Summer Volatility

On a recent outing to Canada’s Wonderland my young nephew fainted on one of the roller coasters, presumably out of fear and anxiety. Most investors would be forgiven for doing same after what has been an historically painful first half of the year. Unfortunately, the financial market roller coaster only appeared to pickup pace in June, particularly in the bond market, where we saw yields at a number of points across the curve experience a 160+ bps round-trip ride over the over of the last month (Chart 1).

Chart 1:

Source: Bloomberg

From May 30^th through the recent peak in yields on June 14^th, the Canadian bond market declined ~5%, only to then recover over half of those loses by month end. That still left the broad Canadian bond market down over 2% in June, marking the 6th consecutive month of losses. As we have noted recently, a losing streak of this magnitude is something investors haven’t suffered through in decades – an analysis from Deutsche Bank has said this has been the worst start to a year for the 10-year UST since 1788! To put the first half returns into a more recent context, the loss has been more than 4 standard deviations below the mean since the lead up to the GFC (Chart 2). Most North American equity indices were down mid-to-high single digits on the month, as the year-to-date selloff intensified.

Chart 2:

Source: FTSE/Russell; Bloomberg

The primary pain point for financial markets continues to be elevated, persistent inflation, central banks’ reaction functions to it and impact that will have on economic growth. Expectations for the most aggressive rake hike cycle since 1994, and the tightening financial conditions associated with it, have already proven to be a significant headwind to markets and this will likely continue in the coming quarters. For most of the first half of this year, market sentiment was focus on “slowflation” concerns, where growth was expected to slow, albeit remain positive, while inflation would persist. This has proven to be a painful combination for almost all asset classes, with no where to hide for most investors. Market sentiment has shift quickly in recent weeks, as evidenced by the rise and fall in government bond yields, to concerns over the potential for recession. Investors now perceive the risks that central bank tightening will significantly damage the economy to have risen substantially, as evidenced by the acceleration in equity market declines. One of the few, small sliver linings from this recent shift in sentiment has been the rally in yields. Negative growth and associated moderation in inflation that would be expected during a recession is a positive combination for few asset classes, however government bonds would be one that should perform well that environment. This implies that the traditional 60/40 balanced portfolio should perform better than it has so far in 2022.

After all the aforementioned volatility in June, the bell-weather UST 10-year yield rose modestly on the month to 3.02%, up 17 bps month-over-month. YTD the yield has risen 152 bps – recall it rose only ~60 bps in total last year. In Canada, our 10-year GOC yield rose 33 bps on the month to 3.22% and has risen 179 bps YTD. Thus, the Canadian market underperformed the US market in June and over all for the first half of the year.

Over the month and YTD, Canadian Federal bonds returned -1.75% and -9.47%, respectively, while the overall Universe Bond Index declined 2.18% and 12.23%, respectively – again, one of the weakest periods since the early 1980s. These results further pushed their returns over the past year into the “red”, with returns of -9.18% and -11.39%, respectively. Corporate bonds slightly outperformed their government counterparts in June, returning -1.53% on the month, -10.97% YTD and -10.13% over the past year. With their longer average term-to-maturity, Provincial bonds continue to be the worst performing sector on average, falling -3.10% on the month, -15.62% YTD and -14.32% over the past year.

Rates Markets

The benchmark UST 10-year yield endured a sharp selloff during the first half of June, with its yield spiking to a post-2018 high of 3.50% after reaching a low of 2.74% on the second last day of May. The yield declined quickly for there however, rallying to finish the month just above 3%. After dropping in early stages of July, at the time of writing, the yield is again trading near the 3% threshold. Bond market volatility has remained elevated by historical standards as is approaching its pandemic crisis highs (Chart 3).

Chart 3:

Source: ICE/BofA; Bloomberg

Domestically, the Canadian benchmark 10-year yield had a recent trough to peak increase of 85 bps to reach over 3.6% in early June – its highest level since 2011. The end of Q2 saw the yields decline quickly to finish June at 3.22% (Chart 4). This represented an overall rise of ~33 bps on the month, thus underperforming the US market. At present, the GOC 10-year yield is little changed so far in July.

Chart 4:

Source: Bloomberg

With the outlook for policy in Canada and the US having converged over recent quarters, so too have longer-term yields in the two markets. GOC/UST 10-year yield spread has been trading in a narrow range for much of 2022. In June the spread widened to highest level of the year as GOC bonds failed to keep pace with UST during the rally into quarter end. We would expect the recent divergence in policy expectations for the two central banks to be short-lived, with Canada recovering some of its recent underperformance. This should see the 10-year yield spread return to it -10 bps to +10 bps range (Chart 5), but for now Canada looks attractive from a relative valuation perspective.

Chart 5:

Source: Bloomberg

After a 40-year secular decline, inflation in North America has been well anchored around 2% for much of the last decade. In fact, most developed market central banks have been more concerned with the risk of deflation rather than inflation for most of the post-GFC period. Clearly much has changed over the past two years and with price measure at their highest levels since the 1980’s and policy rates only recently moved off their zero lower-bound, central banks are clearly playing catch-up. Despite the Federal Reserve and the Bank of Canada being consistent in their commitments to do whatever it takes to control inflation and return to it to levels consistent with their longer-term targets, i.e., 2%, we have seen a dramatic reduction in policy expectation in the markets. Following the much higher than expected CPI report for May, the market was discounting that Fed Funds rate would reach 4% by early 2023. Today the market expects the policy to top-out at 3.5%. Further, the rate is now expected to decline, i.e., rate cuts, to below 3% by the end of 2023 (Chart 6). The interpretation is that by quickly taking policy rates above “neutral (2.25-2.5%), however briefly, central banks will trigger a material slowdown in growth, likely into recession. This will require policy maker to make a swift “about face” and cut rates in short order in order to support the economy. Thus, the current policy expectation curve is flashing a “warning sign” for growth in the near term, which has been supportive for yields further out the curve.

Chart 6:

Source: Bloomberg

The dramatic and quick repricing of expectations has placed significant flattening pressure on yield curves in North America. A number of different segments of the yield curve have re-inverted in recent weeks and are at or near their lows for the year (Chart 7). As such, some of the market-based recession signals are starting to “flash” more brightly at present and we will be monitoring them closely over the next few months.

Chart 7:

Source: Source: Bloomberg

From a macroeconomic perspective, the focus over the first half of 2022 has been on inflation. Pricing pressure have remained stubbornly elevated well above central bank’s comfort levels. “Transient” has been replaced by “Persistent” in the Fed’s lexicon. Growth, while showing cracks, also remained strong in early 2022. The combination of the highest inflation rates since the 1980’s and strong, albeit weakening growth, is challenging environment for bonds and with it we have seen considerable upward pressure on bond yields through mid-year. As we start the second half of the year however, the inflation narrative appears to have shift to one focused on the growth, or lack thereof, outlook. With global central banks now expected to remove their pandemic-induced monetary stimulus at the quickest pace since 1994, markets are growing increasingly concerned this will inevitably result in recession. A 200bps spike in US 30-year mortgage rates are starting to negatively impact the housing market, high inflation is acting as a “tax” on household spending, which has dented consumer confidence, and leading indicators such as PMIs have rolled over. Further, market-based recession indicators such as the shape of the yield curve are also point to heightened recession risks over the next year. That said, employment growth continues to be strong as people re-enter the labour force and strong labour demand leads to higher wages. Secondly, household balances remain strong and income growth has been solid, providing tailwinds to consumption. Overall, with inflation measures still to have convincingly peaked, there maybe some near-term risks to higher yields. However, with an expected slowdown in growth and moderation in inflation rates in the second half of the year, there is a reasonable chance we have already seen the peak in bond yields for this cycle. Given our near-term expectations that yields will move higher in the short-term, we have positioned the Fund with less interest-rate risk than its benchmark. However, we would use any backup in yields to add back duration given the cloudy forecast for growth.

Rates positioning: (i) modest duration underweight; (ii) neutral yield curve exposures; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada

Credit Markets

Headline inflation in most developed markets is running more than 4x higher than central bank targets. It is obviously not surprising then, that central banks have been clear on their focus and commitment to bringing prices down. Even banks with so-called “dual mandates” that set out both inflation and employment targets will say that inflation takes priority. Most major global central banks are “behind the curve” and as a result have had to signal a more aggressive path towards the removal of monetary stimulus. Ideally, they would be able to raise rates enough to cause a moderation in inflation but not so far as to push the economy into recession. Historically this has been a difficult balancing act and with inflation running at multi-decade highs and showing uncomfortable persistence, the risks that central banks will be forced to prioritize inflation at the cost of an economic downturn are rising. This uncertain environment will likely continue to present headwinds to risk assets. The challenges that tighter monetary policy presents for growth could create downside pressure on earnings and profit margins and conversely upside pressure on risk premiums. While recession over the next year is still not our base-case scenario, the risks have certainly risen with the Fed’s acknowledgement that they should have raise rates sooner and thus will need to pick up the pace and magnitude of tighten going forward. 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. That said, we believe that both macroeconomic and credit fundamentals will remain constructive over the next 2-3 quarters, with overall economic activity and earnings still well supported. However, as we move towards the end of the year, growth is expected to moderate, perhaps sharply – leading indicators such as global PMIs have already rolled over, yield curves have flattened significantly, and margins and earnings will face greater headwinds in late 2022. Technical factors, such as supply/demand dynamics, in credit market have been pressured in the early part of this year as corporates looked to raise funding before rates moved higher and poor absolute returns in fixed income led to fund outflows from the asset class. Our expectation is that the supply/demand balance should improve over the course of the year as issuance slows. The outlook for fund flows is somewhat less straight-forward, with the underperformance of bonds likely to prompt some asset allocations shift into fixed income, but those could be offset by ongoing exits due to the poor absolute returns. In addition to increasingly growth concerns, a key headwind to credit spreads this year has been to spike in volatility in the rates market (Chart 8). This has created uncertainty amongst credit investors and thus instability in risk premiums. If rates volatility were to subside it could provide some support to risk premiums.

Chart 8:

Source: ICE/BofA; Bloomberg

Finally, credit spreads have widened materially so far in 2022. The average investment-grade corporate yield spread over government bonds in the US started the year at ~95 bps. These risk premiums are now trading close 160 bps. These valuation levels are interesting given that in recent history, in non-recessionary periods, spreads at or slightly above 150 bps have proven to be attractive risk/return entry points (Chart 9). Given the warning signs being signalled by leading indicators and the yield curve, while our near-term base case is that we avoid recession, the tail-risks of such an event have increased. As result, we have a neutral outlook on credit at present and we have yet to add risk exposures are these cheaper valuation levels. Should we gain higher conviction that the economy will avoid recession, we will look to add credit. Conversely, should we get more concerned over the potential for a policy mistake-induced economic contraction, we would look to reduce risk in the portfolio.

Chart 9:

Source: ICE/BofA; Bloomberg

Canadian investment grade corporate bonds fell ~1.5% in May, outperforming government bonds by ~16 bps. Over the past year, Canadian corporate bonds have declined ~10% and have trailed government bonds by ~100 bps. US IG corporates returned -2.354% on the month, underperforming UST by ~1.6%. Over the past year, US IG corporates have declined 13.8% and have lagged government bonds by ~4.4%.

Given rising risks of an economic slowdown or even contraction in 2023/2024 and the forward-looking nature of financial markets, we have further reduced our credit exposures in Q2, having started de-risking in Q1. While the economic recovery should continue to generate growth that is well above potential GDP in the first half of 2022, later in the year growth is expected to moderate and will therefore provide less support for credit in the second half of 2022 and into 2023. Bottom-up credit fundamentals continue to improve but we will continue to watch Management behaviour closely for evidence of more shareholder-friendly activities such as M&A and share buybacks. We will also be monitoring pricing and margin pressures to access potential deterioration in the earnings outlook. Finally, while valuations have cheapened to reflect greater risks to macroeconomic outlook, they are still not in “recession territory” and thus would still have further room to widening if the economy were to slow materially.

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