Following the heightened volatility experienced earlier in the summer, market activity was fairly subdued in August; most assets traded in fairly tight ranges, as investors waited for policymakers to deliver further signals on potential changes to monetary and fiscal stimulus programs. Movements in global government bond markets were mixed; yields fell in the UK and Australia after central banks in both countries took steps to further stimulate their economies, while rates increased in most other markets on heightened speculation that the US Federal Reserve is moving closer to hiking rates again. Global investment grade and high yield credit spreads generally declined; in Canada, corporate spreads modestly tightened, while provincial spreads widened. Riskier assets performed well, with emerging market equities and energy prices leading the rally.
Ongoing concerns over the state of their domestic economies prompted policymakers in the UK, Australia and Japan to undertake additional easing measures during the month. Even as UK economic data released in August proved better than expected, continued uncertainty over the timing of Brexit negotiations and the potential impact on the UK economy prompted the Bank of England to both cut its policy rate by 25 basis points to 0.25% and introduce further quantitative easing; expanded easing measures include additional purchases of both government and corporate bonds and the launch of a term funding program for commercial banks. In Japan, rising concern over stagnating growth and the recent drop in headline inflation below zero led Japanese Prime Minister to introduce a ¥28 trillion stimulus package – that includes just ¥7.5 trillion in new spending – in an effort to boost domestic demand; while the fiscal package underwhelmed investors, Bank of Japan governor Kuroda also signaled that the central bank is prepared to introduce additional monetary stimulus to boost activity. Finally, in Australia, the Reserve Bank cut its overnight rate by 25 basis points to a record low 1.5% amid concerns over softening activity and the recent strength of the Australian dollar.
While US economic data releases were mixed during the month, most indicators continued to suggest growth in activity remained steady, if somewhat lackluster. Job gains and wage growth remained solid – non-farm payrolls rose by 255,000 – and the housing market continued to expand, with both new home construction and sales increasing; offsetting this strength, second quarter annualized real GDP growth was revised lower to just 1.1% quarter-over-year. With no US Federal Open Market Committee meeting in August, investor attention was focused on a number of comments from Federal Reserve officials suggesting that additional rate increases are likely; of particular focus was Governor Janet Yellen’s speech at the annual Jackson Hole Economic Policy Symposium, where she said “I believe the case for an increase in the federal funds rate has strengthened in recent months”. Markets responded to these comments by raising the probability of at least one fed funds hike in 2016 to 60%, up sharply from the 10% probability at the end of June following the UK Brexit vote.
Canadian data released during the month was generally softer than expected. Statistics Canada announced that second quarter real GDP declined by an annualized 1.6% quarter-over-quarter, with much of the weakness related to the wildfires in Alberta; with trade volumes – both resource and non- resource – down, the trade deficit reached a record high of $3.6 billion and the current account deficit rose to 3.4% of GDP. Labour markets also softened, as employment fell by 31,200 in July, pushing the jobless rate to 6.9%. Headline inflation fell to 1.3%, while core inflation remained steady at 2.1%, close to the Bank of Canada’s 2% target.
Policymakers in core developed markets – especially in the Eurozone and Japan – continue to grapple with the deflationary impact of large debt overhangs in the aftermath of the bursting of the credit bubble, even as investors become increasingly concerned about rising geopolitical risk and the potential market and economic impacts of the eventual unwinding of the current unprecedented levels of monetary stimulus. In emerging markets, growing political uncertainty, a downward shift in secular growth rates and the sharp decline in commodity prices over the past several years have increased the vulnerability of many emerging economies to the renewed spikes in market volatility as the US Federal Reserve waits for opportunities to cautiously continue with its first tightening cycle in a decade.
While global economic activity has been weak, current signs of recovery suggest momentum will increase in coming quarters; despite this, growth is likely to remain below levels that have historically been seen at this point in the recovery cycle and that would be expected given the extraordinary level of monetary stimulus. In developed markets, the pace of activity will be mixed: the drop in energy prices since 2014 will continue to benefit commodity importers – in the coming year, real GDP growth will likely approach 2.5% in the US, while reaching close to 1% to 1.5% in Japan and Eurozone as increased stimulus is dampened by ongoing structural challenges and the near term impact of the UK’s Brexit vote – while continuing to weigh on commodity exporters – real GDP in Canada and Australia will expand by around 1.5%, with Canada’s energy sector facing near-term headwinds from the devastating wildfires in Fort McMurray – as weaker currencies have been slow to provide significant offset to the underperforming resource sector. In emerging markets, growth rates will also be uneven, with activity in commodity importing countries outperforming that in commodity exporters; importantly, growth in the Chinese economy will further decelerate to a still-strong 5% to 6% pace, as policymakers continue to shift from an export and investment driven growth model to one more reliant on consumption and services.
With most developed market policy rates at or below zero, major central banks have continued to use a variety of tools – both conventional and non-conventional – in an effort to combat deflationary pressures. While the Federal Reserve is set to continue cautiously raising rates in the coming year, the Bank of Japan, the European Central Bank and now the Bank of England have adopted more aggressively stimulative policy stances – despite the uncertainty and potential adverse effects of the unconventional measures that have been implemented – suggesting global liquidity will remain high for some time. In this environment, bond yields in core developed markets are likely to remain below levels that have typically corresponded with underlying economic fundamentals.
In the US and globally, volatility across asset classes is expected to climb higher, as investors have been forced to confront rising political risk – including the unexpected outcome of the Brexit vote and November’s increasingly acrimonious US presidential election – and the Fed’s decision to begin tightening monetary policy in response to important indicators pointing to a US economy that is strengthening. Wage gains have finally moved higher in response to an unemployment rate that remains near the Fed’s 4.7% forecast for 2016 and core inflation that has continued to exceed 2%; consequently, we expect the Fed to further raise rates at upcoming meetings. However, given the deflationary impact of a strengthening US dollar, the central bank can and will be slow and careful in removing stimulus.
While the sharp decline in global oil prices since 2014 continues to negatively impact both the resource sector and broader Canadian economy, energy markets have rebounded from recent lows and should continue to modestly improve in the coming year, as excess supply is reduced by production cuts and global demand continues to grow at a solid pace. After three years of steep decline the Canadian dollar has moved higher from the lows experienced in January, but remains highly competitive and should – along with stronger growth in the US economy – help to boost manufacturing and services exports. Following a period of restrained federal spending, the multi-year deficits announced by the new Liberal government will provide a modest fiscal stimulus. While the housing sector remains a key risk, low interest rates and continued employment growth in non-energy producing provinces suggest that overall demand for both new and existing homes should remain reasonably strong and that any downturn in the sector will be limited primarily to Alberta, Saskatchewan and Newfoundland. Even with weakness in the energy sector, business and household credit growth continues to expand at a solid pace, providing ongoing momentum for the economy.
NexGen Corporate Bond Fund:
Gross of fees, the Fund outperformed the FTSE TMX Canada All Corporate Bond Index during the month.
Positive contributors were the overweight exposures to exposure to A-rated financials and BBB- rated utilities. A yield curve flattening exposure, as yields declined in intermediate and longer maturities and a yield carry advantage also contributed to value added.This was offset by shorter than benchmark duration and by the overweight exposure to provincials as interest rates generally declined and spreads widened in that sector. The top contributors to value added were TD Bank, GE Capital and Bank of Montreal while top detractors were Melancthon Wolfe, Trillium Windpower and North Battleford Power.
Net of fees, the Fund slightly underperformed the FTSE TMX Canada All Corporate Bond Index during the month.
In this environment, we continue to favour the following strategies:
- Duration - Monetary policy is very stimulative and yields are still near record lows in Canada. We believe that Canadian core inflation will remain at the 2% level as the economy rebounds from weakness related to oil production outages and performs better than expected over the coming 12 to 18 months. While we are not expecting a substantial rise in yields in the near term, we have positioned the portfolio with a shorter than benchmark duration – in part through holdings of floating-rate notes – as yields remain unattractive at current levels and should move higher with the strengthening global and Canadian economy.
- Yield curve – Markets have become more pessimistic about the state of the Canadian economy, with low shorter term yields currently reflecting expectations for Bank of Canada rate cuts. The portfolio is positioned with a yield curve flattening exposure, as we believe these expectations are excessive and shorter and intermediate term yields will increase more than longer term yields when yields ultimately rise.
- Sector allocation – The portfolio remains underweight corporate bonds and overweight ABS and provincials; within the corporate sector, we continue to favour high-grade financials, BBB-rated utilities and select high-yield issues, while maintaining an underweight to utilities in general and the more cyclical industrial sector.
For more information about NexGen Corporate Bond Funds, please contact your financial advisor.