BMO ETF Portfolio Strategy Report

Transcription

1 BMO ETF Portfolio Strategy Report First Quarter 2016 BMO EXCHANGE TRADED FUNDS We Have Lift-Off Alfred Lee, CFA, CMT, DMS Vice President, BMO ETFs Portfolio Manager & Investment Strategist BMO Asset Management Inc. In this report: Recent Developments... 1 Things to Keep an Eye on...2 Changes to the Portfolio Strategy...3 Stats and Portfolio Holdings...4 Portfolio Characteristics...5 The Good, the Bad, and the Ugly...6 All prices or returns as of market close on January 11, 2016, unless otherwise indicated. In this report, we highlight our strategic and tactical portfolio positioning strategies for the first quarter using various BMO Exchange Traded Funds. Our key strategy changes are outlined throughout the report and in our quarterly outlook on page six. For the first time since late 2008, the U.S. Federal Reserve ( Fed ) raised its overnight rate at its December Federal Open Markets Committee (FOMC) meeting. This was widely anticipated by the market, with numerous data points suggesting the U.S. economy now has the capacity to stand on its own. Unlike , we expect this tightening cycle to be more gradual and transparent as the Fed will be more patient with the absence of inflation and an uneven global economic recovery. Additionally, the relative strength of the U.S. dollar will be an additional handcuff to the Fed s monetary policy, as it is the only major central bank currently with a hawkish stance. Despite the recent rate hike, we expect interest rates to remain low in the U.S. in 2016, with no more than another quarter point hike potentially in the second half of the year. We believe that policy divergence, a theme we pointed out at the start of the previous year, will continue to dictate the price behaviour of assets around the globe. Whereas the U.S. is looking to tighten monetary policy, other central banks will remain accommodative. Both the European Central Bank ( ECB ) and the Bank of Japan ( BoJ ) remain in easing mode, while the Bank of England ( BoE ) is the closest to tightening, but won t likely do so until Although the economic recovery internationally lags that of the U.S., we believe there is more upside for earnings growth in areas such as Euro-zone, which is why we continue to favour European equities.. Over the last 16 months, lower oil prices have been a supply side issue. However, ongoing concerns of a global economic slowdown, particularly in China, now may also negatively impact the demand side of the equation for crude. We expect West Texas Intermediate ( WTI ) crude to be trading in a lower range between US$25-US$40/barrel, particularly with a stronger U.S. dollar being an additional headwind. Sustained lower oil prices will continue to weigh on the economies of commodity exporting countries such as Canada and many emerging market countries. Although the Bank of Canada ( BoC ) has recently hinted at unconventional policies and negative interest rates, we believe the central bank will be hesitant to cut interest rates by more than a quarter point with an already inflated housing market and household debt at all-time highs. Lower commodity prices will be a negative for Western Canada, but a lower Canadian dollar may be beneficial for Central Canada s manufacturing focused economy. Avoiding commodity related areas will continue to be a theme in Canadian equity investing in the new year. Macro- over micro-economic risk will continue to play a larger role in dictating asset price behaviour in This means correlations within equity and fixed income sectors will continue to be high, making thematic an efficient way for investors to better control the risk and return characteristics of their portfolios. As the market remains focused on headline risk, managing volatility across asset classes will continue to be extremely important. 10-Year Treasury Spread (U.S. - Canada) Chart A: 10-Year Yield Spread (U.S. - Canada) is Favourable for U.S. Dollar Thousand Barrels/Day Chart B: OPEC Production Continues to Rise 33,000 OPEC Crude Oil Production 32,000 31,000 30,000 29,000 28,000 27,000 26,000 Jan-2000 Aug-2000 Mar-2001 Oct-2001 May-2002 Dec-2002 Jul-2003 Feb-2004 Sep-2004 Apr-2005 Nov-2005 Jun-2006 Jan-2007 Aug-2007 Mar-2008 Oct-2008 May-2009 Dec-2009 Jul-2010 Feb-2011 Sep-2011 Apr-2012 Nov-2012 Jun-2013 Jan-2014 Aug-2014 Mar-2015 Oct-2015 Source: Bloomberg Nov-2009 Feb-2010 May-2010 Aug-2010 Nov-2010 Feb-2011 May-2011 Aug-2011 Nov-2011 Feb-2012 May-2012 Aug-2012 Nov-2012 Feb-2013 May-2013 Aug-2013 Nov-2013 Feb-2014 May-2014 Aug-2014 Nov-2014 Feb-2015 May-2015 Aug-2015 Nov-2015 Source: BMO Asset Management Inc., Bloomberg

2 Portfolio Strategy Report First Quarter Things to Keep an Eye on... Oil Price ($US/barrel) $1.20 West Texas Intermediate Crude ($US/barrel) CAD/USD $1.10 $1.00 Jan-2000 Jan-2002 Jan-2004 Jan-2006 Jan-2008 Jan-2010 Jan-2012 Jan-2014 Jan-2016 Source: Bloomberg $0.90 $0.80 $0.70 $0.60 CAD/USD Many Canadian investors have been focused on the loonie over the last two years and even more so now given that it recently hit a 12-year low relative to its U.S. counterpart. With the Canadian dollar breaking under its 2009 recession lows, many investors have been calling for a bottom. As a petro-dollar, however, its underlying strength will be largely dependent on the demand for commodities and, more specifically, oil. As illustrated by the chart to the left, the value of the Canadian/U.S. dollar cross (CAD/USD) is highly correlated to oil prices as indicated by WTI crude. Recommendation: Monetary policy between the Canadian and U.S. central banks are diverging. The Fed s move to gradually tighten monetary policy will cause shorter term rates to rise, attracting demand for U.S. currency. The BoC on the other hand, recently made headlines by discussing the possibility of negative interest rates if economic prospects further weaken. This could keep downward pressure on the Canadian dollar, sending it closer to 2002 lows. Consequently, we recommend remaining non-currency hedged when investing in U.S. assets Relative performance (U.S. Investment Grade Bonds vs. U.S. High Yield Bonds) Jan-2015 Mar-2015 May-2015 Jul-2015 Sep-2015 Nov-2015 Jan-2016 Source: BMO Asset Management Inc., Bloomberg Global economic weakness has led to lower risk taking over the last year and a half and, hence, credit spreads widening, particularly with sub-investment grade bonds. U.S. high yield bonds have benefited from the general low interest rate environment, as investors have stretched beyond their risk profile in search of yield. We believe a tighter monetary environment will favour U.S. investment grade bonds, as the higher coupons of newly issued mid-term investment grade bonds could attract fund flows with a lower risk profile than U.S. high yield bonds. We have already begun to see U.S. investment grade bonds gain relative strength over non-investment grade bonds. Recommendation: It is worth noting that the energy exposure of U.S. investment grade bonds tend to be issued by companies with stronger balance sheets than high yield issuers. Thus the energy-related issuers rated investment grade tend to be more capable of weathering the current weakness in energy prices compared to their sub-investment grade equivalent. The BMO Mid-Term US IG Corporate Bond Index ETF (ZIC) continues to be one of the largest weightings in our portfolio strategy and provides diversification for Canadian investors. China Margin Trading 25,000 23,000 21,000 19,000 17,000 15,000 13,000 11,000 9,000 7,000 Source: Bloomberg China Margin Trading (Outstanding Balance) Shanghai Composite Index Jan-2015 Mar-2015 May-2015 Jul-2015 Sep-2015 Nov-2015 Jan ,500 5,000 4,500 4,000 3,500 3,000 2,500 Shanghai Composite Economic data out of China continues to suggest its economy is slowing down. In addition to the more obvious declining gross domestic product (GDP), both the China Manufacturing Purchasing Managers Index (Seasonally Adjusted) and year-over-year exports (in USD) experienced five consecutive months of decline. Much of the margin debt that fuelled the impressive rally in Chinese stocks in early 2015 continues to come out of the market. Data suggesting a further deterioration in the world s second largest economy will cause the slide in Chinese equities to continue. Recommendation: We have avoided Chinese equities due to its worsening economic backdrop. However, a case can be made to also exclude emerging market equities in a portfolio, despite the attractive valuations. Stock exchanges in China, quickly suspended circuit breakers after they twice triggered a market close in the first week it was introduced. This may prevent fund managers in the region from selling equities in adjacent open markets to raise cash to meet redemptions. However, with China being an important trade partner for many emerging market countries, its softening economy will likely have a negative impact.

3 Portfolio Strategy Report First Quarter Changes to Portfolio Strategy Asset Allocation: We believe policy divergence is a theme that will continue to drive markets in The Fed will be the lone central bank that will look to tighten monetary policy, while its counterparts will remain accommodative. This will lead the markets from various regions to become less correlated. However, headline risk remains macroeconomic driven, meaning thematic investing will continue to thrive and correlations between individual securities may remain high. Many of the themes discussed in this report have been highlighted over the previous quarters and we have already largely positioned our portfolio strategy. This quarter we will focus on fine tuning our strategy rather than implementing a major overhaul, as we believe we are already well positioned. Fixed Income: One of the largest benefactors of the Fed s Zero Interest Rate Policy ( ZIRP ) over the last six years has been high yield bonds. As the Fed moves to gradually tighten its monetary policy, we believe some investors may react by de-risking the fixed income portion of their portfolios. In our view, U.S. investment grade bonds will likely benefit as it presents a Goldilocks scenario, where it is less risky than high yield bonds, but provide more yield than treasury bonds. In addition, a robust U.S. economic backdrop should be favourable for credit spreads for investment grade bonds. This quarter we are raising our position in the BMO Mid-Term US IG Corporate Bond Index ETF (ZIC) by 2.0%. Equities: We believe our portfolio strategy is well positioned within our equity allocation. In terms of our geographical exposure, we continue to favour International and European equities with a tilt towards dividends and higher quality factors. We are thus increasing our position in the BMO MSCI Europe High Quality Hedged to CAD Index ETF (ZEQ) by 3.0%. In both the U.S. and Canada, low volatility has been a factor that has been successful in both reducing risk and outperforming the broader composite. Additionally we currently favour large over small capitalization companies given the lack of risk appetite of global investors. Portfolio Strategy Region, Style and Currency Exposure Region Weighting Factor (s) Canada Underweight Low Volatility N/A Currency Exposure U.S. Market Weight Low Volatility Non-Hedged International Overweight High Quality and/or High Dividend Hedged Emerging Markets No Weight N/A N/A Non-Traditional: After a difficult first three quarters of the year, preferred shares experienced a sizable rally in the final quarter of The BMO Laddered Preferred Share Index ETF (ZPR) returned 8.3% on a total return basis over the fourth quarter. Although still finishing down on the year, there are many positives about the preferred share market. First, we believe the negative sentiment has driven the price of preferred shares, particularly rate resets below what we feel to be fair value. Secondly, many investors (both institutional and retail) that do not typically invest in preferred shares have slowly been entering the market, as valuations have become extremely attractive. Although, we believe preferred shares present an attractive opportunity, there are some potential headwinds that remain, such as another potential rate cut by the Bank of Canada and the low probability of issues scheduled to reset in 2016 being redeemed, thereby not reducing supply in the face of new issues hitting the market. However, we believe preferred shares will begin to rebound in the second half of In the interim, ZPR pays a 5.9% dividend as we wait out the first two quarters before we potentially add to our position. We are eliminating our 5.0% position in the BMO Equity Linked Corporate Bond ETF (ZEL) for the time being. This ETF has provided our portfolio strategy downside protection, but given we believe Canadian equities will continue to face difficulties in 2016, the long call options in this ETF may provide less equity upside. As a result, we are repositioning part of this in ZIC. Non-Traditional: Several years ago, we recommended to unhedge U.S. exposure based on the strengthening economic fundamentals south of the border. With the U.S. dollar now trading at 1.43 relative to its Canadian counterpart, our exposure to the greenback has benefited our overall performance. We are keeping a close eye on this currency pair to look for signs of a bottom, at which time we will begin to hedge our currency exposure. With the anticipation for another potential rate cut from the BoC, we believe it is still too early to hedge our currency exposure. Sell/Trim Ticker (%) Buy/Add Ticker (%) BMO Equity Linked Corporate Bond ETF ZEL 5.0% BMO Mid-Term US IG Corporate Bond Index ETF ZIC 2.0% BMO MSCI Europe High Quality Hedged to CAD Index ETF ZEQ 3.0% Total 5.0% Total 5.0%

4 Portfolio Strategy Report First Quarter Stats and Portfolio Holdings Investment Objective and Strategy: The strategy involves tactically allocating to multiple asset-classes and geographical areas to achieve long-term capital appreciation and total return by investing primarily in exchange traded funds (ETFs). Ticker ETF Name Position Price Fixed Income Management Fee 1 Weight (%) 90-Day Vol Volatility Contribution ZDB BMO DISCOUNT BOND INDEX ETF Debt Core $ % 11.0% % 1.9% 0.46 ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF Debt Tactical $ % 15.0% % 4.0% 0.42 ZCM BMO MID CORPORATE BOND INDEX ETF Debt Tactical $ % 9.0% % 3.3% 0.55 Total Fixed Income 35.0% 19.1% Equities ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF Equity Core $ % 11.5% % 2.6% 0.20 ZLU BMO LOW VOLATILITY U.S. EQUITY ETF Equity Core $ % 11.0% % 1.9% 0.14 ZDI BMO INTERNATIONAL DIVIDEND ETF Equity Core $ % 14.0% % 5.1% 0.33 ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF Equity Tactical $ % 10.0% % 2.2% 0.11 ZWB BMO COVERED CALL BANKS ETF Equity Tactical $ % 3.0% % 5.9% 0.42 ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF Equity Tactical $ % 3.0% % 4.9% 0.32 ZBK BMO EQUAL WEIGHT U.S. BANKS INDEX ETF Equity Tactical $ % 4.0% % 1.5% 0.07 Total Equity 56.5% 69.8% Non-Traditional/Hybrids ZFH BMO FLOATING RATE HIGH YIELD ETF Equity Tactical $ % 3.5% % 5.1% 0.62 ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF Debt Tactical $ % 5.0% % 6.2% 0.28 Total Alternatives 8.5% 11.1% Total Cash 0.0% % 0.0% Portfolio 0.31% 100.0% % 3.4% Management Fee as of January 11, Yield (%)* Yield/ Vol Ticker Top Holdings Weight ZIC BMO MID-TERM U.S. IG CORPORATE BOND INDEX ETF 15.0% ZDI BMO INTERNATIONAL DIVIDEND ETF 14.0% ZLB BMO LOW VOLATILITY CANADIAN EQUITY ETF 11.5% ZDB BMO DISCOUNT BOND INDEX ETF 11.0% ZLU BMO LOW VOLATILITY U.S. EQUITY ETF 11.0% ZEQ BMO MSCI EUROPE HIGH QUALITY HEDGED TO CAD ETF 10.0% ZCM BMO MID CORPORATE BOND INDEX ETF 9.0% ZPR BMO S&P/TSX LADDERED PREFERRED INDEX ETF 5.0% ZBK BMO EQUAL WEIGHT U.S. BANKS INDEX ETF 4.0% ZFH BMO FLOATING RATE HIGH YIELD ETF 3.5% ZWB BMO COVERED CALL BANKS ETF 3.0% ZWA BMO COVERED CALL DOW JONES INDUSTRIAL AVERAGE HEDGED TO C$ ETF 3.0% Core 47.5% Tactical 52.5% Cash Non-Traditional (8.5%) Equities (56.5%) Alternatives Equities Fixed Income (35.0%) Fixed Income *Yield calculations for bonds is based on yield to maturity, which includes coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity and for equities it is based on the most recent annualized income received divided by the market value of the investments. **Cash is based off the 3-quarter Canadian Dealer Offered Rate (CDOR).

5 Portfolio Strategy Report First Quarter Portfolio Characteristics Regional Breakdown (Overall Portfolio) Cash Emerging Markets Canada 39.5% United States United States 36.5% Canada Europe 22.6% Asia 1.4% *Regional Breakdown includes equities, fixed income and alternative sleeves. Equity Sector Breakdown Utilities Financials 27.6% Telecommunication Health Care Services 7.0% Industrials 8.4% Materials Information Technology 3.4% Information Technology Materials 4.7% Industrials Telecommunication Services 4.6% Utilities 10.7% Health Care Consumer Discretionary 10.0% Financials Consumer Staples 13.6% Energy Energy 10.7% Consumer Staples Fixed Income Breakdown Consumer Discretionary Federal 11.2% Provincial 10.6% Investment Grade Corporate 68.8% Non-Investment Grade Corporate 9.6% Weighted Average Term 7.79 Weighted Average Duration 6.07 Weighted Average Coupon 3.4% Weighted Average Current Yield 3.3% Weighted Average Yield to Maturity 3.1% Weighted Average Current Yield: The market value weighted average coupon divided by the weighted average market price of bonds. Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity. Weighted Average Duration: The market value weighted average duration of underlying bonds divided by the weighted average market price of the underlying bonds. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates.

6 Portfolio Strategy Report First Quarter The Good, the Bad, and the Ugly Conclusion: The global economy will have to increasingly rely on the U.S. and to a lesser degree Europe to shoulder growth this year. With economic growth being revised lower, particularly in China, oil prices remaining low and political unrest developing in areas, central bank policy will once again be critical in steering the economy to a soft landing. Policy divergence will continue to be a main theme that drives asset prices, between exporter and importer of commodities. We believe 2016 will be difficult for most equity markets, with volatility returning at times. In fixed income, we believe higher quality credit will separate from sub-investment grade debt as the credit cycle is entering its later stages in some industries. The positioning of our portfolio strategy remains defensive, focused on higher quality, less volatile areas. Global-Macro/Geo-Political Fundamental Technical Good U.S. unemployment continues to show signs of improvement. The latest change in manufacturing, non-farm payrolls came in better than expectations while unemployment remained at 5.0%. Unemployment in the Eurozone is clearly trending lower, now at 10.5%, down from its peak of 12.1% in May Retail sales in the Eurozone is trending higher, showing signs of consumer confidence. European equities remain attractive from a valuation perspective. Its 21.6x current price-toearnings (P/E) ratio is below its 23.8x average. Sentiment in preferred shares has become so negative that the current prices on some issues are already implying negative interest rates. Upside in share prices may be possible, when sentiment turns positive. Low volatility stocks are displaying relative strength in Canada, U.S. and internationally. Although the CBOE Volatility Index has broken to the upside, its current level is only moderately higher than its long-term average. A positive considering the equity sell-off to start the new year. Investor confidence in the Eurozone has also trended higher since late Bad Canadian manufacturing is showing signs of contraction with the RBC Canadian Manufacturing PMI below 50 for the fifth consecutive month. Industrial production m/m (seasonally adjusted) is negative in the U.S. National house prices in Canada fell for four consecutive months before recovering in November. Although still far fetched at this point, the Bank of Canada has hinted at adding negative interest rates as part of its tool-kit in the future. The valuation of U.S. stocks has become more attractive given the recent sell-off, however, the 17.2x current P/E remains above its historical average P/E of 16.4x. High yield credit spreads have widened. The 5-Year CDX High Yield Index is at its highest since late Gold made its third consecutive year of losses. While increased macro-economic uncertainty has recently helped bullion prices, a stronger U.S. dollar and lower inflation will remain headwinds. Margin debt in the Chinese stock markets remain high. Although much of the necessary deleveraging has already occurred, recent selling restrictions introduced by its regulators will prevent the markets in normalizing over the short-term. Shorter-term momentum measures show Chinese equities are oversold, however, longer term measures indicate further potential downside. The U.S. dollar has been range-bound for most of 2015, but policy divergence may lead the U.S. dollar to breakout to the upside. Ugly Year-over-year GDP in Canada turned negative in October for the first time since December 2009 China s export trade (y/y) was negative in nine of the 12 months last year. Oil prices have not been this low since the peak of the recession. With emerging market urbanization unlikely, commodity demand will likely remain low. Emerging market equities continue to become increasingly attractive relative to both historical and relative measures. However, given many developing nations rely on commodity exports, we continue to avoid this region. Canadian equities have loss significant momentum, but index levels remain well above 2009 lows. Further downside is possible should commodity prices remain low over a sustained period. Household debt levels in Canada remains at alltime high, which potentially limits how much the BoC can reduce its overnight rate

7 Portfolio Strategy Report First Quarter Visit bmo.com/etfs or contact Client Services at S&P and S&P 500 are trademarks of Standard & Poor s Financial Services LLC ( S&P ) and TSX is a trademark of TSX Inc. These trademarks have been licensed for use by S&P Dow Jones Indices LLC and sublicensed to BMO Asset Management Inc. in connection with ZSP, ZIN, ZEO and ZPR. ZSP, ZIN, ZEO and ZPR are not sponsored, endorsed, sold or promoted by S&P Dow Jones LLC, S&P, TSX, or their respective affiliates and S&P Dow Jones Indices LLC, S&P, TSX and their affiliates make no representation regarding the advisability of trading or investing in such ETFs. The Dow Jones Industrial Average Index is a product of S&P Dow Jones Indices LLC and has been licensed for use by the BMO Asset Management Inc. Dow Jones, Dow Jones Industrial Average, and DJIA are registered trademarks of Dow Jones Trademark Holdings LLC ( Dow Jones ), and have been licensed to S&P Dow Jones Indices LLC and and sublicensed for use by BMO Asset Management Inc. in connection with ZWA. ZWA is not sponsored, endorsed, sold or promoted by S&P Dow Jones Indices LLC, Dow Jones, or their respective affiliates, and S&P Dow Jones Indices LLC, Dow Jones and their respective affiliates make no representation regarding the advisability of trading or investing in such ETF. The exchange traded funds referred to herein are not sponsored, endorsed or promoted by MSCI, and MSCI bears no liability with respect to any such exchange traded funds or any index on which such exchange traded funds are based. The prospectus contains more detailed description of the limited relationship MSCI has with BMO Asset Management Inc. and any related exchanged traded fund. This communication is intended for informational purposes only and is not, and should not be construed as, investment and/or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. BMO ETFs are managed and administered by BMO Asset Management Inc., an investment fund manager and portfolio manager, and separate legal entity from Bank of Montreal. Commissions, management fees and expenses all may be associated with investments in exchange traded funds. The indicated rates of return are the historical annual compound total returns including changes in prices and reinvestment of all distributions and do not take into account commission charges or income taxes payable by any unitholder that would have reduced returns. Please read the prospectus before investing. Exchange traded funds are not guaranteed, their value change frequently and past performance may not be repeated. BMO (M-bar roundel symbol) is registered trade-mark of Bank of Montreal, used under licence.