In each of the last few years, the Canadian bond market has hit a seasonal period of weakness in the first quarter; so, the selloff this January appears to fit the same pattern. While there is no denying that the global economy is recovering, the wave of optimism that swept through financial markets last month appeared overdone because it ignored the serious and fundamental challenges facing Europe, the United States, and Japan. And Canada’s economy is not immune; it will follow the lead of the U.S. economy over the coming year. If the U.S. growth rate accelerates in 2013, Canada’s will too. However, if the U.S. falls into recession, so too will Canada.

The relatively weak finish to 2012 of the U.S. economy is, therefore, a concern. While the U.S. housing sector will likely continue its recovery and boost GDP growth by about 0.5%, the impact of the federal tax increases and spending cuts may dwarf the boost from increased housing activity. The consumer represents roughly 70% of the U.S. economy, and with the payroll tax increases shrinking paycheques, U.S. growth will be subdued at best. In addition, there are scheduled cuts to federal spending that will begin in March, further reducing growth. As well, the debate over the long-term viability of entitlement programmes like Medicare has yet to start in earnest, but will likely result in further spending reductions.

In light of the past seasonality of the Canadian bond market and the current uncertainty regarding near term growth, we are keeping portfolio durations close to benchmarks. If upcoming economic data justifies the recent wave of optimism, we will shift the portfolios into a more defensive structure, including reducing duration and increasing cash levels. We will also be monitoring the demand for Canadian bonds as a safe haven investment, as events in Europe and Asia unfold. From a sector allocation point of view, we are comfortable with the over-weighting of corporate bonds, but we recognize that the rally in spreads has made their valuations less compelling. Accordingly, we are taking profits in holdings that appear to have little room left to rally. We will selectively replace them with issues that offer better value and prospect of gain.. Only if economic growth falters and a recession looms do we anticipate reducing the corporate sector weighting substantially.

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