Canadian economic data received in August was primarily about activity in June, and showed a rebound from the weakness of the first five months of the year. Notably, there was a sharp reduction in the monthly trade deficit from $3.37 billion to $480 million, as exports jumped 6.3% and imports shrank 0.6%. The improvement in trade should result in June’s GDP increasing after five consecutive declines. Retail sales and wholesale trade were also stronger than expected in the month. The year over year inflation rate increased to 1.3% from 1.0%, and the core rate of inflation edged higher to 2.4% from 2.3% a month earlier.

U.S. data provided increased evidence that the U.S. economy is solidly in economic expansion. The pace of GDP growth in the second quarter was revised from 2.3% to a robust 3.7% rate. Unemployment held steady at a relatively low 5.3%, while the average work week lengthened slightly as business ramped up their activity. Factory orders were robust, industrial production and consumer credit expansion were stronger than expected, and housing starts rose to the highest level since October 2007. Importantly, the average worker saw some improvement, as average weekly earnings increased 2.2% versus year ago levels, compared with a 1.8% increase a month ago. We believe the Fed has been waiting for the average worker to see tangible benefits of the economic expansion before it begins removing its extraordinary monetary accommodation. The rising earnings data in August point in that direction.

The Canadian yield curve steepened modestly in August. The yields of 2, 5, and 10-year benchmark Canada bonds each rose a few basis points, while 30-year yields climbed 10 basis points. The small increases in yields caused bond prices to decline enough to offset the interest income earned. The federal sector returned -0.39% in the month. The provincial sector fared considerably worse at -1.68%, hurt both by its longer average duration and a 9 basis point widening of yield spreads. The widening of provincial spreads appeared to be the result of a combination of foreign selling, the potential impact of the sharply lower oil prices on provincial budgets, and a general “risk off” sentiment. Investment grade corporate yield spreads widened an average 11 basis points in the month, leading to the sector returning -0.96%. As with provincial bonds, the negative economic sentiment was a significant factor in the increased spreads, with lower rated issues experiencing the greatest spread movement. New issue activity was totaled only $1.5 billion in August due to the season and the market volatility. High yield bonds fell 2.97% as investors were not interested in their higher risk. Real Return Bonds declined 3.97% in the month, hurt both by their long durations and by reduced interest in inflation protection as oil prices plummeted.

Preferred shares suffered their third consecutive month of significant price declines, returning -3.82% in August. The market action last month strongly resembled that of the summer of 2013, when the Taper Tantrum caused preferred shares to selloff and then recover sharply in the autumn of that year. With price declines occurring on low volumes and selling indiscriminately spreading from low reset spread issues to all types of preferred shares, the decline of the market during August appeared to be caused by capitulation by some retail investors giving up on the asset class. As well, the preferred share market was negatively impacted by the Chinese equity induced volatility of August 24th. Following that day, however, the preferred share market began recovering as bargain hunters recognized its oversold valuation.

In September, both the Bank of Canada and the U.S. Federal Reserve have scheduled meetings to consider changing their respective interest rates. We believe the Bank is unlikely to cut rates again at its meeting, for a few reasons. One reason is that the Bank traditionally refrains from acting during federal election campaigns so as to avoid potential charges of political bias. A second reason is that the Canadian exchange rate has weakened roughly 4% since the Bank’s July rate cut, and the depreciation will benefit exporters but only with a lag of several months. The Bank will likely wait to see the impact of that depreciation before acting again. Another reason is that the Canadian economy appears to have started growing again, thereby reducing the need for additional monetary stimulus. Although the Bank is unlikely to move in September, another interest rate reduction is possible later this year, so the yields of shorter term bonds (5 years and under) will likely stay near current levels over the next few months. Longer term bond yields, on the other hand, are more likely to follow the lead of U.S. yields and move higher. As a result, we are maintaining a somewhat defensive duration in the portfolios.

There is a significant possibility of the Fed raising interest rates at its meeting in September, although we think it is more likely to make its first move in December. The U.S. economy is in a sustainable economic expansion, with low unemployment. As a result, there is little need for interest rates near zero, and the Fed can easily begin scaling back on its extraordinary monetary accommodation. We believe the most likely time for the Fed to start raising rates is at its December meeting, but we recognize the possibility of an earlier move. When the Fed does finally act, whether in September, December or later, there is the potential for substantial volatility developing in almost all financial markets as investors react to the end of near zero borrowing costs. If the volatility is high enough, bonds may actually rally in the short term as their safe haven quality increases demand temporarily.

While the decline in Canadian GDP in the first and second quarters appears to meet the definition of recession, the growth in jobs and consumer spending so far in 2015 suggest otherwise. We believe that Canadian GDP growth will again be positive in the third quarter and, accordingly, we remain comfortable with corporate credit quality. The risk off market sentiment last month caused both corporate bonds and preferred shares to become oversold, corporates on a yield spread basis and preferred shares on an absolute basis. As a consequence, we are looking to add to both sectors.

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