How markets reacted to Carney’s historic speech

How should markets be interpreting the proposal for Canada to become an associate member of the EU?

Canada-EU

Last week, European Commission President Ursula von der Leyen extended an invitation for Canada to become the first associate member of the European Union (EU). In remarks before the European Parliament, Prime Minister Mark Carney embraced the proposal, stating that “Canada and Europe are stronger together.”¹ I happened to be appearing on BNN at the time of Mark Carney’s speech and thus had an opportunity to be one of the first Canadian investment professionals to respond to it—and as I said that day, I believe Carney hit the nail on the head when it came to many of the speech’s key themes. As I listened to the remarks, what continually struck me was how Carney was, one by one, addressing and countering many of the concerns about investing in Canada that I’ve heard at various conferences and summits, while also highlighting Canada’s strengths. When I travel the world and meet with politicians, companies, and key investors, I often hear that Canada is viewed as a trustworthy nation, a reliable trade partner, and a source of products and commodities that other countries are eager to access. Those were exactly the terms in which Carney framed the country. He also emphasized that as Canada becomes better connected globally, it becomes a more attractive nation to do business with. The fact that healso prioritized shortening the timelines on infrastructure projects, accelerating tax incentives, and building ports to help export our resources to the world are also major positives, especially in light of the supply chain and political risks currently prevalent. As I’ve mentioned previously, Canada’s burgeoning relationship with the EU could be viewed positively or negatively by the United States. On the one hand, an agreement with the EU could make the U.S. look bad, and President Donald Trump’s initial comments on the potential deal—calling the EU’s offer to Canada “laughable”²—would seem to point to that being his interpretation. On the other hand, Carney did highlight in his speech that a stronger Canada would be a better partner for the United States—remarks that seemed specifically designed to head off any U.S. criticism. Overall, we view this as a good story across the board. On the European front, we remain underweight, as even a good news story is not sufficient to overcome the economic headwinds that have afflicted the continent, including weak productivity, high oil prices, and competition from China. For Canada, our concerns were future growth and an uncertain trade landscape. This potential deal would go some way toward addressing both issues. We upgraded our view on Canada from slightly bearish to neutral last month, and if a resolution to Canada-U.S. trade dispute comes to fruition, then our view could become quite optimistic.

Bottom line: Prime Minister Mark Carney’s speech to the European Parliament hit the mark, and we expect that a deal with the European Union would be welcomed by markets.

The Fed

Last Wednesday, the U.S. Federal Reserve (Fed) voted unanimously to raise interest rates by 25 basis points (bps). We were not surprised by the decision, as Fed Chair Kevin Warsh had signalled that a rate hike could be on the table in his speech at Jackson Hole, which most observers had interpreted as hawkish. In particular, Warsh’s language on the dangers of inflation was fairly definitive, and he also highlighted that the economy is generally in good shape—meaning that there would be room for a rate increase. It is now clear that Warsh is invested in keeping inflation in check and views price stability as an important part of the Fed’s mandate. In comments after the rate decision, he again highlighted that the state of the economy and the consumer remain fairly strong, seemingly leaving the door open to another rate hike at the Fed’s next meeting in late October. Our evaluation is that, while another hike is not a certainty, it is unlikely that the Fed would raise rates for the first time in three years and expect that only one increase would get the job done. Markets seemed to absorb the news without much fanfare, as expectations of a rate increase had already been priced in. Looking ahead, a second rate increase has not yet been fully priced into valuations to the same extent, so we do expect to see some softness in equity markets continue in September.

Bottom line: The Fed’s rate hike was not a surprise, and we think there is a strong chance of another hike next month, with some softness in equity markets in the interim.

Bonds

The Fed’s rate decision was also significant for fixed income markets, with the yield on U.S. 10-Year Treasuries having crossed the psychologically significant 5% mark prior to the decision. We had expected yields to rise in anticipation of a hike, and as a result of that movement, we didn’t see a dramatic increase after the announcement; as of Friday afternoon, the yield on 10-Year T-bills remained at right around 5%. As there is more uncertainty about whether the Fed will pull the trigger on another rate hike in October, the bond outlook from here is a bit less clear. However, once expected rate hikes are priced in—and to be clear, we do not expect five or six hikes to be on the table, as they were several years ago—we think that bonds could start to become more attractive. A 5-6% return on a U.S. Treasury bill is nothing to sneeze at, and that kind of environment is entirely plausible in the relatively near future. If it does come to pass, some investors could start to re-think their allocation to equities, reasoning that they could be achieving relatively attractive returns with less risk on the fixed income side. For now, we have not made any allocation changes, remaining slightly underweight bonds because another rate hike is still hypothetical. However, it is certainly a situation worth monitoring, and yields around 5.50% could be enough for us to reconsider our positioning.

Bottom line: It is unclear whether bond yields’ next move will be higher or lower. However, if the Fed does hike rates again in October as we expect, then it is likely that they will rise again.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled The broadening summer rally confronts a higher-rate reality .