Alfred Lee: Investment Outlook (July 2014)

Waiting For a Pause ...

by Alfred Lee, CFA, CMT, DMS
Vice President & Investment Strategist
BMO ETFs & Global Structured Investments
BMO Asset Management
alfred.lee[at]bmo.com

Highlights:

In this report, we highlight our strategic and tactical portfolio positioning strategies for the third quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six.

• As expected, the U.S. Federal Reserve (“the Fed”) plans to continue winding down its bond buying program as credit conditions and employment improve (Chart A). Despite a gradual uptick in inflation, the Fed reiterated its intent to keep an accommodative monetary environment at the June U.S. Federal Open Market Committee (FOMC) meeting. Although the Fed nudged up projections for shorter term rates, it guided down its outlook for longer-term rates.

• Commodities have stormed back year to date, partly due to the European Central Bank’s (ECB) increasing dovish stance on its own monetary policy. Gold prices alone jumped 3.4% on the day of the recent FOMC meeting, potentially as a result of inflation (as measured by the Consumer Price Index “CPI”) coming in higher than expected.

• Global bond yields have continued to normalize in the wake of the Fed’s taper scare, which began just over a year ago. Bonds have rallied back year to date (Chart A) particularly on the long end, with the 30-year Canadian and U.S. government bond yield dropping 45 basis points (bps) and 63 bps respectively over the last 6 months. Although longer term bonds have outperformed, we believe there is risk in over extending duration. If inflation continues to trend higher, longer bonds will be negatively impacted.

• The most recent actions by both the Fed and the ECB should be bullish for U.S. and European equities in the mid-term. Although valuations for U.S. equities aren’t trading at extreme premiums to its 10-year average, they look to be overbought in the short-term. European equities look to be in the earlier stages of its recovery cycle, indicating further potential upside over the long-run. Although, Canadian equities have outperformed year to date, it is unclear whether the increase in commodity prices are driven by a true demand and supply imbalance or a combination of yield normalization and the minor uptick in inflation.

• U.S. high yield credit spreads have continued to tighten, benefiting the price of non-investment grade bonds. The option adjusted spread of the U.S. high yield bonds over U.S. Treasuries, currently sits at 351 bps, considerably tighter than its recessionary highs in 2008 (Chart B). However, the current levels still remain above its ten-year average. The financial strength of the high yield universe is, however, currently sound, as some of the weaker companies failed in the 2008 financial crisis and leaving only issuers with stronger balance sheets. As a result, we believe the high yield spread should ultimately compress to a level tighter than its pre-crisis levels, suggesting further potential upside in prices.

Read/Download the entire report below:

ETF_PSR_Q3_2014_E

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