In contrast, the labour data from the United States was positive. Initial claims for unemployment benefits fell below the psychologically important 400,000 level, job creation improved, and the unemployment rate fell slightly. The improving labour situation was probably responsible for at least some of the improvement in consumer confidence surveys, which continued to recover from the lows of the summer, as well as stronger than expected retail sales. Business confidence also appeared to increase, with a number of manufacturing surveys strengthening. Only the housing sector failed to improve, with average home prices continuing to grind lower.

The yield curve flattened in Canada, as 30-year bond yields fell 24 basis points while 2-year yields were unchanged. The strong performance of long term bonds reflected investor demand prompted by the index duration extension. Among the sectors, provincial bonds returned 1.12% compared to 0.80% for federal issues and 0.60% for corporate bonds. Provincial bonds on average have a longer duration than the other sectors, and that difference accounted for the better returns in November. On a duration-adjusted basis, provincial bonds actually lagged federal and corporate bonds because their yield spreads versus benchmark Canada bonds widened 8 basis points. New issue supply of provincial bonds was significant at $5 billion and accounted for part of the spread widening. The balance of the widening reflected modest risk aversion from any credit risk in the current environment. Corporate yield spreads grew by 7 basis points, also due to the increased risk aversion prevailing in the market.

“The elephant in the room” is an expression that refers to an important and obvious topic, which everyone is aware of, but which isn’t discussed, as such discussion would be uncomfortable. In the European debt crisis, the elephant in the room is the credit default swap market. When European authorities recently negotiated “voluntary” 50% haircuts to private bondholders to reduce Greece’s outstanding debt, considerable efforts were made to structure the cuts so that there would not be a technical default that would trigger CDS payments. A recent estimate of the size of the global CDS market was over $34 trillion notional outstanding, a truly staggering sum if accurate. What began as an insurance policy for bank loans has become an unregulated global vehicle for speculating about the credit worthiness of sovereign and corporate issuers. No one fully understands which organizations have CDS exposure, in what quantity, and to what extent counterparty risk has been effectively managed. The concern is that the default of a single, significant issuer could cause the failure of CDS counterparties that would cascade into a full-blown credit crisis.

That is not to say that contagion from the European debt crisis could not spread in other ways as well. For example, the ten largest money market funds in the U.S., with total assets of $642 billion, have nearly 35% of their holdings in European banks. If one of those banks were to collapse, the ramifications would quickly be felt globally.

We believe that the most likely outcome of the European crisis is that the Eurozone will muddle through to a successful resolution and avoid significant defaults other than Greece. However, the time consuming process will continue to have substantial headline risk, because of the wide dispersion of interests of the various participants and the onerous political process required to ratify changes to the union. Thus, volatility may remain higher than normal.  We recognize, though, that successful resolution of the crisis is far from a sure thing. In other words, there is a significant risk of a credit crisis arising from the European situation. Thus, while corporate yield spreads are historically attractive and the portfolio has significant corporate bond exposure, we are keeping the corporate allocation well below the maximum permitted. In the event that a credit crisis does develop, we will have significant room to add more corporates at very attractive levels. We have also structured the portfolio to have no direct exposure to European financials and nominal exposure to U.S. financials.

With regard to duration, we are targeting below benchmark levels because we believe that current record low yield levels are not attractive relative to inflation or the potential returns of other asset classes. We believe that there is considerable risk of a large selloff in bonds should the European debt crisis be resolved satisfactorily. As well, we anticipate that the North American economies will avoid falling back into recession. In that vein, we are optimistic that the recent strengthening of the U.S. labour market points to the recovery in that country becoming more self-sustaining. We are also optimistic that China has started to ease monetary policy and will avoid a so-called hard landing of its economy. Global growth will slow as a result of the European recession, but remain positive. As our economic outlook unfolds, the flight-to-safety bid for bonds should gradually unwind.

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