The U.S. economy continued to operate at full capacity. Growth in GDP during the fourth quarter of 2019 was reported at a 2.1% rate, slightly stronger than both forecasts and the estimated potential growth rate. Unemployment was unchanged at the historically low 3.5% rate and the excellent labor situation led to better than expected consumer confidence. Housing starts were stronger than expected, rising to the fastest pace since 2006. CPI inflation rose to 2.3% from 2.1% the previous month, but the Fed’s preferred measure, the core Personal Consumption Expenditures deflator, was more subdued at 1.6%. Late in the month, the Fed left its overnight target interest rate unchanged and indicated that it would likely not change rates for several months.

The Canadian yield curve flattened in January as longer term bond yields fell more than short term bond yields. The yield of 2-year Canada bonds declined 26 basis points, while 30-year yields fell 34 basis points in the risk-off atmosphere. The largest yield moves occurred with mid term bond yields plunging in anticipation of future monetary easing by the Bank of Canada; the yields of 5 and 10-year Canada’s dropped 38 and 43 basis points, respectively. As noted above, the Canadian bond market was following the trends of global markets in January and the shifts in Canadian yields were very close to the changes in U.S. Treasury yields in the month. However, the term differentials in the two markets remained quite different, with 30-year Canada bonds having the same yield as 2-year Canada’s, but 30-year Treasuries yielded 65 basis points more than their 2-year counterparts.

The declines in yields resulted in price gains that propelled federal bond returns to +2.37% in January. Provincial bonds earned +3.60%, as their longer average durations resulted in larger price increases when yields fell. The risk-off sentiment in the period, though, resulted in provincial yield spreads widening by an average of 4 basis points, which reduced the sector’s gains. Investment grade corporate bonds returned +2.68%, thereby modestly outperforming benchmark Canada bonds. Demand for corporate bonds was strong, particularly in the first half of the month, leading to a sharp narrowing of their yield spreads. The coronavirus outbreak dampened demand somewhat and spreads moved wider over the balance of the month but, on average, corporate yield spreads narrowed by 2 basis points in January. New issue supply was quite good at $8.2 billion, but in a break from recent months’ experience, new issues toward the end of January failed to tighten following pricing. High yield bonds returned +1.27% in January, underperforming higher quality issues in the more cautious environment. Real Return Bonds returned +4.12%, modestly underperforming nominal bonds on a duration-adjusted basis. Preferred shares rallied at the start of the month but gave up their gains as bond yields fell sharply later in the period. With 5-year Canada bond yields dropping 38 basis points in the month, it was noteworthy that preferred shares still had a positive, albeit very small, return of +0.06%.

If the coronavirus outbreak worsens, that will increase the likelihood of a rate reduction by the Bank of Canada, which in turn will extend the recent bond rally. However, while we do not claim to be experts in immunology, we think the disease will likely be contained and the long term effect on markets will be fairly small. To put the novel coronavirus outbreak in perspective, as this is being written, there have been approximately 20,000 confirmed cases and less than 450 deaths worldwide from the disease. In contrast, in the United States the current flu season (which started last September) has seen 19 million people fall ill, 180,000 hospitalizations, and 10,000 deaths according to the Centres for Disease Control.

Given the extraordinary measures being taken in China and other countries, it seems unlikely that the coronavirus will have anything close to the human impact of influenza. The economic impact, however, is likely to be more significant as the world’s second largest economy partially shuts down while China struggles to limit the spread of the disease. Commodities, trade, and particularly air travel have already been negatively affected. Depending on how long the crisis lasts, manufacturers dependent on Chinese made parts and/or materials will face shortages when their inventories run low.

For now, we are assuming the markets’ coronavirus concerns will crest in February, with containment and diagnosis efforts being increasingly viewed as successful. If that proves correct, the economic impact outside of China will be limited. And if the SARS epidemic 17 yeas ago provides a good precedent, growth should rebound fairly quickly after that. Barring an extended period of disruption due to the disease, Canadian economic growth is poised to accelerate from the disappointing pace of the final quarter of 2019. The temporary factors that restrained growth in that period, including the GM strike in the United States, the CN Rail strike in Canada, bad weather on the Prairies, and the outage of the Keystone Pipeline, have ended which should permit growth to rebound.

Strategic positioning of the portfolios includes durations that are shorter than benchmarks, yield curve positioning in anticipation of the yield curve steepening, and an overweight allocation to corporate bonds offset somewhat by a lower allocation to the provincial sector. Within the corporate sector, we are looking for opportunities to shift to higher rated holdings.


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