Lowering U.S. Equity Recommendation by 5% on Higher Inflation, Interest Rates and Slower Growth
We have been consistently bullish on equities with a preference for U.S. stocks for the last ten years. That stance, and our associated underweight recommendation on bonds and cash has helped us outperform our asset benchmarks consistently for the past decade. But we are taking advantage of the powerful rebound we have seen in the S&P 500 and Nasdaq in the last two weeks to lower our recommended U.S. equity weighting by 5%, and to add this to our cash position across the board.
This still leaves us slightly overweight equities but with a preference for Canadian stocks since the composition of the S&P/TSX is well suited to withstand inflation – commodities and other real assets tend to perform very well when generalized price levels are rising – and our market still trades at a historically steep discount to the S&P 500 despite the outperformance we have witnessed so far in 2022.
It also gives us an overweight position in cash to increase the defensiveness of portfolios given the risks posed by higher inflation and interest rates and a looming economic growth slowdown. To be clear, the risks of a recession in the next year have risen but we are not hitting the panic button just yet. Bonds are off to a very rocky start this year and value is being created in the fixed income market, but it is still too early to increase our recommendation there. The bottom line is that we still think equities are a better bet than bonds at this point.
As such, we are maintaining our fair value estimates for the S&P/TSX and S&P 500 at 26,000 and 5,000, respectively. Continued interest rate increases could force us to bring those numbers down. We continue to emphasize quality companies with sufficient growth and pricing power to offset the toxic impact of inflation. As we have noted, valuations are becoming increasingly important in this environment, so we strongly urge investors not to overpay for stocks (i.e., there are still many U.S. technology stocks which we consider very overvalued).
All eyes continue to be on the unprovoked aggression on Ukraine and the suffering of its population. We never advocate profiting from human suffering but must also address the investment implications of this invasion. We continue to firmly believe that this shocking event has not created new trends but, rather, has accelerated pre-existing ones such as higher inflation rates, and a move away from globalization and toward higher defense spending.
Given Russia’s enormous production of energy and basic materials, it is not surprising that prices continue to rise. The same goes for base metal and grain prices which were already on strong uptrends.
The silver lining for Canada and the S&P/TSX is that our country is very well positioned for higher inflation and the current geopolitical crisis. The impact on energy markets will be more substantial and longer lasting than many realize and should encourage Europe to look to North America to secure a safer supply of oil, natural gas, metals and grains. The Great White North just happens to produce all these things in abundance.
While global economic activity remains robust for now we think the rate of growth in activity is bound to slow in 2022, because of tighter monetary conditions and some inflation-driven erosion of consumer confidence. Historically, the market can post small positive returns in such an environment, but the leading sectors have tended to be defensive (think of Consumer Staples, Healthcare and REITs), rather than cyclicals like Technology and Consumer Discretionary stocks.
U.S. Economic Momentum Has Likely Peaked – Important Sector Implications
It is becoming clearer that economic momentum has peaked and, while economic activity is still robust, the best days of the post-COVID rebound are behind us. Global supply chain disruptions continued to cap activity, this time resulting from the war in Ukraine and lockdown measures in key Chinese cities. Meantime, prices paid for materials accelerated further, as inflation continues to run at multi-decade highs.
Inflation Becoming a Key Concern for Investors
All the recent economic and related commodity price strength has led to fears of inflation staying higher for longer. This focus on rising prices is well founded since inflation trends are among the most important determinants of market returns. Since inflation erodes the value of paper currency and fixed income investments, bond investors demand compensation in the form of higher interest rates to protect the real value of their holdings. The impact on equities is more complicated since mild inflation can actually be positive, as it provides additional pricing power to well positioned companies and confirms the risk of a deflationary trap are now firmly behind us.
Market Returns Under Different Inflation Regimes
Stocks generally do better when inflation is declining. It is still possible to make money when inflation is rising, however, one has to be more selective. In Canada, performance has actually been better when inflation was rising, no doubt because of our market’s very high exposure to Basic Materials and Energy which offer good inflation protection. The stock market clearly does better with low inflation but some sectors with reasonably strong pricing power can still generate decent returns when inflation is higher than 3%, including pharma, medical equipment, tobacco, etc. This fits well with our more defensive recommendation and our preference for quality Healthcare, Consumer Staples, Utility and REIT companies.
Valuations Matter Again and That Should Continue
Looking at valuations for stocks or other asset classes is a terrible timing tool. Financial history has proven time and time again that being disciplined about the price paid for assets (having a “margin of safety” as Warren Buffet famously put it) is the best way to ensure an appropriate return for long-term investors.
Canada: Still Trading at an Unusually Steep Discount to the U.S. Based on Price-to-Earnings (Lower) and Dividend Yield (Higher)
While Energy is not a defensive sector, we want to reiterate our view that oil and natural gas stocks remain too cheap given their huge cash flow generation and ability to buy back shares and increase dividends. Looking at the commodities, our analysts believe oil and natural gas prices will continue to be well supported by increased demand as lockdowns ease while supply constraints should be exacerbated by the chronic lack of investment in production growth over the last five years.
The Technical Picture – Russ Visch, CMT Technical Analyst
North American equity markets appear to have completed a fairly routine, medium-term pullback in recent weeks and new buy signals in our short- and medium-term timing models suggest the bias for equities should remain to the upside throughout most of the second quarter.
The S&P/TSX Composite recently broke out of a five-month consolidation pattern above resistance at 21,796. That trendline reversal should result in persistent outperformance through to the third quarter of this year, at least. That’s the good news. The bad news is that the likelihood of more volatility and greater downside risk in the second half of the year continue to grow.
Perfect Storm in Bond Markets
The central bank’s job is getting more complex with a geopolitical conflict adding to an already very challenging first quarter environment of high inflation, low unemployment, signs of slower economic growth and still extraordinarily high monetary stimulus. While the pace of expected tightening has significantly increased, the expected terminal policy rate has not, with the consensus anchored around the U.S. Fed/Bank of Canada targeting a neutral rate ranging between 2.25 to 2.75%.
High inflation will impact consumer demand and economic growth. The rate of change, especially considering the significant increase in global debt during the pandemic, unfortunately leaves fixed income investors with negative returns for a second consecutive year. But before considering selling underperforming securities, there are some silver linings to consider:
1. There has not been any permanent capital impairment and default risks have not increased despite wider credit spreads.
2. While interest rates can continue to rise, we believe the worst is likely behind us.
3. Investors still expect to earn nine months of coupon income this year, the primary reason for investing in fixed income securities.
4. Finally, investors can now invest/reinvest at more attractive rates, particularly in the provincial and corporate bond markets.
In the short term though, we continue to maintain our recommended allocation to fixed income at the lower end of the range.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
If you are already a client of BMO Nesbitt Burns Inc., please contact your Investment Advisor for more information. The information and opinions in this report were prepared by BMO Nesbitt Burns Inc. Portfolio Advisory Team (“BMO Nesbitt Burns”). This publication is protected by copyright laws. Views or opinions expressed herein may differ from the views and opinions expressed by BMO Capital Markets’ Research Department. No part of this publication or its contents may be copied, downloaded, stored in a retrieval system, further transmitted, or otherwise reproduced, stored, disseminated, transferred or used, in any form or by any means by any third parties, except with the prior written permission of BMO Nesbitt Burns. Any further disclosure or use, distribution, dissemination or copying of this publication, message or any attachment is strictly prohibited. If you have received this report in error, please notify the sender immediately and delete or destroy this report without reading, copying or forwarding. The opinions, estimates and projections contained in this report are those of BMO Nesbitt Burns as of the date of this report and are subject to change without notice. BMO Nesbitt Burns endeavours to ensure that the contents have been compiled or derived from sources that we believe are reliable and contain information and opinions that are accurate and complete. However, BMO Nesbitt Burns makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this report or its contents. Information may be available to BMO Nesbitt Burns or its affiliates that is not reflected in this report. This report is not to be construed as an offer to sell or solicitation of an offer to buy or sell any security. BMO Nesbitt Burns or its affiliates will buy from or sell to customers the securities of issuers mentioned in this report on a principal basis. BMO Nesbitt Burns, its affiliates, officers, directors or employees may have a long or short position in the securities discussed herein, related securities or in options, futures or other derivative instruments based thereon. BMO Nesbitt Burns or its affiliates may act as financial advisor and/or underwriter for the issuers mentioned herein and may receive remuneration for same. Bank of Montreal or its affiliates (“BMO”) has lending arrangements with, or provides other remunerated services to, many issuers covered by BMO Nesbitt Burns’ Portfolio Advisory Team. A significant lending relationship may exist between BMO and certain of the issuers mentioned herein. BMO Nesbitt Burns Inc. is a wholly owned subsidiary of Bank of Montreal. Dissemination of Reports: BMO Nesbitt Burns Portfolio Advisory Team’s reports are made widely available at the same time to all BMO Nesbitt Burns investment advisors. Additional Matters TO U.S. RESIDENTS: Any U.S. person wishing to effect transactions in any security discussed herein should do so through BMO Capital Markets Corp. (“BMO CM”) and/or BMO Nesbitt Burns Securities Ltd. (“BMO NBSL”) TO U.K. RESIDENTS: The contents hereof are intended solely for the use of, and may only be issued or passed onto, persons described in part VI of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. BMO Wealth Management is the brand name for a business group consisting of Bank of Montreal and certain of its affiliates, including BMO Nesbitt Burns Inc., in providing wealth management products and services.
BMO Private Wealth is a brand name for a business group consisting of Bank of Montreal and certain of its affiliates in providing private wealth management products and services. Not all products and services are offered by all legal entities within BMO Private Wealth. Banking services are offered through Bank of Montreal. Investment management, wealth planning, tax planning, and philanthropy planning services are offered through BMO Nesbitt Burns Inc. and BMO Private Investment Counsel Inc. Estate, trust, and custodial services are offered through BMO Trust Company. Insurance services and products are offered through BMO Estate Insurance Advisory Services Inc., a wholly-owned subsidiary of BMO Nesbitt Burns Inc. BMO Private Wealth legal entities do not offer tax advice. BMO Nesbitt Burns Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. BMO Trust Company and BMO Bank of Montreal are Members of CDIC.
® Registered trademark of Bank of Montreal, used under license.
