Canadian fixed income markets rallied during July 2015, with the FTSE TMX Canada Universe Bond Index returning almost 1.5% and long bond portfolios returning almost 3.0%. Most of these gains were the direct result of the approximately 0.20% decline in yields, following the Bank of Canada’s July rate cut. This rate decision, unlike the January shock decision, was somewhat expected although only partially priced by fixed income markets. Since the July rate cut, fixed income markets have rallied further and are now pricing in almost a 50% probability of a further rate cut by mid-2016.
We think the Bank of Canada was right to cut rates last month, given a further 20% decline in oil prices during July alone, combined with the deteriorating profile for growth in the non-energy sector. Our downgraded Canadian growth outlook was confirmed on several fronts during the month. Firstly, the Bank of Canada’s own optimistic forecasts were revised lower, with the entire revision to FY 2015 coming from a downgrade to net trade. Secondly, the May GDP data showed that manufacturing output declined 1.7% m/m and will act as a non-trivial drag on growth. Both these points are of concern to us given the perceived benefits that should be arising from a weaker Canadian Dollar. In fact, the Canadian Dollar weakened a further 5% against both the US$ and on a trade-weighted basis during July.
So is the Canadian economy in a recession…? A technical recession, defined as two consecutive quarters of negative economic growth, now appears highly likely. We will, however, need to wait for the June GDP data released on September 1st to confirm this. Whilst defining a technical recession so narrowly detracts from its information value, we nonetheless are of the opinion that the ensuing media attention highlighting that Canada is in a technical recession, alongside further declines in oil prices, will likely weigh on consumer sentiment in the second half of 2015. We have therefore marginally raised our probability of a real (not technical) recession in Canada during the month.
However, this recessionary picture of the Canadian economy is far from the complete story. At least that is what the Canadian labor market is telling us. In the past year, employment has increased by approximately 1%, the unemployment rate has fallen 0.2%, and total hours worked has risen 2.1%. This at least explains why Canadian households and credit growth both remain firm, and are hardly characteristics typical of an economy in recession. Trade data also released early August is now showing some signs of a pick-up in export volumes, a potential early signs that the lagged effects of a weaker Canadian Dollar are starting to creep into the real economy.
Whilst lower yields drove gains in fixed income portfolios during July, these gains occurred despite a broad widening in corporate credit spreads in Canada. The bell-weather Canadian bank deposit notes and distribution utility names were 5-10 basis points wider, with deposit notes in particular widening from renewed supply totaling approximately C$ 4 billion during the month. In addition, higher beta issuers – particularly in the real estate sector – suffered as a result of growing concerns over the Canadian economic outlook and broad housing market. Pipelines, specifically, were the main underperformer, with the Enbridge downgrade to BBB continuing to weigh on credit in the sector in June, combined with the significant issuance pipeline that is expected to come to market imminently for the Enbridge complex.
In Canadian provincial bonds, spreads were broadly unchanged during July with limited reaction to S&P’s downgrade of Ontario from AA- to A+. The downgrade was attributed to Ontario’s high debt burden and weak budgetary performance. Despite this, we continue to favor Ontario over Quebec given the relative debt dynamics and economic outlook of these two provinces. Given the limited reaction to Ontario spreads, however, we have chosen to prudently diversify some of our provincial overweight in Ontario away into other provinces, namely British Colombia and Alberta.
High yield bonds spreads also widened approximately 15 basis points during July, largely driven by energy and mining names given the performance of the commodity complex and broad weakness in lower-rated (i.e. CCC-rated) credit. The energy and mining credits account for approximately 20% of outstanding issuance, and spreads in these sectors widened by almost 200 basis points alone. The widening in global high yield spreads also occurred despite limited high yield issuance during July, in contrast to Canadian investment grade markets. Defaults also rose marginally to 1.92% (based on trailing 12-month par values) during July, although this default rate remain well below long-term historical averages.
Finally, we continue to see further deterioration in liquidity across the Canadian corporate credit complex. Bid-ask spreads on less liquid off-the-run and higher beta names have widened as much as 10 basis points. Furthermore, providers of conventional electronic liquidity have become notably more cautious. We continue to reiterate this liquidity issue to clients and investors – and position our portfolios accordingly – as the divergence between real and perceived liquidity in corporate bond markets will only reveal its true extent during periods of market distress.
Outside of Canada, investors have had plenty of “distractions” during July. Risks surrounding a Greek default and exit from the European Monetary Union escalated into a referendum in early July, but then abated as an agreement, following concessions on both sides, was finally reached. Chinese equity markets also stabilized mid-July, but only after a 35% correction off their highs, further monetary policy easing, and significant direct government interventions in asset markets. The latter of these two is arguably the more important factor as both a signal and a potential source of weakness in the Chinese real economy.
We nonetheless describe the above exogenous factors as “distractions” because they have diverted the focus of capital markets away from arguably the far more significant global event: the start of an interest rate tightening cycle from the US Federal Reserve. This follows an unprecedented seven year period of near zero interest rates. The FOMC also gave us “some” inkling during their 29 July FOMC meeting that they are getting closer to the much anticipated lift-off date, and this has been followed up in early August by important comments from Fed centrist Lockhart that are supportive of a September lift-off.
Obsession over the timing of the first US rate hike, however, masks the far more perplexing question around the pace of policy normalization. For context, there are 10 US Federal Reserve meetings between now and the end of 2016. Fed Funds futures are pricing a 70% probability of four (or fewer) rate hikes by the end-2016. This is an incredibly modest pace of tightening, compared to historical patterns that have averaged 25 basis points per meeting. Getting the call right on this pace of tightening is also far more important than the simple timing of the first rate hike.
Although we think the Federal Reserve will be particularly cautious when raising interest rates, there appears to be a lot more downside risks priced into the market in terms of an economic deterioration and/or a prolonged pause in the Fed’s tightening cycle, with very limited upside risks. Our view on the US economic recovery continues to be a significant factor in our interest rate outlook, offsetting weakness that we are seeing elsewhere in global and emerging markets.
This LW Perspectives article was prepared by the fixed income group at Leith Wheeler Investment Counsel.
This article is not intended to provide advice, recommendations or offers to buy or sell any product or service. The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice. Forward looking statements are based on our assumptions, results could differ materially.
© 2017 Leith Wheeler Investment Counsel Ltd. All Rights Reserved.
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