The federal sector returned -0.62% in the month, as higher yields resulted in lower bond prices. The provincial sector returned -0.64%, with a 3 basis point narrowing of yield spreads mostly offsetting the impact of longer average durations of provincial bonds. Corporate yield spreads shrank by 4 basis points on average in December, which resulted in the sector faring better than government bonds by earning   -0.16%. The narrowing of corporate yield spreads was most pronounced in the long term portion of the sector (8 basis points), with pipeline bonds enjoying particularly good relative performance. BBB-rated issues once again outperformed both A and AA-rated issues. New issue supply was light, with only $4.3 billion coming to market in the month including only $150 million of long term corporate bonds. High yield (non-investment grade) corporate bonds earned +1.70% in December, helped by the addition of a large issuer at relatively distressed prices. In December, Sobeys Inc. was downgraded to non-investment grade by Standard & Poors and the prices of its bonds fell sharply as some investment grade portfolio managers were forced to sell. However, once the Sobeys bonds were added to the high yield index they recovered some of their losses as junk bond specialists scrambled to purchase a new issuer. The Canadian high yield market, which was only about $10 billion in size prior to the downgrade, grew by roughly 15% when the Sobeys bonds were added. Real Return Bonds returned -2.26% in the month, about the same as long term nominal Canada Bonds. Preferred shares performed very well in the month, earning +3.59%. Rate reset issues were particularly strong because investors anticipated higher future dividend rates as 5-year Canada Bond yields rose in the month.

Looking ahead to 2017 there are, in the words of former U.S. Defense Secretary Donald Rumsfeld, a number of known unknowns. Principal among these has to be Donald Trump’s policies once he is President and his ability to have them implemented, either by working with Congress or by administrative decree. Since the election, global financial markets have reacted strongly with a consensus view that the U.S. economy will receive a substantial boost from tax cuts, reduced regulation, and increased infrastructure spending. The markets have largely ignored the potential risks including the possibility of much more restrictive trade policies slowing global growth, the lack of cohesion between Trump’s policies and those of Congress, and the likely delay in any fiscal stimulus having meaningful impact on the U.S. economy. Given the very substantial market reaction since the U.S. presidential election, one wag’s recommendation to “Buy the election, sell the inauguration” has a certain appeal.

Another known unknown is the timing of the British decision to formally leave the European Union. While Prime Minister May has said that the required Article 50 notice would be triggered by March 31st, we would not be surprised if that deadline slips. The incredible complexity of renegotiating thousands of agreements between the E.U. and Britain and the potential negative impacts of Brexit on Britain’s economy suggest that delaying the decision could be the most prudent course. If Brexit is delayed, we would anticipate that investors will start discounting the possibility that it will never occur at all.

Another uncertainty for 2017 is whether we will see further winding down of quantitative easing programmes by the European Central Bank and the Bank of Japan. These extraordinary monetary stimulus plans have had limited if any success in reinvigorating the respective economies, but have caused tremendous distortions in global bond markets by forcing bond yields to ridiculously low levels. Should the ECB or the BoJ indicate that they will slow their respective bond purchases that will reduce the downward pressure on bond yields and allow them to return to more normal levels.

Other potential market drivers include a significant equity market selloff, geopolitical turmoil, and the Bank of Canada over-reacting to disappointing Canadian economic growth. Several observers have noted that the post-election rally has left equity valuations very stretched by historical standards and a correction could result. If stock market correction does occur and if it is severe enough, we would expect a fight-to-safety bid for bonds to develop. Geopolitically, we are concerned that Donald Trump’s diplomatic inexperience could embolden any number of the United States’ traditional foes, leading to crises that will roil markets. With regard to Canadian growth, we expect that it will remain disappointingly slow, even if energy prices continue to recover. The Bank of Canada could decide to lower interest rates again in a futile effort to counteract the weakness, which would be positive for shorter term bonds unless the Bank’s apparent desperation led foreign investors to divest some of their Canadian bonds. Even if the Bank does not cut rates, it is very unlikely to raise them in 2017.

In terms of strategic positioning, we have portfolio durations somewhat shorter than benchmarks because the trend is to higher yields. However, we are cognizant that markets rarely move in a straight line and there may be a rebound in bond prices that will be a better opportunity to reduce durations further. On the yield curve, we have reduced the cash positions because of the correction in shorter term bonds that has resulted in more sensible yields. Among the sectors, corporates continue to benefit from the hunt for yield in this very low yield environment. Consequently, we continue to overweight the sector, but are becoming increasingly selective as some corporate bonds are becoming fully valued. For clients that have broadened their mandates, preferred shares are relatively better value than bonds and provide diversification should bond yields continue to rise.

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