Even though inflation remained extremely high on a historical basis, there were signs in recent economic data suggesting a possible peak in inflation.
On the economic front, Canadian real Gross Domestic Product (GDP) rose at a 3.3% annual rate in Q2, far below the 4.4% expected by the consensus and by the 4% forecasted by the Bank of Canada in its latest Monetary Policy report (MPR).
Given the macroeconomic picture, the U.S. Federal Reserve Board (Fed) has pledged to keep interest rates high to ensure inflationary pressures don’t rebound and inflict further economic pain. Rates may continue to rise, but possibly at a less aggressive pace than in recent months.
In fixed income, the FTSE Canada Universe Bond Index is down -1.15% so far in Q3, which brings the Year to Date (YTD) performance to -11.3%. The rally midway through the quarter was short lived as central banks removed any notion that they are easing up on their plans for future interest rate increases. Canada’s nominal interest rate markets are facing material inversion (i.e., the yield on short-term bonds is higher relative to intermediate (5-10 year) and longer-dated (10+ year) bonds. The level of inversion at certain points along the yield curve is at (or near) record levels in historical terms, indicating that a recession could be on the horizon. Credit spreads also gave back much of their gains with the general weakness in risk assets.
Outlook and challenges
Financial markets have put the pandemic and Ukraine war on the backburner and are now squarely focused on the prospects of a recession. The weakness in housing markets and manufacturing orders relative to inventories is an indicator of an economic contraction ahead. Weakness in commodity prices such as lumber, copper, and fertilizers point to an eventual easing of inflation numbers. With consumer sentiment at record lows, we have to acknowledge that inflation is having an impact on spending intentions.
Given current macroeconomic conditions, our fixed income strategy is to optimize our holdings in provincial and corporate bonds – all else being equal – to capitalize on the “slope” of various credit curves that persist in Canadian fixed income markets. The credit term premia being offered to investors may enhance returns despite the inversion in nominal federal government yield curves.
We believe the ownership of provincial and corporate bonds at targeted maturity points may produce excess return over the medium term. We constantly evaluate provincial and corporate bond credit curves to enhance risk-adjusted returns.
Individual corporate securities also provide interesting opportunities, with some of the bank bonds offering yields above 7%. We expect that most of the increase in long bond yields is behind us as central banks have shown a strong commitment to bringing inflation back down to their target levels, irrespective of the economic consequences. We are now seeing supply pressures ease and leading economic indicators pointing to weaker growth which will translate into lower inflation and interest rates.
There is a greater than normal level of uncertainty surrounding our assessment of the market risks, but we would note that a large proportion of risks seem to be reflected in the market. More restrictive monetary and fiscal policy is well telegraphed, the dire energy situation and military conflict in the Eurozone, and the problems in China are all well understood and reflected in the dire investor sentiment.
Ultimately, we expect that our rigorous security selection process will, in the long term, provide investors in our strategy with superior yields without undue default risk, which should translate into potentially above market returns.