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For much of January, optimism about U.S. economic growth and a potential deal to reduce Greece’s debt burden led to declining Canadian bond prices as investors switched to riskier assets such as equities and European government bonds. Later in the month, though, bond prices recovered most or all of their earlier losses as investors reacted to some disappointing economic data and a more dovish outlook from the U.S. Federal Reserve. The DEX Universe Bond index earned 0.51% in the month.
In Europe, the negotiations to manage Greece’s orderly default appeared to make progress, but were not finalized by the end of January. One of the sticking points appeared to be that Greece’s fiscal situation had deteriorated significantly since last October with the implication that public sector holdings of Greek bonds, including those of the European Central Bank’s, would need to be written down as well as private investors’ holdings. However, there were indications that investors were less concerned about most European sovereign debt, as Italian, Spanish, and French bond yields fell during January, and several countries staged successful bond issues. It appeared that the ECB’s massive 3-year bank financing completed in December had substantially reduced concerns about a pending credit crisis. Outside of Greece, the only near term risk appeared to be Portugal, which saw its bond yields gap 2% higher in the month.
Canadian economic data was mixed in January. The unemployment rate held steady at 7.5%, as the economy began creating jobs again. Housing starts, manufacturing sales, and leading economic indicators were all stronger than expected. However, we also learned that the Canadian economy shrank 0.1% in November, following no growth in October. While some of the slowdown was due to temporary maintenance shutdowns in the energy sector, the lack of economic momentum was worrisome. On the inflation front, the CPI unexpectedly fell to 2.3% from 2.9%, led by lower gasoline prices and passenger vehicles. Several economists suggested, though, that this drop in inflation might be a one month wonder with prices reaccelerating next month. Notwithstanding the drop in the rate in December, for all of 2011 inflation averaged 2.9%, the highest annual reading since 1991.
In the United States, economic data received early in January continued the better than expected pattern of late 2011: unemployment fell to 8.5% from 8.7% as job growth was robust, construction spending was higher than expected, business and consumer confidence rose, and manufacturing activity accelerated. The net effect of the data was that investors felt more confident about the economic prospects and were more willing to take on risk. Bond yields rose as a result. Later in the month, though, the string of positive economic surprises was broken. Retail sales, housing starts, and 4th quarter GDP were all weaker than expected, prompting bond yields to move lower again.
The U.S. Federal Reserve Board met in late January and, as expected, left interest rates unchanged at near zero levels. In a noteworthy effort to be more transparent, however, the Fed released more information about the committee’s deliberations. That information included the forecasts by individual members of when they expected that the Fed would need to begin tightening. Interestingly, the various members’ forecasts showed significant dispersion, with some anticipating the first move to come later this year while others expected no change for at least 4 years. The median forecast, though, suggested that the Fed would keep rates low until late 2014, and that was longer than the market consensus had expected. As a result, bond prices rallied and yields fell, with mid-term bonds most affected. The yield on 5-year U.S. Treasuries, for example, hit record lows following the Fed’s announcement, falling below 0.75%.
The U.S. housing sector remained depressed with average prices continuing to grind lower. We believe that there is substantial pent-up demand for new homes because the supply of new homes has fallen short of the need arising from new family formation and replacement for five consecutive years. During that time, approximately two million construction jobs were lost, with many more jobs in related industries also disappearing. A turnaround in the sector, therefore, would provide an important boost to the U.S. economic recovery. Until prices stabilize, however, it seems unlikely that the pent-up demand for new homes will emerge. Prices continue to fall due to the large stock of foreclosed homes that remain to be resold. So it was encouraging to hear that the U.S. government has started the process to convert pools of foreclosed homes into rental properties. We will be monitoring this initiative in the coming months to see if it has a material impact.
The greater willingness of investors to accept risk in January resulted in good relative performance of corporate bonds. This sector gained 1.00% in the month, as yield spreads narrowed by an average of 11 basis points. Corporate issuance was strong in the month, with $9.2 billion of new deals. Most of the new issues were priced at significant concessions to existing secondary offerings. This factor, combined with healthy investor demand, caused the new bonds to narrow in spread following issuance. Provincial bonds returned 0.42% in the period, helped by a small narrowing of their yield spreads. Federal bonds lagged the other sectors, returning only 0.26%.
The Canadian yield curve became slightly less bowed in January, as 5 and 10-year yields declined slightly while 2 and 30-year yields rose marginally. The shift in the Canadian curve reflected, in part, the mid-term rally in the U.S. bond market. However, it also appeared to reflect investor wariness regarding the low absolute levels of long term yields and their inherent riskiness.
The Canadian bond market may be in a holding pattern for the next few months, as investors try to assess the impact of a European recession on global growth, and North American growth in particular. Central bankers, in Canada, the United States and elsewhere, have kept interest rates very low in efforts to stimulate growth. Expectations that those rates will remain low for very long periods have driven bond yields to record low levels. As well, concerns that monetary and fiscal authorities were running out of alternatives to stimulate their economies prompted investors to seek the security of fixed income. The success of the European Central Bank’s provision of half a trillion euros of liquidity to the European banks and the Fed’s communication of “lower for much longer”, have dispelled some of those concerns.
Our economic outlook calls for tepid growth in Canada that is dependent on that of its largest trading partner. The good news is that we believe U.S. growth will be stronger than consensus estimates. The labour market south of the border continues to improve and that may bode well for an eventual turn around in housing. We believe that the most likely direction for interest rates is up, so we are retaining the defensive duration within the portfolio. With no recession expected in North America, corporate creditworthiness should remain good and that means corporate yield spreads, which are high from a historical perspective, are attractive. We are, therefore, maintaining the overweight allocation to corporate bonds.
With regard to inflation, we are concerned that the recent drop will be reversed. Gasoline prices, in particular, seem to be headed inexorably higher, notwithstanding that many pundits are calling for a sharp fall. Nor will the recent collapse in natural gas prices provide much relief; the price of the commodity is only one of many components in the average utility bill and thus the recent fall is expected to lower inflation by only 0.1% to 0.2%. With central bankers still trying their hardest to stimulate growth, there is no impediment to inflation rising. Therefore, we are retaining the Real Return Bond holding in the portfolio.