The third quarter of 2015 was particularly challenging for investors. Fixed income markets provided little offset to the downturn in global equity markets, with bond returns close to flat due to a widening in credit spreads.
The weakness in global markets was primarily driven by a deteriorating global economic backdrop, particularly in emerging markets. In China, the equity market started the third quarter in the middle of what was ultimately a 45% correction, albeit only unwinding the strong returns experienced earlier in the year. In mid-August, the ongoing volatility prompted the Chinese central bank to aggressively ease monetary policy, intervene in domestic equity markets and devalue their currency. The currency devaluation startled global market participants as most expected China to favor currency stability given their desire for the Yuan to be included in the International Monetary Fund’s basket of reserve currencies. The devaluation created downward pressure on other emerging market currencies and upward pressure on the U.S. dollar.
While the U.S. dollar strengthened, commodity prices remained firmly under pressure during the quarter. WTI spot oil prices traded to below US$40 per barrel, sparking renewed concerns over the stability of high-cost oil producers in Canada and other oil producing countries. The continued decline in oil prices also prompted further easing of monetary policy from Canada and other oil exporters such as Norway. Copper prices, normally a barometer for global industrial activity, declined further during the third quarter to multi-year lows.
In our view, market participants have become overly pessimistic about the emerging market slowdown and signs that developed market economic growth may have started moderating somewhat. We have seen some softening in forward-looking survey data in the United States and a downshift in the pace of employment growth. However, we remain optimistic on the overall strength of the U.S. economy. The negative effects of a stronger U.S. dollar on exporters should be more than offset by the positive boost to U.S. consumers from lower oil prices. The housing market continues to exhibit signs of strength, and the labor market improvement – although moderating – continues to be in relatively good shape. In fact, our view remains that the U.S. labor market is likely to tighten over the coming year in response to the encouraging and ongoing decline in the unemployment rate, which should eventually provide upward pressure on wages and inflation.
In Canada, recent economic data has shown some tentative signs of improvement. Following five consecutive monthly contractions the economy returned to growth in July and August. Importantly, some of that growth was driven by a rebound in non-energy exports, which appear to be benefiting from a weaker Canadian dollar. The Canadian labor market also appears to be having a solid year, despite concerns about job shedding in the oil sector. This strength in the labor market helps explain some of the resilience in the Canadian household sector, where consumption has yet to be materially affected by declining oil prices.
Despite the positive signals we are seeing domestically, there continues to be risks to our outlook. Canadian household indebtedness, as a percentage of disposable income, is at new all-time highs. This is an ongoing risk to financial stability in Canada. Given the accompanying decline in Canadian corporate profitability, we continue to monitor the labor market very closely for signs of more broad-based job losses for a heavily indebted household sector, that could be a cause for concern in the future.
Canadian government bond yields were broadly lower during the quarter; however, there was significant volatility across the interest rate curve with 4-year yields over 10 basis points higher while 10-year yields almost 30 basis points lower. This curve flattening was largely driven by the rise in short term yields, which unwound expectations of further rate cuts from the Bank of Canada. Interest rate forwards are now pricing only a 15% probability of additional rate cuts from the Bank of Canada, following a modest improvement in Canadian economic data and continued weakness in the Canadian Dollar.
In addition, Canadian government bonds with maturities 5 years and longer broadly underperformed U.S. government bonds, as interest rate markets also repriced the timing and pace of rate normalization from the U.S. Federal Reserve. Furthermore, the existence of relatively higher inflation in Canada runs contrary to both the United States and Europe, and this divergence, we believe, has also driven the underperformance of Canadian government bonds in the longer-dated part of the curve.
Our medium term view continues to be that global bond yields will rise very modestly as the U.S. Federal Reserve starts to normalize monetary policy into 2016. However, we acknowledge the increasing uncertainty around this view and as a result have positioned our portfolio close to neutral in terms of overall interest rate risk.
We do not have a larger active position in Canadian interest rates, because as an active fixed income investment manager, we are of the view that the current interest rate environment presents better risk-adjusted opportunities in credit selection and allocation than in directional interest rate risk. Unprecedented global monetary policy initiatives, an unpredictable Canadian central bank and an approaching inflection point in U.S. monetary policy are all working to reduce the risk-adjusted return profile for duration trades. We continue to monitor macro-economic developments and interest rate markets closely for future opportunities. In the third quarter, our decision to reduce interest rate risk helped to minimize any negative performance impact from interest rate movements.
In credit markets, given our economic outlook, we had positioned our fixed income portfolios at the start of the third quarter with the lowest corporate credit risk in almost five years. The resulting market volatility and spread widening that occurred over the quarter vindicated our view and positioning, and has provided us with an opportunity to start re-establishing credit exposure at better levels.
Credit spreads of bank deposit notes were about 20 to 25 basis points wider over the quarter, while lower rated credit, particularly in the BBB-rated category, was as much as 50 basis points wider. Despite the softness in corporate bond markets, our fixed income portfolio’s corporate holdings added value during the quarter, largely due to their high quality and strong liquidity.
We remain overweight corporate bonds in our fixed income portfolio, with the largest overweight continuing to be in short-dated, senior bank deposit notes, which are both highly liquid and high quality. We also added to and diversified our corporate holdings during the quarter through utilities, non-bank financials and industrials. We continue to be overweight the real estate sector due to its compelling risk-adjusted return profile, focused on short-dated Real Estate Investment Trusts (REITS), where our average term to maturity is approximately 4 years.
In the utilities sector, the downgrade of Enbridge, a large utility corporate debt issuer in Canada comprising approximately 1% of the FTSE TMX Canada Universe Bond Index, at the end of the second quarter, continues to put downward pressure on BBB-rated debt. Enbridge entities (Enbridge Inc., Enbridge Income Fund and Enbridge Pipe) were all approximately 50 basis points wider during the quarter. However, our view is that credit markets are being indiscriminate in their pricing of these bonds. We therefore added to our utilities exposure during the quarter via Enbridge Pipe debt, given its superior risk characteristics compared to the other Enbridge entities.
In the financial sector, we have also selectively added credit exposure to non-bank financial issuers through names such as General Electric, while broadly maintaining our overweight in short-dated, senior bank deposit notes. Our view on General Electric is that its recent restructuring, specifically the sale of financial business units, has resulted in the risk profile of the company General Electric shifting from a financial to an industrial issuer. General Electric Canada also recently received a full guarantee from its U.S. parent, General Electric Company, during the quarter. Our view is that General Electric bonds should therefore trade at tighter credit spreads rather than in-line as is currently the case, with bank deposit notes.
We also participated in high quality new issues that became available at attractive concessions from Canadian National Rail and Bell.
In Canadian provincial credit, we switched from a moderate overweight position to a small underweight during the early part of the third quarter, in response to significant outperformance in provincial credit spreads. The subsequent market volatility and spread widening, including provincial credit spreads, enabled us to re-establish a small overweight in provincial credit later in the quarter at favorable levels.
By province, we have diversified our portfolio’s overweight in Ontario bonds into British Columbia. Our core fixed income portfolio now has a larger overweight in British Columbia than in Ontario. The fundamental credit quality in British Columbia was always better than Ontario, as evidenced by its balanced fiscal position, lower debt/GDP ratio and higher credit rating. The shift in positioning was triggered by a narrowing in the premium on British Columbia provincial bond valuations relative to Ontario, which we used as an opportunity to diversify our provincial credit risk. The portfolio remains underweight Quebec, which at current valuations relative to Ontario continues to look expensive.
Our outlook for Canadian capital markets remains cautious. On balance, we continue to expect further interest rate cuts from the Bank of Canada. Our view is that the impact of lower oil prices has yet to fully reverberate through the Canadian economy. The resilience of the labor market will also likely come under some pressure due to declining corporate profitability. Lower household incomes, combined with potential job losses will be exacerbated by a highly indebted Canadian household sector. The Canadian economy, and in particular non-energy exports, will benefit somewhat from a weaker currency. However, this alone will not be enough to offset the hit to household incomes caused by lower oil prices, due to higher unit labor costs in Canada and the corresponding devaluation in currencies of many of Canada’s trading competitors.
In this uncertain interest rate environment, we think it is more prudent to focus on credit markets, where risk-adjusted returns are higher. As a result, we have cautiously been re-establishing some of our corporate overweight that had been reduced over the past five years. Our economic outlook, suggests we should be cautious about the speed with which we increase our corporate exposure, as we can envision a scenario where credit spreads could widen further. In this way, we believe we are well-positioned to weather this challenging and increasingly volatile market environment.
Looking forward, though, we think ultra-easy monetary policy globally combined with lower oil prices should be tailwinds for the global economy and asset prices. However, ongoing turbulence in capital markets is likely as the global economy adjusts in the aftermath of the commodity supercycle, to the rebalancing of the Chinese economy from exports to domestic consumption, and to the potential for interest rate increases from the U.S. Federal Reserve. Global monetary policy outside of the United States has responded aggressively to offset the pains of this adjustment process, with further easing of monetary policy looking increasingly likely from China, Japan, Europe, and potentially Canada over the next 12 months. However, we are cognizant of the fact that low interest rate policies are also approaching a maximum bound of effectiveness.
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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