'You're seeing a lot of the big Canadian pension plans pulling away from private equity': Davis

Key Concepts

• Monetary Policy Expectations
• FOMC (Federal Open Market Committee)
• Interest Rate Cuts
• Financial Conditions
• Tech Stocks
• AI Spending Projections
• Valuation Acceleration
• Profit Taking
• Risk Assets
• Volatility
• US Economic Outlook (2026)
• US Consumer Spending
• Government Spending (Big Beautiful Bill)
• Credit Market Fractures
• Subprime Lending
• Delinquencies
• Private Lending Market
• Private Equity
• Active Management
• Leveraged ETFs
• Systemic Risk
• Speculation
• Prediction Markets

Market Weakness and Tech Stock Sell-off

The morning saw fresh weakness in North American stocks, with a particular focus on the technology sector. Earl Davis, Head of Fixed Income and Money Markets at BMO Global Asset Management, attributes this malaise primarily to shifting monetary policy expectations in the US.

Monetary Policy and Fed Expectations

• Key Point: A significant factor driving the sell-off is the reduction in expectations for an interest rate cut by the FOMC in December.
• Specifics: At the beginning of the week, the market was discounting an approximately 80% chance of a Fed rate cut in December. This probability has since decreased to around 50%, largely influenced by recent "Fed speak" (statements from Federal Reserve officials).
• Impact: This shift implies that financial conditions may not become as accommodative as previously anticipated, acting as a catalyst for the sell-off in tech stocks, equities in general, and risk assets.

AI Spending and Valuations

While acknowledging the extravagant large-scale projections for AI spending (e.g., OpenAI's talk of over $1 trillion over the next decade), Davis reframes this from a valuation perspective.

• Key Point: The market has experienced tremendous valuation acceleration in tech stocks this year, and despite this, they are still up year-to-date.
• Argument: It is not surprising to see volatility and profit-taking, even with a positive outlook, given the significant valuation run-up.
• Perspective: Davis believes this is largely profit-taking combined with existing volatility.

Outlook for Risk Assets and Volatility

Despite the current weakness, BMO Global Asset Management remains positive on risk assets heading into 2026. However, they anticipate considerable volatility in the interim.

Drivers of Volatility

1. Fed Easing Chances: As mentioned, the uncertainty surrounding the Fed's December easing decision.
2. US Data Releases: Upcoming data releases from the US, including employment numbers and more detailed CPI (Consumer Price Index) and inflation data, are expected to add to volatility over the next month as they reflect the "catch-up" from the reopening.

December Fed Cut and "Hawkish Cut"

• Davis's Stance: BMO Global Asset Management believes the Fed will cut rates in December, but it is expected to be the last one.
• Impact of Cut: A 25 basis point cut, in the grand scheme of things, may not have a significant impact.
• "Hawkish Cut": If a cut occurs, it will likely be a "hawkish cut," signaling that the Fed is essentially on hold thereafter.

Favorable Outlook for 2026

The positive outlook for 2026 is based on three key factors:

1. US Consumer Spending: The US consumer is expected to continue spending.
2. Government Spending: The "Big Beautiful Bill" (referring to government spending initiatives) will kick in.
3. Easy Financial Conditions: Financial conditions are anticipated to remain conducive for longer-term investment.

These factors combined create a favorable outlook for 2026, leading Davis to view the current volatility and sell-off as an opportunity to accumulate and buy risk assets.

Concerns in the Credit Market

The discussion also touched upon emerging signs of fractures in portions of the credit market, including subprime lending and private lending.

Subprime and Private Lending Issues

• Observations: Rising delinquencies are being observed for some players in subprime lending. The private lending market, described as opaque, is also showing emerging problems.
• Real-World Application: This is evidenced by recent headlines, including major Canadian pension plans pulling away from private equity investments and restructuring their outlooks for private equity.
• Davis's Perspective: While acknowledging these issues, Davis categorizes them as an "awareness" rather than a "concern."

The Role of Active Management

• Argument: The presence of both good and bad in the market underscores the importance of active management.
• Actionable Insight: Investors need to be selective in choosing assets to own and be aware of potential dangers.

Leveraged ETFs and Market Culture

The conversation shifted to the emergence of exotic, aggressive, leveraged ETFs and their potential to blur the line with gambling.

Leveraged ETFs and Sophisticated Investors

• Article Reference: A piece in The Globe and Mail discussed leveraged ETFs, suggesting they can resemble gambling.
• Davis's View: While not having read the specific article, Davis notes that many complex structures are typically in the hands of more sophisticated investors, not retail investors.
• Central Bank Concerns: Central banks are primarily concerned about whether these risks can become systemic. Davis believes they would likely be isolated and manageable by central banks, thus not a systemic concern, but contributing to overall volatility.

Speculation vs. Gambling in Markets

• Question: Is there a gambling mentality in the market, potentially fueled by platforms like Robinhood and their "prediction markets"?
• Davis's Response: Davis smiles at this, calling it "speculation." He argues that speculation has always existed in markets, and nothing is promised except for investing in government debt.
• Information Advantage: He emphasizes that his role in the industry provides access to more information and a wider array of data, which is crucial for assessments and analysis. Dedicated credit analysts are employed to scrutinize markets.
• Key Takeaway: The ability to pick and choose what to own is paramount in the current environment, especially after a long period of global growth. He doesn't view it as gambling but acknowledges the inherent speculation involved.

Conclusion

The current market weakness, particularly in tech stocks, is largely driven by shifting expectations around US monetary policy and the potential for fewer Fed rate cuts. While there are concerns regarding credit markets and the proliferation of complex financial products like leveraged ETFs, these are viewed more as areas of awareness requiring active management rather than systemic threats. Despite short-term volatility, the outlook for risk assets into 2026 remains positive, supported by strong consumer and government spending in the US and generally accommodative financial conditions. The market environment necessitates careful asset selection and an understanding of the inherent speculation involved in investment decisions.