Speaker 1 (00:00):
BMO has been continuing to help clients navigate shifting geopolitical risks. A recent BMO digital event offered insights about how volatility from the situation in the Middle East is affecting market positioning, investment strategies, and the economic outlook. Listen to find out more.
Speaker 2 (00:20):
Welcome to Markets Plus. We're leading experts from across BMO, discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes.
Sadiq Adatia (00:35):
Joining us are Katherine Krantz, Managing Director Portfolio Strategy, BMO Capital Markets, and Robert Kavcic, Director and Senior Economist at BMO. Katherine, Robert, thank you for joining me today. We've got a lot to uncover for sure and things are probably changing on the fly as we speak. Let me start with you, Katherine, first. From a macro strategy perspective, what has been the main drivers of asset prices since the energy shock from the Iran conflict? And are those factors still dominant today?
Katherine Krantz (01:07):
Yeah, thanks, Sadiq. So actually, it might come as a surprise to most people that our view of what's driving the market and will drive it in 2026 hasn't really changed all that much, even given the conflict. When we started out the year, our thesis was based on all the stimulus that we had in the pipeline. We had a significant amount of monetary stimulus. We have the One Big Beautiful Bill that was set to increase GDP growth by about one percentage point this year. And we've had a lot of infrastructure spending by companies. And so that told us that leading indicators were going to be improving. And so our outlook was for cyclical leadership, which we definitely saw in the first part of the year. What's interesting is obviously when the events unfolded, we took a step back to see, do we need to make a change to our positioning or recommendations?
But we held firm for a couple of reasons. One is that we were already looking at cyclicality with a quality add-on and also a valuation add-on because we've always had the view that inflation was going to be problematic as the year went on. Last cycle, we never got a recession. And typically what happens is it's sort of a cleansing mechanism and you get excess capacity and labor markets. And then when stimulus is put into the pipeline, that sets things off. And typically you get a significant number of quarters of non-inflationary growth before that becomes a problem. But we were always calling for it to be more of a problem sooner because we didn't have that excess capacity. Now, the oil price shock has obviously kind of put that on steroids. And so we were waiting to see what was going to happen in terms of leadership.
But what's been encouraging to us is that on the days where there's positive news progress toward some kind of resolution, a ceasefire, the so-called taco trade, we're going right back to that cyclical leadership. So, we had the opinion that this would be resolved at some point. And if it didn't drag on too long, you were really better off staying positioned for the recovery.
Sadiq Adatia (03:12):
And maybe just a little follow-up to that. Are you a little surprised that despite the fact that we've seen markets rebound back, oil prices have remained higher than expected, especially in the first few days after the ceasefire, oil prices continue to stay at a higher path at $100 level?
Katherine Krantz (03:27):
I can't say what we're really surprised. There's been a lot of destruction of infrastructure that's going to take time to come back online. So we really didn't anticipate us to go right back to where we were in February. And BMO's Randy Ollenberger -- his calling for oil to settle somewhere around $80 a barrel. If this is resolved somewhat quickly, if not, then obviously there's still upside to that, but we didn't expect it to just rebound right back to where it was. There's significant rebuilding to be done. And there's going to be a lot of moving parts here. And one of the things that we think could be a byproduct of this is that a lot of countries are going to lean more toward green energy to avoid having this stranglehold on their economies in the future.
Sadiq Adatia (04:09):
Yeah, that's a great point. I think you'll see a lot of dynamics change as a result of this and people don't want to be in that same situation that we've seen so far. And that supply issue that was there early on in oversupply is now being predominantly gone that will put the baseline prices of oil much higher than what we saw two months ago. Continuing with you, Katherine, to what extent is there a geopolitical risk premium in equity, bond, and commodity markets, and is it stable or is it shifting?
Katherine Krantz (04:36):
Yeah, I mean, I think it is shifting. Obviously, we've seen the VIX index come up and down, so that's telling us that risk is being repriced on a constant basis, but I don't think it's gotten out of hand. I think that, again, given the way we've seen the market rebound when there's been good news, that's to me that I think most investors are sort of cautiously optimistic. But going forward, again, I think it comes down to the amount of time it takes for this to be resolved. If it looks like it's going to drag out for some reason, then we may see a repricing of that risk.
Sadiq Adatia (05:08):
And you think that repricing would act relatively quickly or would it take much longer?
Katherine Krantz (05:12):
That's hard to say. I would put that in the category of one of the unknown unknowns. I was just saying earlier, we just published a report talking about investing through the fog of war, which is a reference to a documentary about the Vietnam War. And really, there are things that we know, there are things we don't know, and there are things that we don't know that we don't know. And I put that in that category of it's hard to say what a surprise could look like.
Sadiq Adatia (05:48):
Katherine, one more for you. In addition to the situation in the Middle East and its impact on commodities, are there any other geopolitical risks that investors should consider when reviewing their strategies?
Katherine Krantz (05:58):
Obviously, trade's been at the forefront. I don't know if you call that geopolitical, but certainly a global phenomenon. So I think obviously relationships have been changed around the world, especially based not only in the past year, but based on this conflict. And so I think there's going to be a lot of realignment going on going forward. And you hear this anecdotal evidence of certain people in different countries looking to buy products that are not made in America and things like that. So that's certainly a risk that we have to see going forward. But it's hard to say because human behavior is resilient. And so right now, tensions are high, but we don't know in six months, 12 months, what will still be on the global brain of consumers.
Sadiq Adatia (06:42):
I think it's important that the Russia-Ukraine situation is still going on for quite a bit of time. And though this one looks like it's coming relatively closer to an end than where we were at a few weeks ago, who knows where this turns. I like to think of this as a two chess players playing, but unfortunately, now that one of them are very good at what they do and very unpredictable. So, it's hard to decide what the next move's going to be. Robert, to moving over to you. In the previous events focused on the Middle East, your colleagues referred to resilience in the US and Canadian economies, the shock of higher oil prices. Would you say the same thing and what's behind the resilience?
Robert Kavcic (07:17):
Yeah, thanks, Sadiq. I would say there is quite a bit of resilience, and you can see that as evidence just what we're seeing in the equity market coming back really quickly, right? Simplest answer would be that, look, Canada, the US are both actually net oil and gas exporters now. Historically, the US wasn't. To be fair, there's a big regional difference. It's going to feel and look a lot different in somewhere like Alberta versus, let's say Ontario and Quebec, but in the aggregate scale, that is the case. I think we also have to keep in mind that the economies were very solid coming into the oil shock as well, especially in the US. Look at something like private domestic demand in the US, which would basically be consumer spending and business investment. We were seeing really, really rock solid, like two and a half, 3% growth in real terms.
So, there is capacity there just in the underlying momentum of the economy to handle a period of higher oil prices and it's proving to be the case. And then probably the biggest factor if we're really stepping back and looking at this would be that the economy in North America and especially the US is just less sensitive to oil prices than in the past. I know we think about an oil shock. We always immediately think about, let's say, like the really bad old days of the 70s and 80s where higher oil prices would really quickly trigger a recession. The economy was just significantly different back then, relying a lot more on stuff like heavy industrial output. So for context, and not to go too into the weeds on this, but for some context, the US consumes about 20 million barrels a day of oil right now, basically taking 0.7 barrels to produce $1,000 of real GDP.
And the comparison we always make is we go back to the 70s, it took more than two barrels to produce that same amount of real GDP in today's dollar. So effectively, the US economy is about a third as energy intensive as it would've been back then when these shocks would really quickly trigger recessions. And then of course the difference is that we're a much more service-based economy, much more finance, much more tech-based economy where we just don't get the immediate impact of higher oil prices on actual economic activity and employment. So short answer is yes, there's more resilience and the market I think is reflecting
Sadiq Adatia (09:23):
Thanks. Two-part question here. For the US, the tax refunds that are coming up, you think that's helping to soften a bit of that blow and keeping the consumer resiliency there. And then maybe for the Canadian part of it, the fact that we have higher oil prices, is that a positive for Canada's economy because of the energy, obviously emphasis that's there, or is it a detractor because consumers are going to pay more at the pump as well? How do you distinguish that part?
Robert Kavcic (09:47):
So that's a good question. So the tax rebate checks that are coming, the wave of those rebates is, it's timely in that it's going to buffer some of the impact. As Catherine mentioned, there's quite a bit of stimulus in the pipeline, and that's one example that is going to be there to offset the impact of higher oil prices. On the Canadian side too, I mean, what are we seeing policymakers do right now? We're seeing policymakers push out various relief measures. We're going to get a fiscal update from Ottawa in the next couple of weeks and what are they going to do? They're going to right away cut 10 cents a liter off gas prices in Canada through the excise tax. So there is fiscal support. In terms of being a net positive or net negative in Canada, this is always one that's a little bit debatable.
In the aggregate, it's going to raise nominal GDP. It's going to raise incomes and government revenues as a net exporting economy. The issue is that we start to really fracture the economy in Canada when you have big shocks like this. So, a province like Alberta, Saskatchewan, incomes in economic activity, fiscal positions are going to improve pretty significantly there. The flip side is that if you're sitting in Ontario or Quebec where the economy's already kind of struggling to grow at potential, this doesn't help you at all. So, in the aggregate, it's debatable. It's probably a small net positive overall though on the ground, it's probably going to fracture economic conditions from a regional perspective even more.
Sadiq Adatia (11:02):
Perfect. Thanks, Rob, for that. Sticking with you again, how high would old prices have to be and how long would they need to stay at those levels before central banks respond with monetary policy changes?
Robert Kavcic (11:12):
So, our view is that where we are right now in terms of the level, we're not going to get a monetary policy response through tightening. So, we're probably going to be faced with this reality of three and a half, if not slightly higher inflation in North America through the summer. The central banks are probably going to look through that. I'd probably get more concerned if we were starting to look at four handles on inflation, maybe $120 oil to get us there. Just based on what the market's doing right now, it's hopefully not the case. And with respect to policy, I mean, the duration matters a lot here too, right? So you probably need higher oil prices well into the summer. And the Bank of Canada is one example, is going to be pretty pragmatic about this as they always are. They're probably going to look through the initial impulse.
The flip side of that is they're probably going to need to see at least three months of stubborn core and evidence that inflation at the pump or at the grocery store are spreading more broadly across different categories of core inflation before they would become concerned enough about it to actually raise rates. And so that probably takes us at least to the end of the summer, early fall before they would have enough evidence in hand to actually make a policy switch like that. And rounding this all out is that coming into the oil shock, if you look at core inflation trends in Canada month to month or over the last three months, they're actually improving pretty significantly. So, I think the bar is pretty high for them at this point to actually turn around and start raising rates. And we think the Bank of Canada's on hold right through the year.
Sadiq Adatia (12:40):
And maybe just not to ask you to look into their crystal ball here, but maybe I am, do you think it's generally around the world that central banks have pretty much deferred out that interest rate decision? And you think it's changed from cuts to maybe neutral or from neutral to hikes at all? Or you still think it's still, like you said, a bit more of a wait and see still?
Robert Kavcic (13:02):
Yeah. So this is where it gets kind of interesting because in a sense there has already been a bit of a policy response. You just don't see it very much. And what I mean by that is I would actually argue that before the oil shock started, the bank Canada was probably quietly thinking about or talking internally about possibly cutting rates this year. And what the oil shock did was basically took that out of the equation, rightfully so, right? You've seen that reflected in bond yields, pricing out any kind of easing. Similar at the Fed, what was the Fed doing? The Fed was in the middle of an easing cycle and what the oil shock has done is kind of put them on hold and prolong the pause that they were sitting with. So incrementally at the margin, it's taken some of the easing out of the system or the potential easing out of the system and left central banks on hold.
So I mean, technically you can probably call that some incremental tightening or some policy shift versus what the baseline would've otherwise have been.
Sadiq Adatia (13:53):
Yeah, that's true. It's things happening behind the scenes obviously and giving the policymakers some time to think through this. And again, as you said, the duration matters a lot here, right? The short term, they can see past that, but longer term, they'll have to wait a little longer to make those decisions. Sticking with you, Robert, one more time. For firms with complex supply chains facing the higher input cost and volatility, what are the most important second order effects for them to plan for?
Robert Kavcic (14:18):
Let's think about an oil shock. Traditionally, you would see obviously inflation being front and center, right? So there's going to be an immediate inflation impulse on gas prices. Second order affects when you start to probably see that impacting food inflation through transportation costs, broader core inflation pressure in the system if we're kind of stuck at these levels. That would be one for sure. Probably looking at potential margin pressure too as a second order effect, right? So if you're a firm that has enough pricing power to say pass on higher input costs, great, but if you don't, or if you're in a very competitive market or if you're in a software economic backdrop where you don't have that ability to pass on cost pressure, you're probably going to see margins get squeezed. And this is an environment where margins have been exceptionally solid. So there's room there.
And then the other typical second, third order effect would be when oil prices are high enough for long enough that they start to choke off economic growth. And that's probably something that we'd be concerned about if prices were to move higher and sustain there into the summer. So that would be like a traditional oil shock. A couple of things that might be specific to this environment, particularly if you look at things like the supply chain, like is there going to be a more persistent disruption of traffic and oil activity through the Middle East? Is there going to be things like a risk premium on pricing, higher insurance costs, things like that from a supply chain perspective and be a little bit sensitive supply chains right now, of course, coming out after the pandemic when the entire global economy was kind of riddled with supply chain problems, right?
So that's one area to be sensitive of. And then the last thing I would maybe just point out here is too is this a lot of talk about at the macro level, kind of this K-shaped economy forming, where the high end is performing exceptionally well, the bottom end is struggling. Well, where does gas price inflation and food price inflation hit hardest? It's at the lower end of the income spectrum. So if anything, this probably exacerbates that.
Sadiq Adatia (16:16):
Can you just expand just a little bit on that K shape? How much of the economy is driven by the high income meters versus the low income meters, just so the audience understands that?
Robert Kavcic (16:24):
So a lot of the strength in, let's say like consumer spending, which has been very resilient, has been on the back of the higher end of the income spectrum, right? Disposable income has been growing now with inflation back down. Of course at the lower end, you tend to see higher gas prices and food prices choke off disposable income pretty quickly. The other side too that maybe goes a little bit under reported is the household balance sheet is in very, very strong shape. Even in Canada where we have a lot of debt, we have significant liquid asset levels just on the back of post pandemic savings and a really strong bull market in equities. So disproportionately, I think we are seeing more and more of that strength coming from the higher end of the income spectrum and that wedge is widening out.
Sadiq Adatia (17:07):
Katherine, just a follow-up from that. If you think about what we've seen kind of bouncing back in the last few weeks in the markets, technology has actually done quite well versus some of the other sectors. Do you think that's tied to the fact that that has least been impacted obviously by energy or do you think that's just a valuation thing that's caused it to bounce back now given the pullback?
Katherine Krantz (17:28):
Well, I think there are a lot of moving parts there. So, the growth, which is technology is a big part of the growth segment. Traditionally, we think of that as a stability segment of the market. And so typically it's kind of that in between cyclicals when the economy's booming and people are really seeking out that kind of pro- cyclical exposure, but before you go to defensive. So, we took the performance of sectors as a positive during the conflict. The fact that people weren't just piling into very defensive names and they were going back into the tech stocks. Now, certainly there's a love affair out there, especially with the mega cap tech stocks. So, I do think a lot of people saw it as an entry point to buy the dip with them coming back a little bit. But on the other hand, growth stocks are much more sensitive to higher rates and higher inflation than cyclicals are or defensives.
And so we still think those stocks are in a danger zone for the rest of the year. And like I said, we already had an outlook that we thought inflation was going to be a problem. And we totally agree with what Robert was saying for something like an oil shock, it takes six to nine months for that to finally feed through to core inflation. And so we think we have quite a ramp of potential for higher prices going forward. So we think that weighs on the PEs of growth stocks more than cyclicals.
Sadiq Adatia (18:50):
Yeah. I think coming into the ed, there's a big theme of diversifying away across sectors, away from just the Mag seven and technology, which obviously played out really well in the first part of the year, and we're seeing a bit of a catch-up. As you said, those who may have missed the tech rally found the pullback in tech names as an opportunity to jump in. The question is, will they remain in that and will they rotate into the other sectors
Katherine Krantz (19:12):
Over time? One thing that's interesting, my colleague Jonathan Zuko just told me yesterday, the technology sector equal weighted is near an all-time high. So that tells us that it's the entire ... It's not just the Mag seven, right?
Sadiq Adatia (19:25):
That's a great point. It has been moving down that spectrum for sure. Maybe a question for both Katherine and Robert and maybe Katherine, I'll go to your first on it. What is the one risk you think investors may be underestimating and one stabilizing force they may be overlooking as they plan for the next quarter?
Katherine Krantz (19:40):
I'd say we would put inflation as that risk. People just aren't talking about it. Robert was making a point about Fed policy earlier and something that's interesting that we've noticed we track a series called the Monetary Policy Sentiment Index, and basically it's a series that tracks the rhetoric of Fed officials, how hawkish or doublished they are. And we know typically the Fed's much more concerned with the state of labor markets and inflation. Part of that's just because inflation hasn't really been an issue in 40 plus years. So they've always been more reactive to the labor market issues. But we saw the inflation surprise index start to tick up at the end of last year and the monetary policy sentiment index ticked up right along with it toward a more hawkish stance. And this is months before the conflict even started. So to us, we think that inflation is on the radar screen for the Fed.
And given where labor markets are, we have a huge, huge headwind in demographics. We had labor markets, about 15 to 16% of people were retired in the US for decades and starting in 2010 when the first boomers turned 65, it's just gone vertical. And so these are people that are not coming back to the workforce. And so when you have that on top of a restrictive immigration policy or below replacement rate on the birth rate, it's inflationary. So when the shock does start to feed through to core inflation, we already have a situation where labor markets are potentially inflationary. So we think that's the biggest risk that isn't quite on the radar screen right now. I think the stabilizing factor is what I said in the beginning, which is all the stimulus we have in the pipeline. If you look back historically, if we're in the negative part of the cycle and there's not stimulus, maybe you're kind of on the tail end of a cycle and the Fed's starting to raise rates.
When you have a shock like this, markets are much more volatile and have a much more negative reaction. So we were lucky in a sense that we were in a position with all the stimulus in the pipeline and improving the leading indicators when this conflict started.
Sadiq Adatia (21:46):
That's a great point because you're right, markets didn't react as badly as you might have expected with that shock. Same question to you, Robert. What are your thoughts?
Robert Kavcic (21:53):
So, a risk, I would say maybe not necessarily understood or misprice, but maybe just forgotten for now would be, let's say the US fiscal situation, especially now with potentially big increases in defense spending. And in the reality that, look, we're in a pretty solid economic position. I don't want to say top of the cycle, but certainly high in the cycle and we're still running a budget deficit that's 6% of GDP. So, what's going to happen when the US economy inevitably does fall into recession? Well, you're very going to quickly see that jump percentage points higher. And then this ultimately just leads us to some pretty tough fiscal choices at some point down the road. That's kind of inevitable. Stabilizing force, I mean, pretty consistent with what we were talking about earlier and some of Katherine's conference is that the baseline that we were dealing with coming in this stock was actually very favorable and especially from an equity perspective, very, very favorable.
So, we were looking at things like US economic growth running above potential. We were seeing prints around the 3% mark for a period there coming into this, double digit earnings momentum in the US, in the S&P 500 as well, broad disinflation trends, which are allowing the Fed. And meantime, the Fed is able to ease it into an environment of strong growth and strong earnings growth is exceptionally bullish. And then you have strong productivity growth on top of that, that's allowing it. And then in addition to that, you have kind of a major investment theme in the build out of AI technology going on in the background as well. So that all combined is basically the recipe for a bull market in US equities, right? Even if that's the backdrop, it kind of suggests that if we can get through this oil price shock and if, again, if the duration can be contained, that those underlying fundamentals are still there.
Sadiq Adatia (23:32):
Well, excellent. Katherine, Robert, thank you for your insights on helping us take a step back and considering how investment strategies and supply chains may change based on the economic and market outlook. We also appreciate the insights that you provided on the impact of heightened geopolitical risks on asset prices and decision making and appreciate you helping us navigate the uncertainties ahead. Thank you all for watching and listening and thank you everyone and have a great rest of your day.
Speaker 2 (24:02):
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Speaker 1 (24:14):
The views expressed here are those of the participants and may not necessarily represent those of BMO Capital Markets, its affiliates or subsidiaries. For BMO disclosures, please visit bmocm.com/podcast/disclaimer.
