Unfortunately, we don’t believe that the European debt crisis is close to resolution. Mario Draghi’s statement was supportive about the Eurozone, but it lacked details regarding implementation. It also, apparently, lacked support from other members of the ECB’s Governing Council, who were surprised by his comments. In any event, it is unlikely that the ECB can solve the debt crisis single-handedly. The more heavily indebted countries in Europe cannot simply cut spending and raise taxes to balance their budgets. The decline in economic activity due to the austerity measures is resulting in lower tax revenues, thereby exacerbating their budget deficit problems. In the United States, growth is slowing due to global uncertainty, a higher exchange rate, and the lack of political will to address the fiscal cliff of higher taxes and reduced spending until after the election. The U.S. housing sector continues to recover, but it probably will not be sufficient to offset other areas of weakness in the U.S. economy. China has started to ease, but growth in the world’s second largest economy continues to decelerate.

The weak global outlook is problematic for the Canadian economy, given the importance of trade. In the recent financial crisis, Canada fared better than many other economies, declining less and recovering more rapidly. However, we are left with relatively little pent-up demand with which to offset declines in external trade. As a result, the Bank of Canada is unlikely to raise interest rates for a few quarters. Indeed, there is a non-trivial possibility that it will need to lower rates next year if more countries fall into a double dip recession.
Bond yields are near record lows and not particularly attractive in our opinion. However, in the current uncertain economic environment, yields may stay low for several more months. Canadian government bonds, particularly AAA-rated federal issues, are in demand because they are perceived to carry less risk than most alternatives and that demand seems unlikely to slacken in the near term. We are keeping portfolio durations, therefore, close to the benchmark.

The short term portion of the yield curve remains quite flat and expensive. Yields of 3 to 5-year bonds are unattractive because they fail to compensate investors for the additional risk they carry. Accordingly, we have de-emphasized those terms, preferring to hold bonds with 2 years or less to maturity.

Corporate bond yield spreads are attractive from a historical perspective, but may widen further should economic growth falter. Weightings of corporate bonds in the portfolio are relatively high, but not at policy limits. Should spreads widen and become even more attractive, we will have capacity to add at very attractive levels. We continue to avoid issuers with substantial exposure to Europe, and have limited direct exposure to U.S. issuers. We continue to monitor individual holdings to minimize the potential impact of an economic downturn.

From a longer term perspective, do low bond yields mean that investors should shift away from fixed income assets? We would argue “No”, for several reasons. First, wanting higher returns does not mean that those returns will actually be achieved. Shifting to riskier assets does not guarantee higher returns, but does increase the risk of losses. In our view, low positive returns are preferable to losses, large or small. The second reason for maintaining asset allocations to fixed income is that the economic situation is uncertain and slowing. Bonds often outperform other investments in that sort of environment. A third argument for holding bonds is a demographic one. The Baby Boom is aging, with the leading edge already beginning to retire. Demand for fixed income investments will increase as more Baby Boomers start to live off their savings. A final reason for holding bonds is that their steady stream of income and return of principal at maturity reduces volatility and improves returns. Bonds continue to make sense, even with low yields.

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