As in recent months, real economic data continued to demonstrate growth in spite of weak consumer and business confidence. In the United States, GDP grew at a 2.5% pace in the third quarter, better than both the tepid 1.3% of the first quarter and the recessionary predictions of some doomsayers. Output of the cyclically important manufacturing sector continued to grow moderately, and investment spending by businesses was strong. Job growth was stronger than expected, with upward revisions to previous month’s estimates, but not enough to reduce the 9.1% unemployment rate. Stability in the labour market appeared to encourage consumers, as retail sales were higher than expectations. In particular, auto sales moved higher, demonstrating a willingness to purchase big-ticket items. We anticipate that vehicle sales will continue to improve because of pent-up demand, with the average age of cars in the U.S. having increased to over ten years during the recession. Only the housing sector failed to register significant improvement in the month, with average prices eroding further. Notwithstanding the excess capacity in the American economy, CPI inflation increased to 3.9% from 3.8% a month earlier.

US Light Vehicle Sales

In Canada, the economic news was even better than in the United States. Growth rebounded further from the second quarter slow patch; GDP grew 0.3% in August following July’s 0.4% increase. Unemployment fell to 7.1% from 7.3 % the previous month, as job creation was robust. Manufacturing sales were stronger than expected, with transportation equipment, food, and petroleum and coal sectors reporting healthy gains. Consumers were also contributing to economic growth as retail sales beat expectations. Inflation ticked up to 3.2% from 3.1%, with the core rate jumping to 2.2% from 1.9% a month ago. Even though the all-items inflation rate has been above its 3% upper limit in six of the last seven months, the Bank of Canada decided during October to leave its trendsetting overnight interest rate unchanged at 1%. We subsequently challenged a Deputy Governor regarding the lack of action on inflation, and he explained that the Bank was expecting Canadian economic growth to slow and thereby reduce inflation to only 1% by mid-2012. In particular, the Bank anticipated lower energy and food prices to be the primary factors behind the lower inflation rate.

The Canadian yield curve executed an almost perfect parallel shift upward in October. Following the substantial volatility described earlier, benchmark Canada bond yields rose 13 to 16 basis points across all maturities. In contrast, the U.S. yield curve steepened as 2-year yields were unchanged, but 30-year yields finished 28 basis points higher.

Provincial and corporate bonds outperformed the broad index, which fell 0.43% in the month. Provincial yield spreads narrowed by 7 basis points on average, and the sector returned -0.28%. Corporate bonds returned -0.38%, as slightly more risk tolerance by investors allowed corporate yield spreads to narrow by 4 basis points. Federal bonds declined 0.56%, thereby lagging the other two main nominal bond sectors. Real Return Bonds substantially outperformed nominal bonds, gaining 2.42% on average. The largely unexpected rise in inflation undoubtedly played a part in the better performance of RRB’s.

The progress in expanding the European bailout fund, the European Financial Stability Fund, supports our optimism that the European debt crisis will eventually be resolved. However, we fully expect that the process will continue to be tortuous, with plenty of negative headline risk. The competing interests of the many players in this drama are clearly making the negotiations difficult and heated. But, at the end of the day, the benefits of restructuring the Greek debt and preventing a spread of financial contagion to other countries, such as Italy and Spain, are simply too great not to arrive at a solution. Economic growth in Europe will be hurt by the austerity measures that each country has implemented, though, and a recession in that region is likely.

From a fundamental economic perspective, Canadian growth is continuing at a moderate pace implying bond yields are too low and they should rise over time. As a result, portfolio durations are defensively positioned less than benchmarks, although we recognize that the rise in yields may occur slowly and not necessarily smoothly. Certainly, there will not be any immediate impetus from the central bankers to move yields higher. The Bank of Canada is concerned about slowing global growth negatively impacting Canada’s economy, and it is unlikely to raise rates before the second quarter of 2012. We believe that the Bank may be proven incorrect. We are also concerned that the Bank is being overly optimistic regarding the future path of inflation. Energy and food prices may not fall as it expects, and other inflationary pressures may also prove stronger than anticipated. Accordingly, we are maintaining the holdings of Real Return Bonds to hedge the risk of inflation not falling back to more desirable levels. We also remain concerned that the current extraordinarily low interest rates continue to encourage risky household borrowing and inflated debt levels that could make our economy vulnerable when interest rates normalize.

1 2 3