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COVID-19 Morphing into the Flu? Positive Implications for the Recovery Trade
The Omicron variant is now a household name all over the world only a few short months after having been discovered in South Africa. It is hard to see the positive, although we do believe there is a silver lining as Omicron is fast crowding out all other forms of the variant and appears to have milder health implications.
In December, our research partners at Cornerstone Macro hosted a call with noted Epidemiologist Glenn Grossman in which he made the bold prediction that Covid – as we’ve known it to date – could effectively be over in the Spring (in North America) and be replaced with something more akin to a common cold as opposed to a deadly virus.
We believe the investment implications of this scenario are profound and likely quite positive, especially for so called “recovery stocks” which have been under pressure for months. By this we mean travel and hospitality-related companies (i.e., Air Canada, McDonald’s). More generally, we remain bullish on stocks, particularly in Canada, which has a strong valuation advantage over the U.S. and a market composition that actually BENEFITS from inflation. We expect consumers to remain strong and businesses to continue investing in technology, automation and to generally bolster their supply chains, which will help give more momentum to the rising capital expenditure cycle.
Our bullish call on equities is anchored by our still positive view of the economy. While it would be far too optimistic to expect a repeat of 2021’s 20%+ stock returns, we believe we are transitioning into a continued, albeit slightly slower economic recovery in 2022. Most importantly, our models show a very low probability of recession in North America. Specifically, we get odds of 12% or even below 10%.
On a related note, corporate earnings estimates have increased relentlessly over the last year and recent public company quarterly reports support a continued upward trajectory, especially for energy, financial, consumer and industrial companies, which happen to carry the biggest weight in the S&P/TSX Index.
As noted by BMO Economics: Against a backdrop of sturdy demand, both supplier delivery delays and prices paid for materials took a big step down, suggesting capacity constraints started to ease at the end of 2021.
Backing up the supply chain improvement narrative is the sharp decline we have seen since last October in the Baltic Dry Index, which provides a benchmark for the price of moving major raw materials by sea. The index has come down more than 60% and now sits close to its historical average.
The private sector increased hiring (in all major industries except manufacturing), as did the government. The “quits” rate in the private sector jumped 0.3 ppts to 3.4%, suggesting more confidence to leave one’s job for another. This data is highly supportive for consumer spending and the housing market, at least for the next few quarters in our view.
Chart-wise, the “COVID reopening” trade has been on pause throughout much of the second half of 2021 with most sub-industries trading sideways since the summer as the Delta and now Omicron variants raged around the world. We’re starting to see signs of life again though with the S&P 500 Restaurants sub-industry, recently breaking out of a six-month consolidation pattern and signaling a resumption of the long-term uptrend. Favorite names in the sector include:
• McDonald’s Corp. (MCD-NYSE)
• Chipotle Mexican Grill (CMG-NYSE)
• Domino’s Pizza (DPZ-NSDQ
The S&P 500 Apparel Retail sub-industry also looks to be headed for a challenge of the upper end of a nine-month consolidation pattern. A close above resistance at 2,553 would open a new upside target of 2,986, which would represent a gain of nearly 25% from the current level.
Favorite names in the sector include:
• The TJX Companies (TJX-NYSE)
And finally, the Hotels, Resorts, and Cruise Lines sub-industry also looks set to challenge the upper end of a year-long consolidation pattern.. A close above resistance at 582 would signal a resumption of the long-term uptrend and open a new upside target of 697, which would represent a gain of 25% from today’s level.
Favorite names include:
• Expedia (EXPE-NSDQ)
• Marriott International (MAR-NSDQ)
• Hilton Worldwide (TLR-NYSE)
Groundhog Year for Interest Rates?
After a challenging year that resulted in negative total returns for bond investments, the 2022 consensus view for interest rates trajectory remains higher still, as central banks turn their focus to combating inflation. While this is similar to 2021, there are important differences which could lead to different portfolio total return outcomes.
First, inflation is admittedly past its transitory nature and overall market expectations are now well above early 2021 levels. Upside surprises remain possible but with consumer prices already close to 7% in the U.S. and 5% in Canada, we believe markets are better positioned for this risk; U.S. 5- and 10-year inflation expectations have been rising to between 2.5% and 3% after barely reaching 2% a year ago (the Fed’s long-term target for consumer prices is 2%).
Secondly, the risk of inflation expectations becoming un-anchored is leading many central banks on a tightening path with policy rate increases expected, including the Bank of Canada (“BoC”) ending its asset purchase program in October, and the U.S. Federal Reserve (“Fed”) speeding up its tapering to end purchases this spring. While no policy rate changes were factored into last year’s forecast, the markets are now expecting three rate hikes in 2022 on both sides of the border, and more to come in 2023.
The assessment of the risk for the economy may be different for Omicron and future waves. This should provide further support for central banks to lift rates sooner and help manage strong overall demand and inflation risk.
Despite one of the worst starts to a new year, and a gloomy outlook for rates rising – we find some solace in the following factors:
• 2022 should mark the start of the first tightening cycle, but short-term markets have already priced in the first three expected rate hikes in 2022. Policy surprises (larger hikes/faster tightening) are possible, but we see limited risk at this stage.
• Interest rates in general are starting the year at more attractive levels than January 2021. Higher rates mean better portfolio yields, with investors earning higher income per dollar invested in 2022.
• Finally, the combination of reduced government funding requirements going forward and the insatiable demand for safe and positive-yielding securities (i.e., Canada and U.S. securities) should continue to provide some support.
Total Return Expectations
Considering current market risks and the potential for these forecasts to materialize, we believe that targeting a slightly negative to neutral portfolio duration (interest rate sensitivity) compared to our preferred benchmark (50% FTSE Short-term Index/ 50% FTSE Mid-term Index), and an overweight allocation to credit with a focus on maximizing income should help investors navigate the market risks.
What may surprise fixed income markets this year is the rise of real yields (which remain deeply negative), as central banks remove stimulus and raise policy rates. The net effect of rising real yields and decreasing inflation expectations should still lead nominal rates higher in 2022, but we believe the expected increases will be more limited. For portfolios, this means income should be a larger component of total return in 2022, which should help mitigate the risk of another disappointing year for bond investors.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
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