Browse below for the latest commentary from some of our Portfolio Managers.
For the third year in a row, economic optimism experienced in the first three months of the year faded as second quarter data indicated slower growth. This year, the Canadian and U.S. bond markets rallied strongly in the first week of April in response to weak labour market news. Bonds held those gains over the balance of the month as economic growth appeared to slow, particularly in the United States. As well, dovish remarks from the central banks reinforced investors’ expectations that short term interest rates would not rise for the foreseeable future. The DEX Universe Bond index gained 1.14% in April.
In Canada, the labour market data was particularly weak. Unemployment rose to 7.2% from 7.0% as 54,500 net jobs were lost in the most recent month. The data more than offset the robust 50,700 gain in jobs the previous month, and brought the average gains over the last several months more in line with the slow growth suggested by other indicators. As well, the trade deficit widened as export demand weakened. More positively, retail sales and GDP were both stronger than expected, but because both data points were for February, they were believed to be stale, with limited value in assessing the current situation. The Bank of Canada kept interest rates unchanged at its scheduled rate-setting meeting, but extended its forecast of how long the Canadian economy would operate at less than full capacity. The Bank expected that the output gap would remain until mid-2015, compared with its previous mid-2014 forecast.
In the United States, unemployment rose to 7.7% from 7.6% as job creation was disappointingly slow. Initial claims for unemployment benefits spiked higher early in April, although they declined over the balance of the month. Consumer confidence dipped lower, leading to an unexpected drop in retail sales. Manufacturing surveys also pointed to reduced economic activity. Of particular concern was that the slowdown in growth started to occur before the federal spending cuts, known as sequestration, would have impacted the economy. That meant the spending cuts might compound an already deteriorating situation. Representatives of the U.S. Federal Reserve, who had weeks earlier been talking about reducing the pace of the Fed’s bond purchases later this year, began to discuss publicly the possibility of actually expanding the scale of bond purchases to offset the weaker growth. The weaker economic data, combined with the potential for more quantitative easing, led to a surge in bond prices that pushed yields toward the record lows of late 2012. Interestingly, not all investors appeared to be concerned about future economic growth, because some U.S. equity market indices hit all-time records during April.
Globally, economic developments were also disappointing. In Europe, unemployment rose to 12%, retail sales declined, and manufacturing continued to contract. Politically, there seemed to be a shift in European thinking; after three years of austerity, politicians in several European countries noted the need to promote growth as well. While it will be several months before the growth initiatives bear fruit, an eventual easing of the European recession would be a positive development for global growth. In China, GDP growth remained positive, but was slower than expected. That news, in particular, led to a sharp decline in the prices of commodities such as gold, copper, and oil as investors and speculators became concerned about future demand growth. In some cases, the price adjustment in commodities was so severe that it reinforced the safe haven status of fixed income investments. With some commodity prices plunging more than 10% in little more than a day, bond prices rose in response to the apparent uncertainty.
In the Canadian bond market, yields of all maturities fell in the month, but 10-year bonds enjoyed the largest decline, dropping 18 basis points in the month. In contrast, 5 and 30-year bond yields declined 14 basis points, while 2-year yields went down 6 basis points. The pattern of yield changes was similar to what occurred in the U.S. bond market, except that 30-year U.S. Treasuries had the largest drop in yields, falling a whopping 22 basis points. That resulted in a price jump for the long U.S. bonds of more than 4 ½ percent.
Lower yields resulted in price gains, and that propelled federal bonds to an average return of 0.91% in the period. The provincial sector gained 1.56% in April, as the longer average duration of provincial bonds produced bigger price gains as yields fell. The yield spreads on provincial bonds were under pressure for much of the month, moving to the widest levels in roughly three months. Late in the month, though, bargain hunting by investors led to higher demand for provincial issues and the yield pickup versus benchmark Canada bonds narrowed somewhat. The corporate sector returned 1.03% in April, as yield spreads were little changed. New issue supply, at approximately $5 billion, was substantially less than the previous month, but the less rosy economic environment dampened investor demand for corporate bonds. Real Return Bonds earned 2.30% in April, as their longer average durations resulted in greater price gains as yields fell. RRB’s also benefitted from the outsized jump in inflation the previous month which was reflected in this month’s inflation adjustment.
Our economic outlook remains for slow growth in Canada, as consumers continue to reduce debt levels and governments restrain spending in order to control their deficits. Business investment spending should help offset the consumer and government sector weakness, but may be uneven in terms of timing. Export growth, which some economists expect to boost Canadian growth this year, will depend on the pace of U.S. and global growth. Fortunately, that growth should improve following what we believe will be a temporary slowing in the second quarter.
The Bank of Canada is not expected to raise interest rates until early 2014 at the earliest, which should provide some stability for shorter term bond values. Inflation is expected to stay within the lower half of the Bank’s 1% to 3% inflation targeting band, allowing the Bank to avoid raising rates this year. However, low inflation will also mean that RRB returns will be relatively disappointing. Longer term bond yields, which have fallen close to record lows, are not attractive in our opinion. We believe that the economic pessimism that propelled the recent bond market rally will diminish and bonds will again start to lose their safe haven bid. Accordingly, we are maintaining a defensive duration in the portfolios.
We anticipate that anticipated changes to the various bond indices in June will lead temporarily to increased demand for bonds commencing in the second half of May. As a result of approximately $32.6 billion of 1-year bonds rolling out of the DEX Universe Bond index, as well as the payment of over $7 billion in coupons, the index duration will increase approximately 0.21 years in June. The smaller DEX Long Term Bond index will extend 0.42 years as $19 billion government bonds that mature in June 2023 will no longer qualify for the index. While clients’ liability durations will not be affected by the index changes, index funds will be forced to add duration to reflect the changes. Typically, that will result in increased purchases of 10-year bonds for Universe index funds and 30-year bonds for long term duration index funds. Usually, the impact of the increased demand from index funds starts to fade within a day or two of the actual index changes.
Corporate bonds remain our preferred sector. However, corporate yield spreads are not as attractive as they once were, and could widen in the face of substantial new issue supply or further economic slowing. As a result, we are being vigilant in evaluating the risk/return trade-off of each holding, and will look to take profits in any issue that no longer offers superior prospects of gains.
