ZDB - BMO Discount Bond Index ETF

The North American fixed income space remains at a crossroads. In the front-end, U.S. yields are expected to be under some pressure given the potential for additional Federal Reserve (Fed) cuts (due to a deteriorating labour backdrop) while Canadian dollar (CAD) yields are likely to better supported. The big caveat for the latter is (of course) the status of the United States – Mexico – Canada Agreement (USMCA) trade deal in the coming quarters.

In the Q3 edition of this report, we were more constructive on our outlook for the U.S. fixed income space relative to Canada. This reflected our view at the time that the market was underpricing the risk of Federal Reserve (Fed) rate cuts in the fall, while the Bank of Canada (BoC) was likely at the end of its cycle.

Fast forward three months, we’ve largely seen this story play out. U.S. rates have outperformed as Canadian dollar (CAD)-U.S. dollar (USD) spreads have tightened aggressively across the curve.

As the global trade paradigm shifts, countries are reassessing old economic configurations.

Consider, that with the United States retreating from free trade, developed market economies can now expect the contribution from net trade to economic growth to decline in the coming years. Indeed, those same economies will now need to chart a different course as the degree of access to U.S. markets has changed dramatically.

This is the second quarter for our Tax efficient portfolio.* This portfolio is meant to follow the same fundamental framework as our Balanced Portfolio, though the instruments are adjusted to be more tax efficient for Canadian investors.

Ever been to a really good party that you didn’t want to end? Remember that feeling you get when the lights start to come back on, the bar is closing and the music is winding down? There’s a slight wistfulness that the fun is over and it’s time to go home – even if you feel like it’s still a bit too early and want to keep dancing.

In our first ​‘Tax Efficient’ Portfolio, we are following the same fundamental rationale as our ​‘Balanced Portfolio’ with a few caveats. First, we are prioritizing capital gains over income. This means focusing more on discount bonds in the fixed income sleeve of our portfolio while also continuing to prioritize shorter duration products.

As an example, we have removed ZBI and replaced it with ZCDB (BMO Corporate Discount Bond ETF) at a lower weight. We are also increasing the weight of ZDB in this portfolio to 10% (from 5% in our balanced fund).

Second, we are prioritizing Canadian and U.S. underlying holdings over international investments. That means a greater weight for core exposures in ZCN and ZUQ. At the same time, we are removing ZIQ and ZEM.

For the tactical exposures, we have elected to go with a covered call strategy for Tech ZWT (BMO Covered Call Technology ETF) as well as a covered call strategy for Utilities ZWU (BMO Covered Call Utilities ETF). Both allow us to earn tax efficient income in sectors that we think should still continue to perform.

Additionally, both of the aforementioned strategies will help to make up for the relatively lower income that comes with utilizing discount bond ETFs in the fixed income sleeve.

We are also removing our exposure to ZGI (BMO Global Infrastructure Index ETF) and reallocating that to ZLSC (BMO Long Short Canadian Equity ETF).

There is a deep contradiction between perception and reality that is currently playing out in the U.S. economic landscape. In many ways, it reminds us of the setting to the famous 1999 movie, The Matrix (a friendly spoiler alert for those that haven’t seen it – skip ahead to the next paragraph). In the movie, the world in which the protagonist wakes up is a simulated reality powered by an engine that most don’t see. This ​“invisible engine” dynamic helps us square the inconsistency between the prevailing narrative of U.S. economic fragility and incoming data that shows resilience.

Despite the recovery in broad risk over the past few months, the underlying issue remains the same. The decades-long integration of global trade — with the United States at the hub — has been permanently disrupted. And unless we see a complete reversal from the Trump administration, the current regime of higher trade barriers is likely here to stay.

What’s more, we also appear to be in the early stages of something more nefarious — a capital war. As congressional members pass the ​“One, Big, Beautifull Bill Act”, a provision like Section 899, even if excluded, should send a reminder to non-U.S. investors that foreign investment is becoming less welcome than it has been in the past.