Market dynamics are shifting. Conflicting signals are everywhere. But we shouldn’t be surprised by this. Contradictory trends are typical during investment leadership changes as the markets attempt to find new footing. Even more, rather than marking a point of departure, the latest action extends a long narrative: the post-Covid cycle has been fundamentally different than all other recent cycles. The pandemic effectively broke every previously reliable economic forecasting indicator. And, it continues to do so (take your pick from recession indicators that proved to be head fakes: Fed hikes, inverted yield curves, manufacturing downturns, regional bank implosions and now, perhaps, the Sahm rule). Textbook macro analysis remains in a bear market. 

Geopolitics are also adding to the angst. The weaponization of the dollar following the outbreak of war in Ukraine has quickened moves in many countries, most importantly China, to avoid US treasuries and buy gold as a hedge against America’s financial might. Markets are also having to digest polls in several nations. Even just the elections in the UK, France and the US account for a third of global output — and almost 80 per cent of the MSCI World Index. 

As always, America is hogging the political headlines. The run-up to the November election has been dramatic even by the US’ lofty standards, with Biden’s last-minute withdrawal, multiple assassination attempts against Trump and polls signaling a very close contest. The political priorities of both parties remain somewhat opaque; adding to the challenges financial markets face in assessing and pricing government policy risk.  

No wonder investors are confused. Looking back over the last 18 months, the most dominant trend for asset allocators has been the rush into the perceived safety of cash, bonds and the largest technology stocks, signaling extreme risk aversion. This was never a healthy market dynamic.

But could a market rotation, or what we have called a “broadening bull market”, finally be underway? The initiation of a Fed rate cutting cycle and meaningful monetary and fiscal stimulus in China (at long last) could prove to be the catalyst that propels this shift in earnest. Our thesis remains straightforward: many non-tech asset classes are poised for solid long-term returns. Our investment team has continued to orient clients to this thesis simply because the broader global economy does not face the same credit conditions that led to the large contraction in 2000-2002 (corporations stretched) or 2008 (consumers stretched). In other words, contrary to the continual recession drumbeat, the cyclical upswing out of the pandemic is still in play. 

Cash as an equity offset

• Continued rate cuts from the Bank of Canada have reduced the attractiveness of holding cash.
• However, cash remains a viable portfolio hedge against equity risk, particularly as long-term bonds have an unfavourable risk/reward profile.
• Cash has been kept below benchmark in client portfolios, but has been increased this quarter.

Maintaining equity overweight

• The initiation of the Fed rate cutting cycle and meaningful monetary and fiscal stimulus in China should provide a boost to growth and investor sentiment.
• We expect the equity rally to broaden out across countries and sectors; supported by improving corporate earnings.
• Equity exposure is overweight and has been increased modestly this quarter.

Biotechnology in focus

• Biotechnology (biotech) stocks are highly sensitive to interest rates. The Fed rate cutting cycle should help to reduce operating costs and enhance valuations.
• With the Inflation Reduction Act implementation and patent cliffs approaching, large pharmaceutical companies, sitting on significant cash reserves, are expected to accelerate M&A activity in the space.
• A position in biotech stocks has been initiated in balanced and growth strategies this quarter.

Decreasing fixed income exposure

• Our aversion towards developed market bonds remains, as we expect resilient growth and inflation to put upwards pressure on longer-term bond yields.
• This vulnerability was exacerbated with bond yields grinding lower last quarter.
• Fixed income exposure has been decreased further below benchmark in client portfolios.

Overweight corporate bonds

• Corporate bonds in most markets are trading on tight spreads (relative to history) versus government bonds.
• However, spreads should be supported by solid economic underpinnings, improving liquidity conditions and a likely boost to risk appetite.
• We remain overweight corporate bond exposure in the US and emerging markets this quarter.

Adding to gold mining stocks

• Fed rate cuts may be doubly-beneficial for gold miners; lowering the opportunity cost of owning gold and loosening corporate financial conditions simultaneously.
• Relatively sticky inflation and the potential for downwards pressure on the trade-weighted US dollar would be a positive environment for gold prices.
• Gold mining stocks have been initiated in balanced strategies and added to in growth strategies this quarter.

Income boost from mortgage REITs

• US mortgage REITs offer a hefty double-digit dividend yield.
• The potential for a “bull steepening” of the US treasury yield curve bull would help widen net interest margins, while the underlying US housing markets remains robust with healthy homeowner balance sheets.
• Mortgage REIT exposure has been initiated in balanced strategies and maintained in income strategies this quarter.

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