OUTLOOK 2014/2015 BMO Asset Management Inc.
We would like to take this opportunity to provide our capital markets outlook for the remainder of 2014 and the first half of 2015 and our recommended asset allocation positioning. Our asset allocation process is chaired by Paul Taylor, Chief Investment Officer of Asset Allocation, and includes the expertise of a team of seasoned investment professionals, focused on creating long-term value for our clients. A brief reflection on the first half of 2014 During the first half of 2014, we continued to hold an overweight position in equities versus fixed income. While U.S. stocks performed well, Canadian equities registered greater gains, adding value to our Balanced Model Portfolio (Model Portfolio)** where we held a modest overweight position in domestic stocks. Meanwhile, despite market expectations of rising interest rates, Canadian fixed income posted solid returns, although underperformed developed and emerging market equities. As a result, our underweight position in fixed income added to overall performance of the Model Portfolio. Exhibit 1 BMO Asset Management Inc. Balanced Model Portfolio positioning as of June 30, 2014 % * Benchmark consists of 3% Cash, 47% Fixed Income, 34% Canadian Equity, 9% U.S. Equity and 7% International Equity ** The BMO Asset Management Inc. Balanced Model Portfolio is a model used to implement our house view Outlook for the remainder of 2014 and first half of 2015 We expect a slight acceleration in economic activity in North America, and a continuation of positive, although modest economic growth in the Eurozone and Japan. Both developed and emerging markets should continue to grow at or below potential, pointing to overall lower inflation pressures. However, as Exhibit 2 illustrates, the global economy continues to recover. The Global Purchasing Manager Index (PMI), gauging manufacturing sentiment and reflecting trend changes in final demand, continues to point to momentum (albeit more gradual) in economic activity. Page 1 of 6
Country-specific PMIs are correlated with changes in real GDP and are often used as leading indicators of economic growth. Given that growth prospects are among the key contributors to stock market performance over the intermediate to longer term, Exhibit 2 provides useful insights into regional differences. Developed economies had a solid start to 2014 relative to early 2013, whereas emerging markets, particularly in Asia and Latin America, continued to lag other regions. We expect this trend to continue over the next 12 months, suggesting equities in the developed world will likely have stronger performance. Exhibit 2 Improving economic outlook expected to continue to support equity prices Jan-13 Feb-13 Mar-13 Apr-13 May-13 Jun-13 Jul-13 Aug-13 Global 52.0 51.8 51.7 51.3 52.1 52.4 52.9 53.3 54.3 52.0 54.0 53.8 54.0 53.1 53.5 52.8 54.2 55.4 U.S. 52.3 53.1 51.5 50.0 50.0 52.5 54.9 56.3 56.0 56.6 57.0 56.5 51.3 53.2 53.7 54.9 55.4 55.3 Canada 50.5 51.7 49.3 50.1 53.2 52.4 52.0 52.1 54.2 55.6 55.3 53.5 51.7 52.9 53.3 52.9 52.2 53.5 Mexico 55.0 53.4 52.2 51.7 51.7 51.3 49.7 50.8 50.0 50.2 51.9 52.6 54.0 52.0 51.7 51.8 51.9 51.8 Brazil 53.2 52.5 51.8 50.8 50.4 50.4 48.5 49.4 49.9 50.2 49.7 50.5 50.8 50.4 50.6 49.3 48.8 48.7 Eurozone 47.9 47.9 46.8 46.7 48.3 48.8 50.3 51.4 51.1 51.3 51.6 52.7 54.0 53.2 53.0 53.4 52.2 51.8 France 42.9 43.9 44.0 44.4 46.4 48.4 49.7 49.7 49.8 49.1 48.4 47.0 49.3 49.7 52.1 51.2 49.6 48.2 Germany 49.8 50.3 49.0 48.1 49.4 48.6 50.7 51.8 51.1 51.7 52.7 54.3 56.5 54.8 53.7 54.1 52.3 52.0 Italy 47.8 45.8 44.5 45.5 47.3 49.1 50.4 51.3 50.8 50.7 51.4 53.3 53.1 52.3 52.4 54.0 53.2 52.6 Spain 46.1 46.8 44.2 44.7 48.1 50.0 49.8 51.1 50.7 50.9 48.6 50.8 52.2 52.5 52.8 52.7 52.9 54.6 Netherlands 50.2 49.0 48.0 48.2 48.7 48.8 50.8 53.5 55.8 54.4 56.8 57.0 54.8 55.2 53.7 53.4 53.6 52.3 Ireland 50.3 51.5 48.6 48.0 49.7 50.3 51.0 52.0 52.7 54.9 52.4 53.5 52.8 52.9 55.5 56.1 55.0 55.3 Greece 41.7 43.0 42.1 45.0 45.3 45.4 47.0 48.7 47.5 47.3 49.2 49.6 51.2 51.3 49.7 51.1 51.0 49.4 UK 51.0 48.1 50.2 50.6 52.2 52.8 55.0 57.4 56.4 56.1 57.9 57.0 56.5 56.4 55.6 57.2 56.8 57.2 Switzerland 50.5 51.7 49.3 50.1 53.2 52.4 52.0 52.1 54.2 55.6 55.3 53.5 51.7 52.9 53.3 52.9 52.2 53.5 Norway 50.4 48.3 50.5 48.8 52.3 46.2 48.8 53.2 52.5 52.9 53.1 50.9 52.7 51.2 52.2 51.0 49.6 49.6 Czech Rep. 48.3 49.9 49.1 49.5 50.1 51.0 52.0 53.9 53.4 54.5 55.4 54.7 55.9 56.5 55.5 56.5 57.3 54.7 Poland 48.6 48.9 48.0 46.9 48.0 49.3 51.1 52.6 53.1 53.4 54.4 53.2 55.4 55.9 54.0 52.0 50.8 50.3 Hungary 55.9 54.1 55.5 51.5 47.1 50.8 49.0 51.8 54.4 51.1 52.6 50.5 57.8 54.3 53.7 54.6 53.8 51.7 Russia 52.0 52.0 50.8 50.6 50.4 51.7 49.2 49.4 49.4 51.8 49.4 48.8 48.0 48.5 48.3 48.5 48.9 49.1 S. Africa 50.3 51.3 49.9 51.1 51.3 48.8 51.2 51.0 49.8 51.5 51.6 50.5 50.3 51.5 50.2 49.4 49.7 49.5 Turkey 54.0 53.5 52.3 51.3 51.1 51.2 49.8 50.9 54.0 53.3 55.0 53.5 52.7 53.4 51.7 51.1 50.1 48.8 Australia 40.2 45.6 44.4 36.7 43.8 49.6 42.0 46.4 51.7 53.2 47.7 47.6 46.7 48.6 47.9 44.8 49.2 48.9 Japan 47.7 48.5 50.4 51.1 51.5 52.3 50.7 52.2 52.5 54.2 55.1 55.2 56.6 55.5 53.9 49.4 49.9 51.5 China 52.3 50.4 51.6 50.4 49.2 48.2 47.7 50.1 50.2 50.9 50.8 50.5 49.5 48.5 48.0 48.1 49.4 50.7 Taiwan 51.5 50.2 51.2 50.7 47.1 49.5 48.6 50.0 52.0 53.0 53.4 55.2 55.5 54.7 52.7 52.3 52.4 54.0 S. Korea 49.9 50.9 52.0 52.6 51.1 49.4 47.2 47.5 49.7 50.2 50.4 50.8 50.9 49.8 50.4 50.2 49.5 48.4 Singapore 50.2 49.4 50.6 50.3 51.1 51.7 51.8 50.5 50.5 51.2 50.8 49.7 50.5 50.9 50.8 51.1 50.8 50.5 Indonesia 49.7 50.5 51.3 51.7 51.6 51.0 50.7 48.5 50.2 50.9 50.3 50.9 51.0 50.5 50.1 51.1 52.4 52.7 India 53.2 54.2 52.0 51.0 50.1 50.3 50.1 48.5 49.6 49.6 51.3 50.7 51.4 52.5 51.3 51.3 51.4 51.5 Vietnam 50.1 48.3 50.8 51.0 48.8 46.4 48.5 49.4 51.5 51.5 50.3 51.8 52.1 51.0 51.3 53.1 52.5 52.3 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 contraction neutral expansion Page 2 of 6
Canadian businesses continue to anticipate an improvement in sales over the next 12 Canada months, while business sentiment towards exports is firming. However, capital investment in the private sector is expected to remain modest - albeit higher than in 2013, while net gains in employment could remain subdued. Nevertheless, earnings should expand and sentiment remain firm enough to support P/E multiples at current levels. In terms of our outlook for consumers - while CPI inflation picked-up during the second quarter of 2014, it was partially driven by the impact of a weaker Canadian dollar on import prices. However, the Bank of Canada expects that inflation will remain close to its 2% target. Meanwhile, bond yields should rise modestly in the U.S. and Canada, as the U.S. Federal Reserve continues to unwind its bond-buying program. Going forward, the Canadian dollar will likely continue to depreciate, driven by economic slack in Canada and relatively higher interest rates in the U.S. As we anticipated in the previous publication of our capital markets outlook, economic United States growth has improved since the very weak first quarter of 2014, in part weighed down by harsh weather conditions. We expect that the U.S. economy will continue to rebound over the next 12 months on the back of strengthening leading indicators and as the impact of fiscal drag continues to fade. The U.S. has been posting solid gains in employment since February, while manufacturing activity remained firmly entrenched in expansion territory. With this improvement in the labour market, rising house prices and strengthening consumer confidence, household income and wealth should support consumer spending and therefore corporate profits. In addition, we anticipate modestly higher business investment in the U.S. which should benefit the broader economy and capital markets. Meanwhile, as economic growth continues to gain traction, market expectations of future changes in U.S. monetary policy will likely put some upward pressure on interest rates, limiting gains in fixed income returns. Page 3 of 6
Economic performance in non-north American developed economies (EAFE) came in International below expectations, while equity returns delivered weaker results than in other geographic regions. CPI inflation in the Eurozone continued to fall thus far in 2014, prompting the European Central Bank (ECB) to step in and offer economic stimulus. While the ECB s package has yet to have an impact on the real economy, it should encourage lending and support consumer spending over the next 12 months. In addition, geopolitical risks emanating from Eastern Europe should eventually subside, helping to lift business and consumer confidence and foreign investor appetite for local assets. Meanwhile, the latest set of economic reforms in Japan should push asset prices higher; however, the recent increase in Japan s consumption tax and its impact on retail sales could limit equity returns. We expect China s real GDP growth around 6.8 to 7.2% in the latter half of 2014 and early 2015. While this pace of economic expansion is below China s historical GDP growth, it should continue to support demand for commodities. However, a soft landing in China will likely weigh on investor sentiment towards other emerging markets in the region. Until the recent developments in Ukraine and the Middle East, a number of markets in Emerging Europe showed renewed vigour in economic activity as PMIs pointed to improving manufacturing sentiment. Going forward, economic and capital markets prospects in the region will depend on whether these geopolitical risks subside. In Latin America, Mexico s export oriented industries should benefit from stronger U.S. growth, while investor sentiment toward Brazil could be fragile in the run up to presidential elections in October 2014. Page 4 of 6
Equities in developed and emerging markets remain fairly valued Exhibit 3 Valuation heatmap SHORT-TERM 1 MEDIUM-TERM 2 P/E trail P/E fwd P/B P/CF P/S PEG Div Yield AVG P/E trail P/E fwd P/B P/CF P/S PEG Div Yield AVG Developed -1.0-0.4-1.5-0.3-1.2-0.3-0.8-0.8-0.1-0.3 0.0-0.1-0.4 0.0 0.0-0.1 U.S. -1.1-1.9-1.9-0.3 0.0 0.0-0.8-0.9 0.0-1.6-0.3 0.2-0.1-0.1-0.2-0.3 Canada -2.2-0.1-1.2-0.7-0.8 0.0-0.3-0.8-0.6-0.6 0.1 0.0-0.5 0.0 0.0-0.2 Japan 0.1-1.8-0.9-0.6-0.9 0.0-0.8-0.7 0.0-0.7 0.1 0.1-0.4 0.1 0.1-0.1 EZ -1.4 0.5-1.8-0.1-1.9-0.1-1.4-0.9-0.4 0.8 0.1-0.1-0.3 0.0-0.3 0.0 Germany -1.3-1.6-1.5 0.4-1.7-0.6-1.6-1.1 0.0-1.2-0.6 0.0-0.6 0.0 0.0-0.4 France -1.5 0.5-1.8-1.3-1.8 0.0-1.2-1.0-0.1 0.7 0.2-1.2-0.7 0.0-0.2-0.2 UK -1.0 1.6-1.4 0.2-1.4-1.3 0.4-0.4-0.1 0.2 0.0 0.1 0.1 0.0 0.5 0.1 Australia 0.0-0.1-1.2-0.3-0.8-0.1-0.8-0.5 0.0-0.1 0.3 0.1-0.3 0.0 0.0 0.0 Emerging -0.1-0.1 0.2 0.2 0.3 0.0 0.1 0.1-0.8-0.2 0.3 0.0 0.2 0.0 0.1 0.0 China 1.3-0.8 1.2 0.2 1.0 0.1 1.0 0.6 0.8 0.0 0.9 0.0 0.8 0.1 1.2 0.5 S. Korea -0.5-0.2 0.2-0.4 0.6-0.1-0.8-0.2-2.5-0.7 0.2-0.6 0.1 0.0-1.1-0.6 Brazil 0.1 0.1-0.4 1.0 0.1-0.1 0.2 0.2 0.0 0.2 0.3 0.9 0.4 0.0 0.2 0.3 Mexico -1.4 0.2-0.2 0.1-0.5 0.0 0.1-0.2-1.6-0.3-0.1-0.2-0.5 0.0 0.1-0.4 1. Based on the last 36 months 2. Based on the last 120 months Notes: Each value is a statistically normalized value calculated as (the latest 3-month average - average for the reference period (3 or 10 years)/standard deviation for the reference period (3 or 10 years). Each number is then adjusted by the strength of the relationship between a given variable (e.g. trailing P/E) and stock returns in that country. Colours correspond to the level of over/undervaluation. Red numbers suggest equities may be overvalued; green indicators point to potentially undervalued equities; while yellow cells correspond to fairly valued equities. Source: BMO AM Inc., Bloomberg As global financial markets registered gains during the first half of 2014, concerns over equity valuation continued to linger. As Exhibit 3 illustrates, equities in developed countries are relatively more expensive than in emerging markets, particularly over a short-term forecast horizon. However, while some individual indicators point to overvalued stocks, our aggregate measure suggests that equities in both developed and emerging markets remain fairly valued relative to their recent as well as long-term history. These findings can also be validated by looking at Exhibit 4, showing that the trailing 12-month S&P 500 s P/E multiple is within its historical norm, albeit gradually approaching the upper band. This suggests that despite the continued equity rally in North American equities in recent years, risks of a correction driven by overvalued markets remain low, offering further upside potential. Page 5 of 6
Exhibit 4 U.S. equities remain in fair-value territory 35 S&P500: Historical PE 30 25 20 15 10 PE ratio 5 Hist average hist avg +/- rolling 5yr stand. deviation 0 Jul-54 Jul-64 Jul-74 Jul-84 Jul-94 Jul-04 Jul-14 Source: BMO AM Inc., Bloomberg On the European front, equities continue to be attractive from a valuation perspective. Monetary stimulus offered to financial markets by the ECB should support multiples at the current levels. However, any further escalation of geopolitical risks could limit equity gains. Meanwhile in Japan, P/E ratios appear to have more potential for expansion than in North America from a technical perspective; however, we believe that stronger earnings growth in the U.S. and Canada will help the S&P/TSX and S&P 500 outperform Japanese equities. Investment Strategy Our largest overweight continues to be in U.S. equities, followed by EAFE and the remainder in Canadian stocks. We have trimmed our EAFE overweight in favour of U.S. equities based on our expectations of relative economic and capital markets performance, driven by both domestic factors and external risks. We continue to focus on higher quality companies with solid growth potential and reasonable valuations which should continue to generate attractive risk-adjusted returns. In addition, we believe that corporate bonds will likely outperform government debt over the next 12 months given our expectations for credit spreads and interest rates. Having said that, from an asset mix perspective we continue to maintain an underweight position in fixed income as we believe interest rates will rise (albeit modestly) over the medium term. Page 6 of 6
We thank you our clients, partners and prospects for your continued support! Disclosure/Disclaimer TM/ Trade-marks/registered trade-marks of Bank of Montreal, used under licence 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. All Rights Reserved. The information contained herein: (1) is confidential and proprietary to BMO Asset Management Inc. ( BMO AM ); (2) may not be reproduced or distributed without the prior written consent of BMO AM; and (3) has been obtained from third party sources believed to be reliable but which have not been independently verified. BMO AM and its affiliates do not warrant or make any representations regarding the use or the results of the information contained herein in terms of its correctness, accuracy, timeliness, reliability or otherwise, and do not accept any responsibility for any loss or damage that results from its use. Registered trade-mark/trade-marks of Bank of Montreal, used under license.
We thank you our clients, partners and prospects for your continued support! For more information about our line-up of Equity, Fixed Income, Currency and ETF solutions, please contact: Marija Finney Senior Vice President, Head of Institutional Sales & Service Tel: (416) 359-5003 marija.finney@bmo.com