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All eyes are on the invasion of Ukraine by Russia, and we want to reiterate that our thoughts are with the Ukrainian people and the numerous Canadians of Ukrainian descent as this conflict continues. A somewhat surprising by-product of this unprovoked aggression by Russia has been the reaction from Western allies which has been more forceful and unified than many would have predicted.
To date, major (upward) volatility has been seen in energy, grain and metal markets which makes sense given Ukraine’s massive wheat production and the fact that Russia produces about 10 million barrels of oil per day, supplies 40% of Europe’s natural gas needs and produces sizable quantities of metals. Given North America’s low bilateral trade exposure with Russia/Ukraine, we believe it is primarily through this prism that investors should consider the market ramifications of this military action. According to PSC Macro Research, the exposure of U.S. banks to Russian banks is small but, “European banks have much larger exposures to Russian banks. The European Central Bank is much more likely to be concerned about the current crisis turning into a systemic problem than the Fed is, making it less likely to raise rates this year than it was last week”.
Canada and the S&P/TSX Index are well positioned for higher inflation amid 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 Natural Gas (through further LNG investments for instance). Unequivocally, the key winners are North American energy producers and, especially, oil sands companies as investors look for long-lived oil reserves in politically stable areas. Renewable energy stocks also figure prominently in supplying Western Europe’s future energy needs. Higher grain prices will be a huge boon to farmer incomes which should continue to support agriculture equipment manufacturers.
We have long maintained that exogenous shocks tend not to have a long-lasting impact on the market and that the economic cycle is by far the most important driver of financial asset returns. We stand by that view. The market impacts of different military conflicts are clear: a typical negative initial reaction with a subsequent recovery. Going back to 1940, the median downdraft was 2%, followed by a gain of 8% in the next 6 months, and over 20% in the subsequent year.
We continue to argue for a more defensive stance and a focus on companies with pricing power (we like a number of Consumer Staple, Utility, Healthcare and defense stocks along with the commodity plays listed previously), based on the risks of more persistent inflation and the slowdown in economic momentum.
Difficult Task Ahead for Central Banks
The Bank of Canada (“BOC”) responded to high inflation with a 25 bps (basis points) rate hike in early March, initiating its third tightening cycle since the financial crisis. The loonie’s softening this year has influenced the bank’s Canadian inflation outlook despite surging energy prices, offering no safety valve for consumers and driving pump prices to record highs.
For the U.S. Federal Reserve (“Fed”), inflation is now such a heavy-duty risk that the Fed’s Chair, Jerome Powell, has little choice but to proceed with hiking, even in the face of conflict. Compared to pre-conflict, when there were high odds of a 50 bps move, BMO only expects a 25 bps hike in March. Due to the higher uncertainty, financial conditions will remain relatively accommodative for the foreseeable future, which limits the near-term downside risk for housing and financial markets.
Additional sanctions and outcome uncertainty is being felt already across commodities markets, with energy prices at the center stage. This will translate in continued inflationary pressure and has led to an increase in inflation expectations close to cycle highs. As the world adjusts to higher prices and overall disruption in global trade, the risk that economic momentum slows further than originally anticipated has increased. This has been reflected in North American fixed income markets as real yields plunged deeper into negative territory.
Low interest rates and a flatter yield curve than previous cycles leave less flexibility for both the BoC and the Fed to tighten aggressively, and comfortably raise rates without inverting the yield curve. In this environment, the BoC’s goal of containing inflation with limited economic consequences will be more challenging to achieve.
Both the U.S and Canadian economies continue to recover and should be able to withstand the impact and trajectory of higher interest rates. We continue to recommend a more defensive positioning, adopting a less interest sensitive portfolio strategy.
Inflation, Rates and High Duration Stocks
Interest rates can have a great impact on “high duration stocks” (e.g., a stock trading at over 10 times sales), where the bulk of the value comes from expected future growth in cash flows. After years of outperformance, expensive tech stocks have been coming down aggressively since the end of last year. We expect this trend to continue since we still consider several of these former high-flyers to be far too expensive.
Dividend paying stocks with a historical track record of hiking their payouts are especially well positioned for the current environment.
Dividend Payers Outperform in Tightening Cycles
The key conclusions of a recent Ned David Research study are that:
1. Dividend payers tend to outperform non-payers after the first rate hikes, especially deeper into the tightening cycle;
2. The highest dividend yielders have outperformed other types of dividend stocks during tightening cycle, on average; and
3. Dividend payers are quite inexpensive.
Every important indicator strengthens our view that emphasizing lower duration stocks (through higher dividends in this case) will be increasingly important in 2022.
The Technical Picture
Russ Visch, CMT
The S&P/TSX Composite has been range bound since November, consolidating the big run-up that occurred throughout much of 2021. We still think the S&P/TSX Index is likely to outperform its U.S. counterparts for the foreseeable future, as it has since December.
U.S. equity markets recently completed a “low, rally, re-test” bottoming sequence at the end of February, effectively signaling an end to the medium-term correction underway since the beginning of the year. All of this indicates the ability/desire to sell is waning, and that’s exactly what we saw during the late February slide. The expectation should be for a challenge of the all-time highs at some point in the weeks ahead.
In terms of buying opportunities, the two main beneficiaries of the war in Ukraine are gold and defense stocks. Gold recently broke out of a year-long base pattern above resistance at US$1,916. The 2020 all-time high at US$2,072.50 will provide some resistance, but the swing target measurable on the breakout measures to US$2,150.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
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