Current Environment
Little about the current economic cycle has conformed to historical norms. With divergence in employment data and leading economic indicators, recent data released sent mixed signals that left investors perplexed about the near-term economic outlook.
On one hand, the job market remains overwhelmingly strong, with ISM (Institute for Supply Management) Services bouncing back from extreme lows in December and retail sales also rebounding. The re-opening of the Chinese economy will likely provide a breather on global supply chain issues while boosting demand. Consumer credit remains well retained as default rates stay low with no warning signs of near-term upticks.
On the other hand, yield curve inversions, a precedent of most recessions, continue to worsen. 3-month U.S. Treasury yields are pushed above 10-year yields by the widest margin since the early 1980s. ISM Manufacturing PMI (purchasing managers’ index) and housing data also point to a gloomy outlook. Corporate sentiment and capital expenditure showed little signs of recovery, and housing permits have rolled back to pre-pandemic levels after surging strongly during Covid.
Source: Bloomberg, January 31st, 2023
The Outlook
While robust job markets and consumer data keep inflation well above the Fed’s long-term target, recent CPI (Consumer Price Index) announcements indicate things are steadily, albeit slowly, moving towards the right direction. The inversion of the yield curve caps the magnitude of further rate increases that could be absorbed by the economy before it slips into a recession. Central bankers are well aware of the long and variable lag between interest rate hikes and their impact on the real economy. It is fair to expect the Fed (Federal Reserve) and BoC (Bank of Canada) to take a pause on hiking interest rates in 2023, while they patiently monitor macro trends as disinflationary forces, such as loosening supply chain shocks and lower home prices work their way through the economy.
The Opportunity
As markets and economies continue to recalibrate, investors are wondering how to position defensively. With higher yields and persistently wider credit spreads going into 2023, short term investment grade bonds may let investors benefit from those higher yields of the short end of the curve, while better managing duration and credit risks. BMO Short-Term US IG Corporate Bond Hedged to CAD Index ETF (ticker: ZSU) and BMO Short Corporate Bond Index ETF (ticker ZCS) are two examples providing this exposure. BMO High Quality Corporate Bond Index ETF (ticker: ZQB), composed of A+ rated corporate bonds, is another solution for investors who may want better quality exposure. BMO Ultra Short-Term Bond ETF (ticker: ZST), and BMO Ultra Short-Term US Bond ETF (ticker: ZUS.U) can complement an investors’ fixed income portfolio, providing liquidity and yields above 4%. These ETFs can be used as an alternative to savings-account ETFs as investors can take advantage of wide credit spreads while staying nimble in this fast-moving market environment.
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