ink spilled on the headline. Our own interest is on which trade partners and which products were the most impacted.

On the trade partners side – Chart 3 shows the percentage (of total imports) that shifted by country in the April trade report. 

Note that the largest drop came from US imports of EU and Swiss goods. 

Chart 3 – The Decline in US Goods Imports by Country (March to April)

Source: BEA

On the products side – Chart 4 shows the percentage import decline in each major category (from the prior month). It’s easy to see the impact of sectoral tariffs here, with imports dropping for autos and parts and industrial materials (steel/​aluminum).

But what is striking to us is consumer goods, which was all driven by the drop in pharmaceutical imports. Until now, Trump has only threatened tariffs on pharma imports.

Chart 4 – Decline in US Goods Imports by Category (March to April, Percentage of Total Import Change)

Source: BEA

The US imports a lot of pharmaceutical products from the EU and Switzerland. Even if threatened tariffs on such products haven’t gone into effect yet, we’re already seeing a pronounced impact on trade flow as it appears that US importers are getting ahead of planned tariffs still.

4.) Portfolio Strategy

Two notable shifts from last week:

• We are removing our tactically bullish view on US duration.
• We have upgraded EM (ex-China) to neutral.

For the former, we’re concerned with market interpretation of recent US data and what that could mean further out the curve alongside the still lingering supply concerns.

For the latter, we’re more constructive on Latin America and India going forward.