Federal bonds returned -0.05% in February as the higher yields resulted in lower prices. Provincial bonds returned 0.31%, with the advantage versus federal issues reflecting a 5 basis point tightening of their yield spreads. Investment grade corporate bonds also returned 0.31%, with their yield spreads narrowing by 6 basis points. The decline in inflation reduced demand for Real Return Bonds slightly and they returned -0.28% in February. High yield bonds, which tend to be correlated to equities, gained 1.57% as stock markets rallied in the month. Preferred shares finally began recovering from their recent selloff and gained 2.08% in the month.

As this is being written we have learned that the Canadian economy slowed substantially in the last three months of 2018, growing at an annual rate of only 0.4%. That indicates the slowing of growth that we have been anticipating actually began sooner than expected. That said, we do not believe a recession is the most likely prospect for Canada in 2019. Nor do we believe the Bank of Canada is likely to reduce interest rates without evidence of substantially greater weakness in the economy. While ongoing trade disputes are negatively impacting global economic growth, there are a number of reasons to be optimistic about continuing Canadian growth. The labour market is very healthy, with robust job creation and unemployment near record lows. Rapid growth in Canada’s population is also bolstering growth. Business investment, which has been disappointing, may increase as accelerated federal depreciation allowances take effect, although resolution of some of the trade and tariff issues may be needed to really improve investment spending. But, we are optimistic that U.S. president Trump, with an eye on the 2020 elections, may eliminate the steel and aluminum tariffs if U.S. growth falters. We also note that oil prices have recovered somewhat from their fourth quarter lows, with Western Canadian Select rising from under $20/barrel in November to well over $40/barrel recently.

The Bank of Canada and the U.S. Federal Reserve are unlikely to change their respective administered interest rates for several months, as they monitor the slowing pace of growth. In Canada, the small differentials between the Bank’s overnight interest rate target and short term bond yields suggest that investors are discounting the possibility of any more rate increases this economic cycle. We disagree, believing that the next rate move, even if months away, will be an increase rather than a reduction. As a result, we believe bond yields are more likely to rise from current levels and the term differentials will increase, resulting in a steeper yield curve. Accordingly, we are keeping portfolio durations modestly shorter than benchmarks, and we are monitoring the market to determine when to reduce durations further. We are also structuring the portfolios to benefit from a steepening yield curve.

The narrowing of corporate yield spreads in January and February has reversed roughly half of the widening that occurred in the final quarter of 2018. In light of our relatively optimistic economic outlook, we believe corporate creditworthiness will remain favourable, so we are maintaining the overweight allocation to the corporate sector. That said, the economic risks have increased somewhat so we are being especially vigilant regarding the credit quality of individual holdings.

1 2 3