Relatively Stable April

While there are clearly risks lurking beneath the surface, financial markets exhibited a degree of relative stability overall in April after a tumultuous couple of weeks in March. That said, the intraday volatility continues, particularly in the rates market and the financials sector of the equity markets, highlighted by renewed US regional banking turmoil to start the month of May. Investors appear to be grappling with fears that even in the absence of a banking system collapse, the tightening in lending conditions resulting from regional bank dislocations may push the US economy into a deeper contraction. Balancing those concerns somewhat have been generally stronger than consensus Q1 earnings, moderating but not crumbling economic data and expectations Fed policy is now on a conditional “pause”. The S&P 500 rose ~1.5% on the month and is up over 9% YTD. The Nasdaq was flat MoM but rallied 17% YTD, while the S&P/TSX gained almost 3% MoM and 7.5% YTD. Thus, despite the headline risks in the financial sector, equity markets have performed well. In our primary market of focus, after yields dropped significantly in mid-March, they remained range-bound in April. The Canadian Universe bond market rose 1.0% on the month (Chart 1) and is up 4.2% YTD.

Chart 1:

Source: FTSE/Russell; Bloomberg

As you can see from the chart above, since the start of 2022, monthly total returns in the Canadian bond market have had difficulty building any sustained positive momentum. So far this year however, it has been a more constructive environment for fixed income markets, with returns for the broad Canadian bond market posting in the “green” 3 out of the last 4 months.

Over the month, YTD and 1-year, Canadian Federal bonds returned 0.6%, 4.1% and 2.0%, respectively and -4.87%, respectively, while the overall Universe Bond Index returned 1.0%, 4.2% and 2.5%, respectively. Corporate bonds outperformed their government counterparts in April, returning 1.4% on the month, 4.2% YTD and 3.7% over the past year. Provincial bonds rose 1.1% on the month, 5.0% YTD (thanks to their longer average term-to-maturity and thus higher sensitivity to changes in yields) and 2.2% over the past year.

Rates Markets

As mentioned, North American yields have shown a greater degree of stability in recent weeks. In April the bell-weather UST 10-year yield traded in 30 bps range between 3.30% and 3.60%, ending the month at 3.43% - just 6 bps higher on the month. Note, this yield hit a recent peak of 4.06% in early March.

The “fireworks” in the rates markets continues to be focused at the front-end of the yield curve. Yet even in shorter-dated maturities, while the day-to-day volatility remains historically high, the overall movements in April have seen calm restored after the wild gyrations in March. The UST 2-year yield finished April at 4.01%, having trading in range between 3.78% and 4.25% throughout the month (Chart 2). While this near 50-bps range is still relatively large, it pales in comparison to the 150-bps intraday swing witness over the 3 days following the SVB collapse – note the UST 2-year peaked at 5.1% in early March.

Chart 2:

Source: Bloomberg

Domestically, the Canadian benchmark 10-year yield has followed a similar path, at least directionally. The GOC 10-year yield finished April at 2.84%, down 6-bps MoM, with an intramonth trading range of 2.77% to 3.10%. Note the recent peak in this yield was 3.47% in early March.

While you would expect the two North American rates markets to trade in similar directions, what has been somewhat surprising recently, is that the Canadian market has outperformed during market rallies amid the banking sector turmoil and underperformed as stability returned and yields retraced some of their move higher. The GOC/USY 10-year yield spread retested its recent low of -0.80% during the SVB collapse but has since moved back to the -0.5% area as UST have outperformed (Chart 3). That relationship remains within its recent -0.4-0.8% range, but from a longer-term historical perspective, the Canadian market looks expensive. Near-term relative performance between the two markets will likely be driven by the market’s expectations on which central bank will be the first to cut rates now that both appear to be on hold.

Chart 3:

Source: Bloomberg

At their policy setting meeting in early May, the Federal Reserve delivered a further 25-bps rate hike, as was broadly anticipated. What held greater intrigue for investors was any indications from the Chairman on the future path of monetary policy and if in fact the central bank was prepared to signal its willingness to “pause” additional tightening. In what many have described as a “hawkish pause”, Chair Powell did just that, contingent on the economy evolving in line with their forecasts. Powell also stressed that the Fed would not hesitate on additional rate hikes if they deemed them necessary. A “conditional pause” as it were. His hawkish was expressed in continued concern on the level and persistency of core measures of inflation. This led to his characterization that the current inflationary environment was not consistent with rate cuts this year. The “higher for longer” scenario those comments entail continues to be at odds with market expectations, as investors continue to look to monetary policy accommodation sooner than the Fed has indicated – a consistent dynamic over the past year. The potential impacts of the stresses within the banking sector on financial system stability and associated increased probability of recession, have seen policy expectations (and bond yields) lowered materially over the past month. Prior to SVB et al. market participants were generally of the view and the US terminal policy rate would likely fall in the 5.75%-6%, with upside risks. As a result of the banking turmoil, the effective terminal rate is now expected to top-out where it is currently at 5.125%. Essentially 75-bps of additional tightening has now been walked back, thus while the central back did raise rates in May, the overall magnitude of tightening they are likely to implement is now notably lower than a month ago – thus you could argue that “accommodation” has already started. Further, as you can see in Chart 4, expectations are for the Fed to cut rates by ~100-bps between now and early-2024. While mounting financial sector stress and a resulting “hard landing” of the economy could certainly make those expectation come to fruition, the Fed’s guidance and the economic data thus far have yet to convince us that this is the base-case.

Chart 4:

Source: Bloomberg

Therefore, with most yield levels across the curve well below policy rates, it does appear that further declines in bond yields will be limited. That said, with inflation expected to continue to moderate and bank sector risks ongoing, upward pressure on yields also appears limited, Thus, in the near-term, we look for bond yields to remain range-bound (3.25%-3.75% for UST 10-year yield) until we get further clarity on the impacts from tighter lending conditions and evolution of core inflation.

Rates positioning: (i) neutral duration; (ii) neutral yield curve exposures; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada but reducing that position on opportunity

Credit Markets

There is an old adage that bigger risk events are not the ones you see coming, but the ones that hit you in the back of the head! That’s certainly how we felt as the first few dominoes in the regional banking saga fell quickly, and risk assets reacted accordingly in March. Credit spreads, which had built up reasonably positive momentum early in the year, widening materially as risk aversion took hold of markets. The Cdn IG corporate bond spread started the year at 162-bps above underlying Government of Canadas, having widened approximately 50-bps over the course of 2022 (Note: the pre-pandemic tight was 88-bps). This spread rallied to the low-140’s in February, as corporates outperformed. The SVB collapse cause the spread to widen over 20-bps in a matter of a week, retracing all the good work that had been done earlier in the year. Canadian corporate risk premium has since improved by about 15-bps has markets have stabilized, and currently little changed YTD, and about 20-bps inside of their 2022 wides (Chart 5).

Chart 5:

Source: Bloomberg

While some degree of confidence and calm has returned to credit markets in April, the resurgence of regional bank concerns in early May highlight that risks remain. Lending standards had already begun to tighten, and lending volumes had started to slow even prior to the banking turmoil. These trends are expected to accelerate in light of recent events. This likely increases the probability of recession, pulls forward its timing and at the margin increases its expected severity. That said, I don’t believe the macroeconomic fundamentals are all doom-and-gloom. The US unemployment rate is currently 3.4%, matching its post-war low. US Non-farm Payroll have increased on average by over 220,000/month over the past 3-month. While this measure has steadily declined for unsustainably high level, it still points to solid employment growth. There remains almost 9.6mn job openings in the US – yes this is down from a peak of 12mn, but still represents 1.7 job openings-per-unemployed person in the economy. Average hourly earnings in April were up 4.4% YoY, again down from a recent peak of 5.9%, but still very solid. Strong labour markets, solid wage gains and continued excess saving should all provide support to consumer spending. Overall, while economic activity is expected to slow further, and could ultimately contract, a severe downturn is not our base case scenario.

What has also been lending support to credit markets recently has been investor optimism that central banks in North America are likely finished with their tightening cycles. The Bank of Canada had already paused their rate hikes, and the Fed signaled at their May meeting that their preferred policy path was also a “conditional pause”. If there will soon be no Fed to “fight” perhaps less-challenging times are ahead! While the market is perhaps looking at most potential catalysts through rose-coloured glasses, with the majority of the monetary tightening behind us; inflation in most developed markets already moderating, labour markets remaining buoyant and consumer balance sheets healthy, perhaps the sky won’t fall as far as most expect. We believe that both macroeconomic and credit fundamentals will remain constructive over the next 1-2 quarters, with overall economic activity and earnings still well supported. Beyond that horizon, the outlook appears less clear.

In addition to resilient macro and credit fundamentals, supply and demand technical factors have been a primary driver of the better credit market performance in recent weeks. Simply put, demand has been very strong to start the year. Factors including short investor positioning, bearish fatigue from last year, less headwinds from central banks, high cash holdings to be put to work, asset allocation shifts in fixed income – all of which have contributed to reasonably steady demand despite all the negative headlines. That said, confidence has certainly been shaken by the ongoing dislocations in the regional banking sector in the US. In contrast, the supply side of the equation has underwhelmed both demand and expectations. While picking up pace somewhat recently, the supply calendar has been lighter than most market participants had expected. There was very little supply to end last year and there appears to be increasing concern that the overall level of supply this year will be lower than the market’s needs, fueling heightened FOMO concerns and increasing demand from the credit investor-base – again despite some nervousness over the outlook. So based on the fundamental and technical backdrop, there are reasons to believe that the market could solidify its recently found firmer footing over the near-term.

The medium-term outlook, however, still appears to warrant caution. Inflation is still running almost 4x higher than central bank targets. Central banks have been clear on their focus and commitment to bringing prices down. Therefore, while rate hikes appear to have stopped, at least for now, rates will likely remain higher for longer. Not to mention the lagged impacts of the most aggressive tightening cycle since the early-1980’s. This creates greater uncertainly associated with the removal of policy stimulus that will result in greater volatility in risk premiums this year. In short, tail risks have risen. Looking into next year, growth is expected to moderate, perhaps sharply – leading indicators such as global PMIs and housing have already rolled over, yield curves have flattened significantly, and margins and earnings are starting to face greater headwinds. One of the drivers of the better risk sentiment we have seen recently has been the better-than-expected earnings. Investors have been buoyed by the fact that revenues and margins on aggregate held-in stronger than many feared. The problem however, in my view, is that top-line growth was supported by companies’ exercising pricing power in a strongly inflationary environment. It will be much more difficult to repeat those price increases going forward, thus putting downward pressure on revenue and earnings growth going forward. The challenges that tighter monetary policy presents for growth will undoubtedly create headwinds to earnings and profit margins and likely upside pressure on risk premiums. Therefore, the overall fundamental environment for credit will likely suffer from both weaker macroeconomic growth and weaker income and balance sheet metrics. In absence of any improvement in forward-looking macro fundamentals, we continue to exercise caution via a higher quality bias in our corporate bond holdings.

While we believe that the combination of constructive credit fundamentals and strong investor demand will keep spreads supported in the 1st half of the year, current valuation levels could present a challenge later in the year. As we have pointed out in the past, spreads at or slightly above 150 bps have proven to be attractive risk/return entry points in non-recessionary periods (Chart 6) but that during recessions, spreads have moved materially wider than that key level. Credit spreads in both markets are now tighter than what would be reasonably expected if we see a meaningful slowdown in economic activity and thus further spread compression is likely limited. While constructive on credit near-term, we remain concerned over the weakening macro fundamentals as we move later into the year. Should we gain higher conviction that the economy will avoid recession, we will look to further add credit. Conversely, should we get more concerned over the potential for a policy-induced economic contraction, we would look to reduce risk in the portfolio. At present, we would argue that valuations are not consistent with a recessionary scenario.

Chart 6:

Source: ICE/BofA; Bloomberg

Credit positioning: (i) overweight credit; (ii) maintain a quality bias in favour of IG over HY, and more defensive credits within IG; (iii) overweight Cdn corporates, underweight US.