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THIS WEEK WITH SADIQ

Is it time to swap Big Tech for Small Caps?

July 15 to 19, 2024

Weekly Commentary

CPI

Last week, markets received more comfort that inflation is headed in the right direction. The latest U.S. Consumer Price Index (CPI) report showed prices rose only 0.1% in June, the lowest pace since 2021.1 Some observers have argued the positive surprise justifies an early rate cut, but we still believe September is penciled in for the first move. After all, this was only one data point, and if the U.S. Federal Reserve (Fed) wants to remain cautious there’s little to be gained from going earlier. Also, central banks prefer to telegraph their actions ahead of time. If they were targeting a mid-summer timeline, we would likely have witnessed dovish comments during their Congressional testimony or in some of the Governors’ speeches. We did not see that. At this point, barring a sudden spike in prices, we expect Chairman Powell to hint at a rate cut over the summer and deliver on the promise in early Fall. Markets surged immediately after the CPI data was released, but later dropped as investors digested the full implications. In monetary policy, is good news actually bad news? Yes, lower inflation could indeed result in a rate cut, which is good, but the recent data also reflect a slowing economy, which is not good.

Bottom Line: All signs appear to point to a September rate cut from the Fed, though a second move is unlikely to come until after the U.S. presidential election.

Bonds

Adding to the mounting evidence for a rate cut is the fact that we’re seeing downward revisions on previous months’ inflation numbers. The Citigroup Economic Surprise Index—which tracks the difference between initial forecasts and official results—recently fell to a nine-year low, indicating that real economic performance is far below estimates.2 This raises the possibility of a rate cut, and also a key question: what parts of the fixed income universe will look more attractive? In general, we still prefer to tilt towards safety. Owning government bonds or higher-rated corporate credit provides confidence that we can capture the benefits of rate cuts without taking on too much risk. After all, a weaker economy results in a flight to safety, not to high yield bonds. Meanwhile, in terms of duration,3 we want to avoid the short end of the curve. But we also do not want to over-commit on the long end, because the Fed could pause after the September rate decision and delay a second rate cut until after the U.S. presidential election. So, there is risk at either end of the curve. Our solution is to strategically increase the tilt towards longer-dated bonds over the next few months and keep a watchful eye on duration as we get to that first rate cut.

Bottom Line: We want to add duration, but given that timing is essential in fixed income, we plan on executing that pivot over several months.

Small Caps

One of the interesting developments we saw recently was a pullback in megacap Technology names and a rotation into small cap equities. Are we making similar moves? Not quite yet. Overconcentration of Tech in the index (and many portfolios) has been an issue and valuations certainly look attractive in the small cap space, but it’s not where we believe flows are headed first. In our view, the first rotation from the Magnificent Seven should be to value-oriented plays within large cap—such as Financials, which benefit from the current rate environment. The multiples on these equities look much more favourable than the Tech heavyweights, and yet they have the size and scale to withstand a potential economic slowdown, which remains a risk factor for the near-term. Small cap companies, by contrast, are more vulnerable to macro risks and a weakened consumer.

Bottom Line: Small caps look attractive from a medium-term perspective, but for now we see better opportunities in value-oriented large cap equities.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Politics and profits: Finding wins in an election year.


1 Consumer Price Index Summary – Economic News Release, U.S. Bureau of Labor Statistics, July 11, 2024.

2 U.S. economic surprise index at 9 year low: Berman, BNN Bloomberg, July 8, 2024.

3 Duration: A measure of the sensitivity of the price of a fixed income investment to a change in interest rates. Duration is expressed as number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with lower duration when interest rates fall (rise).

Market Update

Equity markets rose alongside Fed Chair Powell's testimony to Congress, and encouraging U.S. inflation data.

The S&P 500 gained 0.9%, with rate sensitives leading, while telecom services and the Nasdaq lagged.

Meantime, the TSX jumped 2.8%, with all sectors posting gains.

Photo of Sadiq S. Adatia Photo of Sadiq S. Adatia
Sadiq S. Adatia FSA, FCIA, CFA, Chief Investment Officer

Mr. Adatia joins BMO from Sun Life Global Investments, where he most recently held the role of Chief Investment Officer. Prior to that, he held investment roles at Russell Investments Canada and Mercer Canada. He holds an Honours Bachelor of Mathematics degree in Actuarial Science & Statistics from the University of Waterloo. He is also a CFA Charterholder and is a Fellow, both of the Society of Actuaries (Investment Specialty Track) and the Canadian Institute of Actuaries.

Monthly perspectives

Equities

Neutral

Fixed Income

Neutral

Cash

Neutral
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Asset Mix

  • We remain neutral across our asset mix between stocks, bonds and cash.
  • While the global economy remains resilient, we think equities are exposed to elevated valuation multiples as multiple risks lie ahead.
  • The political cycle is heating up, especially in the U.S. where odds to Trump rose after a challenging debate for the Democrats while France is also facing greater political uncertainty.
  • Investors must also face somewhat sticky inflation fear and delayed U.S. Federal Reserve (“Fed”) cuts, which could turn into headwinds for equities this summer.

Canada

Slightly Bearish

U.S.A.

Slightly Bullish

EAFE

Neutral

EM

Neutral
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Equity

  • Our outlook and the loonie. regional equity mix remains unchanged this month as the economy and markets largely evolve along the lines of our expectations.
  • We remain underweight to Canadian equities and continue to prefer U.S. equities.
  • We prefer to be tilted toward U.S. equities with its bias for higher quality and benefit from the more robust U.S. economy.
  • We expect the Canadian economic outlook to continue to soften as elevated interest rates are weighing on the economic.

IG Credit

Neutral

High Yield

Slightly Bearish

EM Debt

Neutral

Duration

Neutral
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Fixed Income

  • We downgraded high-yield corporate bonds to a small underweight as spreads to government bonds are tight and relatively unattractive
  • While the Bank of Canada appears ready to ease monetary policy more than the markets expect, interest-rate duration ultimately needs some Fed easing, but the Fed remains handcuffed by data for now.
  • We remain bullish on gold as a hedge against the risk that long-term interest rates might continue to drift higher or if the U.S. economy was to cool faster than expected.

Value

Slightly Bullish

Volatility

Slightly Bearish

Quality

Slightly Bullish

Yield

Slightly Bullish
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Style/Factor

  • We continue to prefer higher quality companies who enjoy stronger balance sheets and pricing power, which enables them to have more resilient and wider profit margins.
  • We remain bullish on firms with strong dividends as interest rates are likely to decrease in 2024, albeit modestly; we expect investors to rotate in favour of that sector this year.
  • We remain bullish on value companies as we expect sticky inflation fear to favour value-oriented companies.
  • We remain bullish on low-volatility companies to better navigate a potentially more volatile equity market.

Canadian Dollar

Slightly Bearish

Gold

Bullish
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Implementation

  • We continue to like gold as a hedge against downside macro risks.
  • We think gold could continue to shine if investors were surprised with renewed recession fear or inflation anxiety which could lead to further delaying expectations for Fed rate cuts and re-ignite a risk-off U.S. Dollar rally and weigh on the loonie.
  • Several central banks are steadily increasing their allocation to gold as a share of their international reserves, which is helping boost demand for gold.

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The viewpoints expressed by the Portfolio Manager represents their assessment of the markets at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. Past performance is no guarantee of future results. This communication is intended for informational purposes only.


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BMO Mutual Funds are managed by BMO Investments Inc., which is an investment fund manager and a separate legal entity from Bank of Montreal.

Commissions, trailing commissions (if applicable), management fees and expenses all may be associated with mutual fund investments. Please read the ETF facts, fund facts or prospectus of the relevant mutual fund before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

For a summary of the risks of an investment in the BMO Mutual Funds, please see the specific risks set out in the prospectus. ETF Series of the BMO Mutual Funds trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.

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