OUTLOOK 2014 2015 BMO Asset Management Inc.
We would like to take this opportunity to provide our capital markets outlook for 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 2014 As 2014 began, many investors were predicting stronger global growth, higher interest rates and a stronger US dollar. However, the pick-up in growth was delayed until the latter half of the year after first quarter GDP fell sharply in the US and growth remained sluggish in most other major developed economies. The weakness in the US was the result of a host of factors, including low exports to China, a downward inventory adjustment, cold weather and a quirky fall in health care spending (related to the implementation of the Affordable Care Act). As the year progressed though, strong auto sales, housing starts, employment gains and nominal income growth provided evidence that economic momentum was building in the US. Elsewhere, economic growth momentum stalled in each of the major economies with the Eurozone and Japan retesting recessionary levels and China struggling to sustain its 6% to 7% pace of growth. It was another year of US equity market outperformance, concentrated in Information Technology and Health Care helped by a robust year for stock buybacks. To the surprise of nearly everyone, 10-year US Treasury yields actually fell during the year as investors came to the realization that the process of interest-rate normalization would be more gradual than expected. Outlook for 2015 Key to the outlook for 2015 is the theme of divergence. Like the recent film Divergent, which chronicles a dystopian post-apocalyptic world where people are divided into distinct factions based on human virtues, economies around the world in 2015 will diverge. As central bank policy begins to move in different directions to address their respective economies particular conditions, some regions will fare better than others, with few coasting in between. The clear favorite appears to be the US. The two most battered sectors in the US, banking and housing, have healed significantly. Most importantly, the household sector has unwound nearly 75% of the run-up in the Page 1 of 6
debt-to-income ratio that developed during the credit bubble, and household debt service costs have tumbled sharply. Key to this has been steady, strong employment growth (225,000 new jobs created each month on average over the past year), with further gains expected through 2015. As well, calm in Congress in Washington, DC provides assurance that political brinkmanship over funding the budget is behind us and fiscal policy has turned from a record tightening to a more neutral bias. Based on these factors the US economy should accelerate to a 2.5% 3.0% growth rate in 2015. And then there is oil! Sharply lower oil prices act as a de facto tax cut for US consumers and a reduction in costs for oil intensive enterprises such as airlines. If oil prices remain in the current sub-$70 (USD) per barrel range, an additional 0.4% 0.8% could be realized in US economic growth this year. The other key theme of 2015 is lowflation, the tendency for inflation across most major markets to be pervasive and persistent. It is pervasive in that core inflation readings are below central bank targets across almost all major markets. Beyond the US, cyclical momentum has either stalled, as in the case for the Eurozone and Japan, or weakened as in China. The Eurozone is clearly at an inflection point where an elevated risk of deflation exists and, as a result, additional European Central Bank (ECB) stimulus is likely, broadly expected to be in the form of government bond purchases. In Japan, the Abe government s decision to delay the second sales tax increase only modestly improves the odds of an upside boost to economic growth, as job creation and wage growth remain frustratingly low. In China, weak incoming economic data (i.e. soft industrial production readings) add to the probability of more monetary policy easing and targeted injections of market liquidity to come, particularly in the seasonally soft first few months of the year. Finally, the global impact of lower oil prices and weaker currencies (excluding the US dollar) provide evidence that any risks to inflation are to the downside in 2015. As a result, while we see no route for interest rates except up over the intermediate term, any rise is likely to be very gradual through 2015. Given that growth prospects are among the key contributors to stock market performance, Exhibit 1 on the following page, provides useful insights into these regional differences. Page 2 of 6
Exhibit 1 Overall global growth is positive but on diverging paths Jul-13 Aug-13 Sep-13 Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Global 50.6 51.5 51.7 51.9 52.9 52.9 53.0 53.2 52.4 51.9 52.2 52.6 52.4 52.6 52.2 52.2 51.8 51.6 US 54.9 56.3 56.0 56.6 57.0 56.5 51.3 53.2 53.7 54.9 55.4 55.3 57.1 59.0 56.6 59.0 58.7 55.5 Canada 52.0 52.1 54.2 55.6 55.3 53.5 51.7 52.9 53.3 52.9 52.2 53.5 54.3 54.8 53.5 55.3 55.3 53.9 Mexico 49.7 50.8 50.0 50.2 51.9 52.6 54.0 52.0 51.7 51.8 51.9 51.8 51.5 52.1 52.6 53.3 54.3 55.3 Eurozone 50.3 51.4 51.1 51.3 51.6 52.7 54.0 53.2 53.0 53.4 52.2 51.8 51.8 50.7 50.3 50.6 50.1 50.6 France 49.7 49.7 49.8 49.1 48.4 47.0 49.3 49.7 52.1 51.2 49.6 48.2 47.8 46.9 48.8 48.5 48.4 47.5 Germany 50.7 51.8 51.1 51.7 52.7 54.3 56.5 54.8 53.7 54.1 52.3 52.0 52.4 51.4 49.9 51.4 49.5 51.2 Italy 50.4 51.3 50.8 50.7 51.4 53.3 53.1 52.3 52.4 54.0 53.2 52.6 51.9 49.8 50.7 49.0 49.0 48.4 Spain 49.8 51.1 50.7 50.9 48.6 50.8 52.2 52.5 52.8 52.7 52.9 54.6 53.9 52.8 52.6 52.6 54.7 53.8 Netherlands 50.8 53.5 55.8 54.4 56.8 57.0 54.8 55.2 53.7 53.4 53.6 52.3 53.5 51.7 52.2 53.0 54.6 53.5 UK 54.5 58.4 56.8 56.3 57.7 57.0 56.6 56.4 55.5 57.0 56.6 56.7 54.9 52.9 51.4 53.3 53.3 52.5 Switzerland 52.0 52.1 54.2 55.6 55.3 53.5 51.7 52.9 53.3 52.9 52.2 53.5 54.3 54.8 53.5 55.3 55.3 53.9 Norway 48.8 53.2 52.5 52.9 53.1 50.9 52.7 51.2 52.2 51.0 49.6 49.6 50.8 51.8 49.5 50.8 51.4 49.8 Czech Rep. 52.0 53.9 53.4 54.5 55.4 54.7 55.9 56.5 55.5 56.5 57.3 54.7 56.5 54.3 55.6 54.4 55.6 53.3 Poland 51.1 52.6 53.1 53.4 54.4 53.2 55.4 55.9 54.0 52.0 50.8 50.3 49.4 49.0 49.5 51.2 53.2 52.8 Hungary 49.0 51.8 54.4 51.1 52.6 50.7 57.8 54.3 53.7 54.6 53.8 51.7 56.6 51.0 52.7 55.0 55.0 50.7 Ireland 51.0 52.0 52.7 54.9 52.4 53.5 52.8 52.9 55.5 56.1 55.0 55.3 55.4 57.3 55.7 56.6 56.2 56.9 Greece 47.0 48.7 47.5 47.3 49.2 49.6 51.2 51.3 49.7 51.1 51.0 49.4 48.7 50.1 48.4 48.8 49.1 49.4 Australia 42.0 46.4 51.7 53.2 47.7 47.6 46.7 48.6 47.9 44.8 49.2 48.9 50.7 47.3 46.5 49.4 50.1 46.9 Japan 50.7 52.2 52.5 54.2 55.1 55.2 56.6 55.5 53.9 49.4 49.9 51.5 50.5 52.2 51.7 52.4 52.0 52.0 China 47.7 50.1 50.2 50.9 50.8 50.5 49.5 48.5 48.0 48.1 49.4 50.7 51.7 50.2 50.2 50.4 50.0 49.6 Taiwan 48.6 50.0 52.0 53.0 53.4 55.2 55.5 54.7 52.7 52.3 52.4 54.0 55.8 56.1 53.3 52.0 51.4 50.0 S. Korea 47.2 47.5 49.7 50.2 50.4 50.8 50.9 49.8 50.4 50.2 49.5 48.4 49.3 50.3 48.8 48.7 49.0 49.9 Singapore 51.8 50.5 50.5 51.2 50.8 49.7 50.5 50.9 50.8 51.1 50.8 50.5 51.5 49.7 50.5 51.9 51.8 49.6 Indonesia 50.7 48.5 50.2 50.9 50.3 50.9 51.0 50.5 50.1 51.1 52.4 52.7 52.7 49.5 50.7 49.2 48.0 47.6 Vietnam 48.5 49.4 51.5 51.5 50.3 51.8 52.1 51.0 51.3 53.1 52.5 52.3 51.7 50.3 51.7 51.0 52.1 52.7 contraction neutral expansion Source: BMO AM Inc., Bloomberg Clearly the most significant development for Canada during the fourth quarter was the Canada dramatic fall in the price of oil. After reaching a 2014 high of $107 (USD) per barrel, the price pull-back that started during the summer turned into an unabashed rout. By the end of the year oil was trading in the low $50s; with the expectation that it could go even lower. Oil evidently found its Minsky Moment ; a tipping point at a moment in time when multiple factors conspire to cause a rapid and dramatic shift in sentiment and outlook. Fundamental factors such as tentative European and Japanese economic growth, cooling, but still very healthy Chinese economic growth, and infrastructure oil expansions in the US North East have all been cited as reasons for the downward shift in oil prices. By the November 27 th Organization of the Petroleum Exporting Countries (OPEC) meeting, oil had already fallen to the mid $70s. It was thought that OPEC might opt to cut production to stabilize prices, but that was not the case; instead they refused to reduce supply which just added to the downward price pressures. Page 3 of 6
OPEC has seen its market share erode over the years as supply from the fracking Canada (cont d) industry in the U.S. and the oil sands in Canada have come to market. It is now thought that OPEC will not let this opportunity to enforce pricing discipline across global oil markets pass it by. OPEC producers will benefit by keeping prices low enough for long enough to squeeze the higher cost producers out of the market. The impacts on Canada are many, both positive and negative. On the positive side lower oil prices provide a boost to consumer spending and place downward pressure on the Canadian dollar, which in turn will provide an advantage to our exporting sector. On the negative side, energy companies and government revenues will be negatively impacted. From an inflation perspective, lower oil prices have a direct downward impact on consumer prices and will keep domestic interest rates and the loonie lower for longer. US economic fundamentals differ from those of Canada from many perspectives; one is United States the extent to which the US is a net oil importer whereas Canada is a net oil exporter. While the US oil industry will certainly be impacted by the lower oil price, on an overall economic basis there are more advantages than disadvantages. Even before the US got a boost from lower oil prices it was already distinguishing itself with strong employment growth and a steadily improving economy. From a monetary policy perspective the US Federal Reserve (Fed) completed its extraordinary accommodative stance (Quantitative Easing or QE). Now the focus will shift to when the Fed will start to increase its administered interest rates. In that regard, the mid-november press release of the Federal Open Market Committee (FOMC) statement was notable for the absence of the considerable time phrase that has been a fixture over the past few releases. However to temper expectations, Fed Chair, Janet Yellen, did state that the FOMC was "unlikely to begin the normalization process for at least the next couple of meetings" but also acknowledged the timing of any move would depend on the strength of incoming economic data. Oil, interest rates and economic stimulus were the watch-words for Europe. The Euro International region is still being plagued by decelerating industrial output, and the fear that low oil prices could push inflation past the zero-line to outright deflation. Given Europe s net oil importing status it would seem that they should benefit from lower oil prices. Low oil will benefit the consumer and it also has the effect of supporting efforts of the central bank to stimulate the economy and avoid price deflation. Furthermore the ECB is now in the position of having to make good on the July 2012 pledge to do whatever is necessary in support of the Euro and the health of the Eurozone economy. Mr. Mario Draghi s pledge is running the risk of becoming thread-bare, and the November comment from the ECB that staff was preparing further monetary policy measures indicates that the ECB was getting ready to implement a QE program. Page 4 of 6
While any country would love, or even fear, a GDP growth number beginning with a 7 Emerging Markets or even a 6, for China that represents a moderation in growth. However, despite being lower than the heady past rate it is nonetheless a strong number and should provide at least some support to commodities prices. For the emerging markets it is clear they should not be treated as a homogenous unit. Among the many differentiating factors that are important: political stability and oil dependency. The recent fall in the price of oil serves to illustrate which jurisdictions will benefit from or be penalised by their status of being net oil importers or exporters. However even those that should benefit from being a net importer could be under pressure from a replay of the taper tantrum should the US begin to normalize interest rates. Equities in developed markets are overvalued relative to emerging markets. Overall equities remain fairly valued in developed as well as emerging markets. Exhibit 2 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 -0.8-0.3-0.9-0.6-1.0-0.1-0.6-0.6-0.2-0.4 0.0-0.3-0.5 0.0 0.0-0.2 US -1.5-1.5-1.7-2.0-1.7-1.7-1.0-1.6-0.2-1.6-0.6-0.1-1.5-1.5-0.2-0.8 Canada -0.9-0.3-0.4-0.6 0.1 0.1-0.2-0.3-0.4-0.6 0.2 0.0 0.1 0.0 0.1-0.1 Japan 0.2-1.8-1.4-1.2-1.3 0.1-0.9-0.9 0.0-1.0-0.3-0.4-1.0 0.2-0.2-0.4 EZ -1.3 0.4-1.0-0.3-1.3-0.3-0.9-0.7-0.3 0.7 0.2-0.3-0.3 0.0-0.2-0.1 Germany -0.6-1.4-0.6 0.5-1.1 0.5-1.2-0.6 0.0-1.3-0.3 0.0-0.5 0.1-0.1-0.3 France -1.1 0.8-0.7-1.3-1.0 0.8-0.8-0.5 0.0 0.6 0.3-1.4-0.5 1.0-0.2 0.0 UK -1.2 1.4-0.4 0.1-1.0 0.0 0.5-0.1-0.3 0.2 0.1 0.0 0.1 0.0 0.4 0.1 Australia 0.1 0.0-0.8 0.0-0.3 0.0-0.1-0.2 0.0 0.0 0.3 0.1 0.0 0.0 0.1 0.1 Emerging -0.7 0.2-0.2 0.1-0.7 0.0-0.2-0.2-0.4-0.1 0.2 0.2 0.1 0.0 0.0 0.0 China -1.8-0.1-0.9-0.1-2.0-0.2-0.5-0.8 0.5 0.0 0.6 0.0 0.5-0.1 0.5 0.3 S. Korea -0.1 0.7 0.7 0.1 0.2 0.0-0.7 0.1-0.4 0.0 0.0 0.0 0.2 0.0-1.0-0.2 Brazil 0.1 0.2-0.6 0.6 0.0 0.1 0.4 0.1 0.0 0.2 0.3 0.7 0.5 0.0 0.4 0.3 Mexico -1.1 0.1-0.2 0.0-0.8 0.0 0.0-0.3-1.5-0.5-0.1 0.1-0.6 0.0 0.0-0.4 Notes: Source: BMO AM Inc., Bloomberg 1. Based on the last 36 months 2. Based on the last 120 months 3. Each value is a statistically normalized value calculated as (the latest 3-month average - the average of the reference period (3 or 10 years))/standard deviation of 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. 4. 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. As global financial markets registered gains during the first half of 2014, concerns over equity valuation continued to linger. As Exhibit 2 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 3, showing that the S&P 500 s trailing 12-month 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 3 U.S. equities remain in fair-value territory Source: BMO AM Inc., Bloomberg On the European front, equities continue to be attractive from a valuation perspective and the monetary stimulus offered to financial markets by the ECB should support multiples at 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 the US from a technical perspective; however, we believe that stronger earnings growth in the U.S. will help the 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! 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