A key question is what is causing the recent economic weakness, particularly in the United States. (With little pent-up demand and high consumer debt levels, Canadian economic growth in 2014 will be highly dependent on the pace of U.S. growth.) Possible reasons for the weakness include the severity of the weather this winter, a correction in inventory levels, or more fundamental weakness in the economy. It seems reasonable that the bad weather was a major factor, which means growth should recover as the weather returns to normal. If businesses are trimming their inventories, growth should rebound once the adjustment is complete. However, if fundamental weakness is occurring, growth will not reaccelerate.

We believe that the weather will turn out to be the primary reason for the temporary slowing in growth. As the weather returns to normal, we expect that growth will rebound. However, it may take another month for the economic data to reflect that, and the bond market may experience some volatility until it is clear. We anticipate, therefore, that bonds will be range bound, and we will adjust durations accordingly. Ultimately, though, we look for yields to rise somewhat over the balance of the year and we are looking for opportunities to shorten durations further.

Canadian inflation is widely expected to fall in the next month because of base rate effects. In February 2013, the Consumer Price Index had its largest monthly increase since 1991, rising 1.2%. That jump will be dropped when the February 2014 CPI data is released, and the annual pace may fall back below 1.0% from the current 1.5%. As a result, the Bank of Canada’s concern about low inflation will be undiminished and, therefore, rate increases will likely occur into the future. However, with 2 and 3-year Canada bond yields only a little above 1.0%, short term bonds offer little value and we are minimizing their use. We prefer to hold mid-term bonds to earn the added returns from a steep yield curve.

Corporate bonds remain our preferred sector. Corporate creditworthiness is good and that is expected to remain so at this stage of the economic cycle. Caution is warranted, though, regarding sectors that face excessive competition (e.g. retailing) or that may be negatively impacted by rising yields (e.g. real estate). In the provincial sector, the two largest issuers, Ontario and Quebec, are likely to hold elections this spring and with the outcomes uncertain, we prefer to avoid the anticipated volatility that may develop.

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