Capital markets globally roiled in August, primarily fuelled by growing concerns of a more pronounced slowdown in China. The apparent slowdown in China, as their economy rebalances away from an export-orientated economy towards a more consumer-orientated economy, is well documented, but not particularly well understood given the lack of transparency in Chinese economic data. What prompted the renewed focus was therefore not a deterioration in official data, but rather several expected (reductions to lending rates and reserve ratio requirements) and unexpected (modest currency devaluation) policy responses from the Chinese authorities.
First, we would like to add some context around the devaluation in the Chinese Yuan last month. The move in the CNY/USD fix – the midpoint of a +/- 2% band that the Chinese monetary authorities control – was a very modest 4.7% over the three days beginning 11 August, and follows an over 25% appreciation since 2005 when the currency regime shifted from a U.S. Dollar peg to a managed, crawling currency.
Importantly, the Chinese Yuan is also managed against the U.S. Dollar, which itself appreciated against other major currencies, such as the Euro and Yen, by approximately 20% since mid-2014, effectively dragging the Chinese Yuan stronger with it. This is a classic example of the United States exporting its monetary policy to the rest of the world, particularly in China due to the currency linkage and also through extensive U.S. Dollar-denominated borrowings. We have been highlighting this linkage as a significant global financial stability risk to our clients over the past year, alongside significant research on this area from the Bank of International Settlements.
So why did global equity and credit markets respond so viciously? Volatility in Chinese equity markets had already drawn attention to the weakening outlook in China, but the policy reaction, in our opinion, suggested that officials in China believed that the situation was worse than previously feared. Chinese interest in joining the International Monetary Fund’s Special Drawing Rights as an official reserve currency had been viewed as a rationale as to why the Chinese had not already devalued, which added to the importance of last month’s decision. And finally, this devaluation occurred at a time of heightened market sensitivity as the United States approaches the first tightening cycle in roughly a decade, and during the trough of liquidity due to the summer holiday period.
Fixed income markets were far more immune to volatility than equities, although bonds offered little protection against the equity market correction. The FTSE TMX Canada Universe Bond Index returned -1.0% to investors during August 2015, due to both higher government bond yields and spread widening. The typically negative correlation between government bonds and equities broke down, as both U.S. and Canadian government bonds sold off by 5-10 basis points alongside equities during the month, despite the turmoil in equity and credit markets.
The main driver of broad fixed income markets has and will continue to likely center around the timing of rate hikes in the United States. In this regard, Fed communications in August (both in terms of the minutes and subsequent speeches) have done little to provide clarity in this regard. Fed Funds futures are currently pricing in approximately 30% chance of a rate hike in September, and almost 60% chance that they hike rates before year-end. We continue to think that the Fed will start to normalize interest rates this year, but would prefer to steer conversations away from the timing of the initial hike; the next meeting is scheduled for 17 September, which is starting to seem very close given the absence of more “forward guidance” from the Fed. October doesn’t have a “scheduled” press conference although the Fed has opened the door to an unscheduled press conference if warranted. Starting a rate tightening cycle in December as markets enter a period of illiquidity is viewed by many, including ourselves, as sub-optimal for the first U.S. rate hike in a decade. The more important factor, however, continues to be the pace of tightening, and if market volatility and global policy actions in August are any guide, we are likely in for an unprecedentedly slow and patient tightening cycle from the Fed.
Local Canadian fixed income markets took a relative back seat to global market volatility during the month, but nonetheless it is important to acknowledge that some of the hard economic data has marginally improved. Canada’s June GDP data broke a five month streak of negative growth, most notably due to the improvement in the trade balance.
While it would appear that significant currency weakness is starting to have a positive effect both on non-energy export volumes and consumption patterns (substituting domestic goods for imports), we would prefer to see several months of robust trade balances before drawing more significant conclusions of a structural shift in the Canadian economy. However, we are now officially in a technical recession in Canada, and alongside market volatility it will be interesting to see how Canadian consumer behavior responds. We continue to think we are in the early stages of a commodity-driven adjustment in the Canadian economy, with recession headlines likely to further dampen consumer activity, but the contribution from consumption in the recent June GDP would suggest minimal impact to date.
Canadian credit markets traded particularly weak in August. In fact, Canadian corporate bonds have seen deeper monthly losses only once since June 2013. The bulk of the weakness is originating from the BBB-rated space, due to rising outstanding BBB-rated debt levels and the downgrade of Enbridge ahead of a significant expected issuance pipeline – yields on Enbridge bonds maturing in 2022 rose over 30 basis points during August to their highest level since mid-2014. Meanwhile for comparison, credit spreads on bank deposit notes, which are where we have predominantly focused our corporate overweight in core funds, were only approximately 8-10 basis points wider during August.
High yield bond markets suffered larger losses during August, but significantly outperformed equity markets. By rating, higher quality names clearly outperformed and our High Yield Bond Fund’s focus on BB and B-rated over CCC-rated debt benefited as a result. The main underperformance came from energy names, which we have also largely avoided in our portfolio. High yield mutual funds and ETFs experienced outflows of US$5.0bn in the month, according to Lipper, and overall U.S. High Yield issuance during August slowed to just US$10.1bn.
Our outlook for capital markets remains broadly unchanged during August. In addition to running a near neutral duration position, we have been positioning our fixed income portfolios more conservatively since mid-2014, with the lowest corporate credit risk in over 5 years in anticipation of some spread widening events. As a result, we believe our fixed income portfolios are now well-positioned to take advantage of opportunities as credit markets reprice.
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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