With COVID-19 concerns ongoing and geopolitical tensions intensifying, financial markets have their eyes firmly locked on central banks as they attempt to tackle rampant inflation without reversing economic momentum.
To explore the topic of central banks and monetary policy, BMO Private Wealth hosted a client webcast last week with BMO’s Chief Economist and other BMO Private Wealth experts who shared their insights.
Participants:
Jamie Loughery, Regional President, Ontario Region, BMO Private Wealth
Douglas Porter, Chief Economist and Managing Director, BMO Financial Group
Stéphane Rochon, Managing Director, BMO Nesbitt Burns Portfolio Advisory Team
Naveed Mohammed, Head, Investment Manager Research, BMO Private Wealth
From Highs to Lows
At the end of 2021, the equity markets were at an all-time high. In a matter of months, however, things shifted significantly, with market participants selling off bonds and equities almost indiscriminately. According to Douglas Porter, Chief Economist and Managing Director at BMO Financial Group, the swift change was a response to the evolving tone of the central banks.
Just six weeks ago, most Wall Street banks were looking at two interest rate hikes. Now, some are looking at seven- or eight-rate hikes this year and quantitative tightening within a matter of months. Though the U.S. Federal Reserve (the “Fed”) was slow in responding, it quickly cranked up its hawkishness. The market may have read too much into that hawkishness, noted Porter, but the message was clear: central banks meant business on the interest rate front.
It’s important to remember that 2021 started off solid for both the S&P 500 and TSX. Market returns were very strong (at over 20 percent, compared to a historical seven percent). The robust numbers were a testament to the strong return after the quasi shutdown. Those numbers, in turn, prompted a good year for the stock market. Auto stocks, like Ford, were hitting all-time highs thanks not only to a good corporate structure but strong tailwinds. And, with interest rates so low, growth companies attained valuations we hadn’t seen since the tech bump in the late nineties, Porter explained.
But now we’re seeing high-profile companies like Facebook, Netflix and Shopify take a big hit, becoming especially vulnerable. Comparatively, energy stocks are up strongly. “Our message to clients is you have to be more selective this year because the economic momentum will start slowing down,” said Porter.
Focus Inward
It’s time for investors to start focusing on their own backyard. “Canada holds a lot of potential right now,” explained Porter, adding that valuation discrepancy is among the biggest he’s seen in decades and Canadian stocks are incredibly cheap relative to U.S. equities.
Take the energy market. Investors expected the industry to go bankrupt with everyone jumping onto the Tesla bandwagon, but oil and natural gas are not disappearing anytime soon. Investors are now re-evaluating their stance and the possibilities at home.
Another good bet are the financial firms which are relatively cheap and benefit from higher rates, offered Porter. “And when you look at basic material stocks and industrials, they tend to hold up well in inflationary periods.”
Banks On the Same Page
Though the central banks largely move in sync, two important distinctions are worth noting, said Porter. With wages rising at five percent in the U.S., compared to 2.5 percent in Canada, the Fed is currently facing a more significant danger on the inflation side.
At the same time, Canada has a hotter housing market than the U.S., and the speculative pressure on the market would allow the Bank of Canada (“BoC”) to be more aggressive than usual. Commodity prices would also promote a more aggressive approach in terms of raising interest rates. At the end of the day, however, it seems the banks will balance themselves out.
The Impact of Geopolitics
The rising conflict in Ukraine is concerning, but armed conflict doesn’t have a lasting impact on the market, argued Stéphane Rochon, Managing Director, BMO Nesbitt Burns Portfolio Advisory Team. “It can get a bit volatile; the market can lose 1.5 to 2 percent in a few days after a conflict begins but then it recovers fairly quickly.” Why? Because the market is amoral. “It doesn’t consider morality, per se in its pricing algorithm,” explained Rochon.
“The market looks at what really drives corporate profitability and that tends to be the economic cycle.” The pace of deceleration and interest rate increases are more relevant to the market and investors.
Still, added Porter, it’s important to note that natural gas is a sensitive commodity that would see movement with a conflict in Ukraine due to the importance of its supply to Russia.
Inflation Concerns
While the U.S. and Canada aim for 2 percent inflation, the former currently sits at 7 percent, while Canada is closer to 5 percent, the highest it’s been in 30 or 40 years. “We would need inflation to recede a lot before the BoC and the Fed are comfortable again,” said Porter. “They won’t take their foot off the break until it gets to at least 3 percent.”
While we hear a lot about supply chain issues, supply is at an all-time high globally, he shared. The issue is demand (since people overspent on goods during the pandemic) which has swamped the existing supply chain. Taking the steam out of demand - with the help of higher interest rates and tighter monetary and fiscal policies - is the only answer, said Porter.
As for the housing market, it’s wrong to assume that high interest rates will lead to the collapse of the housing market. For Rochon, the most important factor is economic confidence, as was seen in the mid-nineties when a severe correction in home prices followed a huge run-up in prices. Job insecurity is the strongest factor effecting people’s desire to take on mortgages, Rochon added. Of course, interest rates can combat excess bidding wars and overextending. “But a massive correction will have more to do with the economy.”
Keep in mind that, over the last year, there were 270,000 new units available in the country, the second-highest level we’ve ever seen, shared Porter. “We are actually building enough homes.” The bigger issue is out-of-control demand, whether from investors or people buying multiple properties. “Ultimately, the best medicine would be higher interest rates, which can effect a correction on their own.
Tech Then and Now
It’s a fallacy to compare the tech market today with that of the nineties, which was revolutionary from an investor perspective, said Rochon. Internet companies with little to no profitability or sales witnessed exploding valuations. Today, tech companies boast more established business models, with strong cash flows and sales to support their expensive costs.
The most important advice for any investor is to be selective, cautioned Rochon. Some pandemic “winners” like Zoom saw their valuations become parabolic. But there are older, less sexy, tech stocks which look very interesting.
Reducing our Carbon Footprint
With an overreliance on hydro, provinces like Ontario will struggle to meet the carbon emissions target, never mind the goal of switching to EVs by 2035. And with oil exports so integral to Canada, change will be difficult. On the other hand, there are tons of opportunities in the green space.
People naturally think of Tesla when discussing EVs but it’s an expensive stock, explained Rochon, adding there are other ways to reach our environmental goals. Just look at major automakers like Ford who are shifting strategy. No question, electrification is here to stay, he noted. “When an industry that big says ‘this is real’, you know it is.”
Keep in mind that automakers are a risky industry due to their high cyclicality. Sometimes investors get over-exuberant too. Copper producers - essential for charging stations, whose need will only grow - are also cyclical but offer a nice derivative play. Far less risky are utility stocks, which will see demand increase as regulators allow for the building of more grids or high-power cables.
Waiting on the Bank of Canada
Many were surprised when the BoC didn’t make a move in the last meeting. What are the chances it will move by 50 basis points next time? Never say never, said Porter. Though we haven’t seen 50 basis-point increases since 2000 for either bank, we need only look back to the mid-nineties to see it’s a possibility.
“I don’t think either central bank will start with that but if inflation doesn’t calm down by the spring, we have to entertain the possibility that central banks will realize they are behind the curve and will have to act more aggressively,” Porter explained. “They may move 50 basis points if that’s what it takes.”
You can watch the full discussion here: Central Banks Take Centre Stage (vimeo.com)
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