Keep connected
Our investment management team is made up of engaged thought leaders. Get their latest commentary and stay informed of their frequent media interviews, all delivered to your inbox.
As we noted last month, we do not believe that the Canadian and American economies are currently in recession, and there is a reasonable chance that a recession can be averted. Real economic data, as opposed to confidence surveys and the stock market, continue to show growth and expansion, albeit at a modest pace. Recent market volatility has been caused primarily by uncertainty surrounding the European debt crisis and, unfortunately, we do not anticipate a quick resolution to that situation. As a result, we would not be surprised to see volatility remain high.
We do acknowledge that the risk of a recession developing in the United States next year has risen. With only tepid underlying growth, the impact of expiring tax cuts and the end of other government fiscal stimulus may push the economy into contraction. Given the poisonous state of U.S. federal politics, it is difficult to be optimistic about possible relief from the expected fiscal drag next year. On the positive side, though, the recent increases in consumer borrowing suggests that the deleveraging process may have run its course and the consumer may start to contribute more meaningfully to economic growth. We also anticipate that the U.S. government will soon announce a scheme to reduce the inventory of foreclosed homes held by federal housing agencies. Reducing the overhang of foreclosed homes seems a necessary step to stopping the ongoing decline in house prices. Only when prices have stabilized is it likely that buying activity will pick up. Should that happen, however, the U.S. economy would receive a significant boost as pent-up demand spurred higher residential construction. We are also optimistic that China will start to ease monetary and fiscal restraints as its inflationary pressures appear to be easing. The global nature of the current financial crisis means that no country should expect to export its way out of difficulty, but having stimulative conditions in all major economies will help raise global growth that benefits all.
It seems likely that the Bank of Canada will leave rates unchanged until 2012, because of concerns about slowing global growth. Unfortunately, that means the Bank will not be addressing the potential domestic problems of excessive household debt levels or housing prices that are already very high relative to incomes. It also means that we anticipate less flattening of the yield curve in the near term, so we are selectively reducing the amount of money market securities held in the portfolios.
Yield spreads on corporate bonds have widened in the last two months because of concerns about a possible credit crisis as well as a more generalized recession. Liquidity in the corporate sector has also declined as investors have become more cautious and investment dealers have reduced the size of positions they are willing to hold for future trade.
The following chart illustrates the increased yield spread on a representative long term corporate bond that has developed in the last two months. The greater pick up in yields has improved the attractiveness of corporate bonds, but while the portfolios have significant capacity to add more corporate exposure, we have refrained from buying in the near term.
While current corporate spread levels are attractive from a very long term, historical perspective, the potential for the European debt crisis to cause a full blown credit crisis makes us cautious about increasing the allocation to corporates. The following chart shows that the recent widening is actually quite small compared to the post-Lehman Bros. panic of late 2008. Additions to the existing corporate holdings will wait until resolution of the European crisis and/or substantially more spread widening.
